INTERMEDIATE
ACCOUNTING
Sixth Canadian Edition
KIESO, WEYGANDT, WARFIELD, IRVINE, SILVESTER, YOUNG, WIECEK
Prepared by:
Gabriela H. Schneider, CMA; Grant MacEwan College
CHAPTER
9
Inventories:
Additional Valuation Issues
Learning Objectives
1. Recognize that the lower of cost and market
(LCM) basis is a departure from the historical
cost principle, and understand why this is
appropriate.
2. Explain various definitions of possible market
amounts that may be used when applying
lower of cost and market.
3. Explain how LCM works and how it is
applied.
Learning Objectives
4. Know how to account for inventory on the
LCM basis.
5. Identify when inventories are carried
regularly at net realizable value.
6. Explain when the relative sales value method
is used to value inventories.
7. Explain accounting issues related to
purchase commitments.
Learning Objectives
8. Estimate ending inventory by applying the
gross profit method.
9. Explain the limitations of the gross profit
method.
10.Estimate ending inventory by applying the
retail inventory method.
11.Explain how inventory is reported and
analysed.
Inventories: Additional
Valuation Issues
Lower of Cost
and Market
Other
Valuation
Issues
What is ‘market’?
Net realizable
value
How LCM works
Relative sales
Application of LCM value
Recording market
Evaluation of rule
Purchase
commitments
Estimation: Estimation: Presentation
Gross Profit Retail
and Analysis
Method
Inventory
Method
Presentation of
Gross profit
percentage
Terminology
inventories
Evaluation of
method
Conventional
method
Analysis of
inventories
Special items
Evaluation of
method
Part 1:
Valuation of Inventories
at
Lower of Cost or Market
Lower of Cost or Market
• The lower of cost or market (LCM) is an
exception to the historical cost principle
• When the future potential of the asset
is less than its original cost:
– Re-state asset at cost to replace (market)
• The loss is charged against revenues of
the period
Lower of Cost or Market
• LCM is justified for two reasons:
– Current assets reported at a value
approximately equal to the amount of cash
they can be converted to
– Matching principle: loss of utility reported
in the period the loss occurred
• LCM falls in line with conservatism
What Is Market?
• CICA Handbook, Section 3030 reflects the
desire to provide a more specific description of
‘market’
• Use of the terms:
– Replacement cost
– Net realizable value (NRV)
– Net realizable value less a normal profit margin
• Net realizable value most commonly used
– All three are acceptable methods
– Method adopted must be disclosed
What Is Market?
• Replacement:
Amount required to obtain an equivalent item
• NRV:
Estimated selling price in the ordinary course
of business less costs to complete and
dispose of the item
• NRV less a normal profit margin:
NRV (as defined above) less normal profit
margin
Possible Market Values
Item
Replacement
Cost
NRV
NRV
Less Profit
Spinach
$88,000
$120,000
$104,000
Carrots
90,000
100,000
70,000
Cut Beans
45,000
40,000
27,500
Peas
36,000
72,000
48,000
105,000
92,000
Mixed Veg.
80,000
The company first decides which definition of
market it will apply to LCM
Final Inventory Value Using NRV
If NRV is chosen and applied on an item-by-item
basis, then:
Item
Historical Cost
NRV
LCM
Spinach
$80,000
$120,000
$ 80,000
Carrots
100,000
100,000
100,000
Cut Beans
50,000
40,000
40,000
Peas
90,000
72,000
72,000
Mixed Veg.
