CHAPTER 9: INVENTORY VALUATION AND
ESTIMATION TECHNIQUES
Objectives: Be able to illustrate your understanding of and
record transactions related
1.
Valuation bases: Lower of Cost or Market (LCM)
net realizable value
2.
Purchase commitments
3.
Estimation techniques:
a.
Gross Profit Method
b.
Retail Inventory Method
(conventional and LIFO)
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Background: our general rule is that the historical cost
principle is abandoned when the future utility of the asset
is no longer as great as its original cost.
Note:
Chap. 9's inventory techniques, however, do not
represent complete departures from the FIFO,
LIFO, and average cost bases of valuing
inventory.
For example, the LCM rule results in inventory
being stated at the “lower of FIFO cost or
market,” or "lower of average cost or market,"
etc.
Similarly, the retail method can be adapted to
approximate any of the major cost flow
assumptions: FIFO, LIFO, or average cost.
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Objective 1: Valuation bases
LCM: ARB 43 says that a departure from cost is
required when the utility of the goods is longer as
great as its cost. Utility is defined as the ability to
generate revenue through normal sale.
Step 1:
Choose the middle value of the following
three amounts and call it Designated
market value:
Net realizable value = estimated selling price less
estimated costs to completion and disposal.
Represents the maximum and attempts to prevent
overstatement of inventory, i.e., the ceiling.
Market = replacement cost
Net realizable value less profit = represents minimum
and attempts to prevent understatement of
inventory, i.e., the floor.
Step 2: Compare Cost to the Designated market
value. Choose the lower of the two and that becomes
your LCM.
Example: NRV = $40, Market = $25, NRV-profit = $20,
Cost = $30
Thus, LCM = $25
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Objective 1 (continued)
Deficiencies in LCM:
1.
Inconsistent treatment: it recognizes a loss in the
period when inventory value decreases but delays
inventory value increases until the period when
inventory is sold.
2.
Inconsistent treatment: inventory may be valued at
cost in one year and at market in the next.
3.
Conservative?: LCM inventory valuation results in a
conservative inventory value on the balance sheet,
however, it may have the opposite effect on the
income statement in subsequent periods if expected
sales price declines do not materialize.
4.
Subjective: income manipulation is possible when
calculating "normal profit."
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Objective 1 (continued)
Other valuation bases:
1.
Net realizable value: certain goods (e.g. minerals)
which are sold in a controlled market with a quoted
price and with no significant disposal costs may be
reported at NRV.
2.
Standard costs: manufactured inventories may be
reported at standard costs (predetermined) of the
material, labor and overhead inputs.
3.
Relative sales value method: used with lump-sum
purchases. Allocate the joint cost based on relative
sales value.
E.G. 2 assets are acquired for $l,000. Asset 1 has a
selling price of $700 and Asset 2 has a selling price of
$800.
Allocated cost of Asset 1 = $700/$1500 x $1000 = $467
Allocated cost of Asset 2 = $800/$1500 x $1000 = $533
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Objective 2: Purchase commitments
Key issue is full disclosure
1.
Accounting for ordinary purchase orders which are subject
to cancellation by the buyer or seller: these do not represent
either an asset or a liability to the buyer. They are not
recorded or reported in the financial statements.
2.
Accounting for formal purchase orders for which a firm
price has been established (controversial):
a.
If MP>CP: disclose in footnotes.
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Objective 2, continued
b.
If MP<CP (i.e., market price falls below contract
price):
(i)
Debit loss account and credit liability
Est. loss………………….30,000
Est. Liability……………….30,000
(ii) Eliminate liability when inventory is acquired.
May have record additional price decline beyond
estimated liability
Purchase…………………..70,000
Est. Liability………………30,000
Cash…………………………100,000
or record price recovery up to contract price as
a gain (recovery of loss)
Est. Liability……………..10,000
Unrealized holding gain or loss….10,000
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Objective 3: Estimation techniques
Gross Profit Method: used when an estimate of a firm's
inventory is required. It is acceptable for interim
reporting but not general annual reporting (FASB
recommends retail for interim).
We need 4 items of information to estimate EI:
1.
2.
3.
4.
cost of beginning inventory
cost of purchases for the period
sales during the period
markup (% of cost or % of sales)
Note: in this context, the terms gross margin, gross profit
and markup are synonymous.
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Objective 3, continued
Concept of Markup:
E.G. an item costs $60 and is sold for $75 has a gross
profit or markup of $15.
Markup as a % of sales (will always be lower):
markup/SP = $15/75 = 20%
Markup as a % of cost( if given alone, must covert to
gross profit on sales):
markup/cost = $15/60 = 25%
Formula for converting markup on cost to markup or
gross profit on sales:
% markup on cost/(100% + % markup on cost)
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Objective 3, continued
Example of Gross Profit Method
BI = $60,000
Purchases = $90,000
Sales = $100,000
Markup on cost = 25%
1. Determine markup on sales (or gross profit on sales)
25%/(100% + 25%) = 20%
2.
Determine cost of goods sold:
Sales x (100% - gross profit on sales 20%) = 80%
$100,000 x 80% = $80,000
3.
Use inventory model to determine ending inventory:
1. Beginning inventory
2. + Purchases
Available
- 3. Sales at cost
Ending inventory
$60,000
+ $90,000
$150,000
-$80,000
$70,000
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Objective 3, continued
Retail Inventory Method: another estimate of ending
inventory. Unlike GPM, however, this method produces
estimates that may be acceptable for financial statement
purposes.
We need the following:
1.
Beginning inventory at cost and at retail
2.
Purchases for period at cost and at retail
3.
Sales during the period
4.
The cost and/or retail amounts of markups,
markdowns, employee discounts, spoilage.
Objective:
Retail value of goods available for sale
- Sales
Ending inventory at retail
x cost to retail ratio
Ending inventory at cost
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Objective 3 (continued)
Variations of retail method: it can be used with
1.
Conventional retail (LCM approach): considers
markups only in computing ratio so reflects the
lowest value.
And, in Appendix
2.
LIFO retail (cost approach): considers both markups
and markdowns and excludes beginning inventory.
3.
Dollar-value LIFO retail: same as LIFO retail but
considers changing prices.
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Objective 3 (continued)
There are 3 basic steps in computing all retail inventory
problems:
1.
Compute EI at retail. This step is the same regarless
of which variation is used.
2.
Compute the cost to retail ratio. This step will vary
depending on which variation of the retail method is
used.
3.
Apply the cost to retail ratio (from #2) to EI at retail
(from #1) to obtain EI at cost or at LCM. The step
will vary depending on which variation of the retail
method is used.
4.
If fluctuating prices (dollar-value LIFO retail), have
to deflate EI arrived at in #3, layer it to base layer
and new layer and then restate at appropriate dollar
values.
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