95,000
92,000
92,000
Final Inventory Value
$384,000
Lower of Cost or Market
•
The lower of cost or market may be
applied on a(n):
1. item-by-item basis (as in the example)
2. category basis
3. total inventory basis
•
Whichever method is selected, it
should be consistently applied
Alternative Applications of NRV
Cost
NRV
Item-byItem
Category
Total
Inventory
Frozen:
Spinach
$ 80,000
$120,000
$ 80,000
Carrots
100,000
100,000
100,000
50,000
40,000
40,000
$230,000
$260,000
$ 90,000
$ 72,000
$ 72,000
95,000
92,000
92,000
Total canned
$185,000
$164,000
Total
$415,000
$424,000
Cut beans
Total frozen
$230,000
Canned:
Peas
Mixed
Reported
Inventory
$164,000
$415,000
$384,000 $394,000
$415,000
Recording Market vs. Cost
Under the Direct Method:
• Ending inventory is recorded at market
• No loss reported on Income Statement
Under the Indirect (Allowance) Method:
• Inventory reported at cost with a contra account
for the LCM write-down
• Declines and recoveries are recorded through an
Allowance (Valuation) account on the Balance
Sheet; and Loss Account on Income Statement
• Recovery of Market value decline is recorded only
up to but not exceeding historical cost
Recording the Decline in Market:
Example
Year
End
Inventory
at Cost
Inventory
at Market
Valuation
Adjustment
2000
$65,000
$65,000
$-0-
2001
$82,000
$70,000
$ 12,000
Under the Allowance Method:
Dr. Loss Due to Market Value Decline 12,000
Cr.
Allowance to Reduce Inventory
12,000
Recording the Decline in Market:
Example
Date
Dec.
31st
Cost
Market
Allowance
Account
Balance
2001
$188,000
$176,000
$12,000 cr.
$12,000 cr. Loss
2002
194,000
187,000
7,000 cr.
5,000 dr. Gain
2003
173,000
174,000
0
7,000 dr. Gain
2004
182,000
180,000
2,000 cr.
2,000 cr. Loss
Post the required adjustments.
Adjustment
to
Allowance
Account
Effect
on Net
Income
Recording the Decline in Market:
Example
Inventory – Year End
Allowance Account
2001
188,000
2001
12,000
2002
194,000
2002
5,000
7,000
2003
173,000
2003
7,000
2004
182,000
2004
-02,000
2,000
12,000
Loss Due to Market
Reported Inventory Value
2001 = $176,000 (188,000 – 12,000)
2001
12,000
2002 = $187,000 (194,000 – 7,000)
2003 = $173,000 (173,000 – 0)
2002
2003
5,000
7,000
2004 = $180,000 (182,000 – 2,000)
2004
2,000
Part 2:
Valuation Basis
Valuation Basis: Relative Sales
Values
• Relative sales values are an appropriate basis,
when basket purchases are made
• Basket purchases involve a group of varying
units
• The purchase price is paid as a lump sum
amount
• The lump sum price is allocated to units on
the basis of their relative sales values
Relative Sales Values:
Example
• Intell Company buys three different lots (A, B
and C) in a basket purchase, paying $300,000
• The lots were then sold as follows:
A
$ 75,000
B
$150,000
C
$200,000
for a total of $425,000
• Determine the allocated cost to A, B and C and
the gross profit for each lot
Relative Sales Values:
Example
Lot
Sales Value
Allocated Cost
Gross Profit
A
$75,000
($75,000/$425,000) X $300,000
= $ 52,941
$ 22,059
B
$150,000
($75,000/$425,000) X $300,000
= $105,882
$ 44,118
C
$200,000
($75,000/$425,000) X $300,000
= $ 141,176
$ 58,824
Purchase Commitments
• Where a company commits to purchasing
inventory, but title has not passed to the
buyer
• If the agreement is subject to cancellation, it
is not recorded by buyer or seller
• Noncancellable purchase contracts are not
recorded, but if material, are disclosed in the
notes to the financial statements
• If the contracted price is greater than market
price AND the loss can be reasonably
estimated, such loss shall be recorded
Part 3: Estimating
Ending Inventory –
The Gross Profit Method
Gross Profit Method
• The gross profit method is used to estimate
ending inventory
• This method is used also when an estimate is
needed due to a fire loss
• The method is based on the assumptions that:
1. beginning inventory + net purchases
= goods available for sale
2. goods available - sales (at cost)
= ending inventory
Gross Profit Method:
Example
Given:
• Beginning inventory (at cost): $
• Net Purchases (at cost) :
$
• Sales (net) :
$
• Gross Profit percentage on sales
60,000
200,000
280,000
30%
Estimate the ending inventory using the Gross
Profit Method.
Gross Profit Method:
Example
Beg. Inventory + Net Purchases - COGS = Estimated Ending
Inventory
Cost of goods sold
= Sales X (1 - 0.3)
$60,000 + $200,000 - ($280,000X0.7) = Ending Inventory
$60,000 + $200,000 - ($196,000)
= $64,000
Understanding Markups
1
Given: Gross Profit is 35% of sales. Sales are $10,000.
Cost of goods sold
Gross Profit
= Sales X (1 - 0.35) = $6,500
= Sales X (0.35)
= $3,500
2
Given: Gross Profit is 35% of cost. Sales are $10,000.
Cost + Gross Profit = Sales ==> 100% + 35% = 135%.
Cost of goods sold = Sales X (100/135) = $7,408
Gross Profit
= Sales X (35/135) = $2,592
These calculations are summarized as formulae on
Illustration 9-18 of your text.
Limitations of Gross Profit
Method
• Provides only an estimate; physical inventory
count still required
• Uses past information (gross profit percentage) to
determine a current inventory value
– A current gross profit percentage more relevant
• A ‘blanket’ gross profit percentage may be applied
– Different product lines may have materially different
gross profit percentages, which are better suited
• Not accepted for year-end financial reporting,
appropriate for interim reporting (with disclosure)
Part 4:
Retail Inventory Method
Retail Inventory Method
• Is appropriate for retail concerns:
with high volume sales
• with different types of merchandise
•
• The method assumes an observable
pattern between cost and prices
• The steps are:
determine ending inventory at retail prices
2 convert this amount to a cost basis
1
Retail Inventory Method:
Example
Given for the year 2000:
Beginning inventory
Purchases (Net)
Sales (Net)
At cost At retail
$ 2,000 $ 3,000
$10,000 $15,000
$12,000
Determine ending inventory at retail and at
cost.
Retail Inventory Method:
Example
At cost At retail
Beginning inventory
$ 2,000
$ 3,000
Purchases (Net)
$10,000
$15,000
Goods available for sale $12,000
$18,000
less: Sales (Net)
$12,000
Ending inventory (at retail)
$ 6,000
Times: cost to retail ratio
2/3
Ending inventory at cost
$ 4,000
Markups, Markdowns and
Cancellations
Given:
At cost
$20,500
Goods available
Markups
Markup cancellations
Markdowns
Markdown cancellations
Compute the cost-to-retail ratio.
At retail
$36,000
$ 3,000
$ 1,000
$ 2,500
$ 2,000
Markups, Markdowns and
Cancellations
At cost
$20,500
Goods available
Add: Markups
Less: Markup cancellations
Goods available (adj.) $20,500
At retail
$36,000
$ 3,000
$ 1,000
$ 38,000
Cost-to-retail ratio ($20,500/ $38,000) = 53.9%
Ignore markdowns and markdown cancellations.
Retail Inventory Method
1. Allows for income calculation without
a physical inventory count
2. May aid in determining inventory
shortages
3. Aid in controlling inventory quantities
on hand
4. Interim source of information for
specific purposes
Inventory Analysis
Inventory Turnover Ratio:
• Indicates how many times in a year inventory is
‘turning over’ or sold during the year
• A low number may indicate high stock quantities
– Indicative of high cash level invested in inventory
– Balance this with customer and sales needs
• A higher number indicates frequent turnover and
therefore lower investment of cash
Inventory Turnover = COGS  Average Inventory
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