Chapter 9
Inventories: Additional Valuation Issues
Market can be thought of as:
Recognize decline in value of an asset because of ___________________.
What constitutes designated market value?
 Replacement cost is how much it would cost on the open market to
replace the inventory today.
 Net realizable value is the usual selling price less disposal costs such as
freight out or sales commissions.
 Net realizable value less normal profit margin is the usual selling price
less disposal costs less normal profit margin.
1. Rank the three possible market values (replacement cost, net realizable value(ceiling),
and net realizable value less normal profit margin (floor) and choose the middle value as
the designated “market” value. This recognizes that a decline in selling price may not
always be associated with a corresponding decline in cost.
2. Compare “market” value determined in step 1 with cost:
If market > cost, then use cost
If market < cost, then use market
EXAMPLES
CASE
Cost
1
2
3
4
5
$1.00
1.00
1.00
1.00
1.00
Market Value
Replacement Net Real
NRV less
Cost
Value
Normal Markup
$1.10
$1.50
$1.20
.90
1.00
.70
.95
.80
.56
.40
.80
.56
1.05
.95
.80
Can apply LCM to individual items, pools of items or the entire inventory.
Final Inventory
Value
****Of the two ways mentioned in the text, the theoretically (and most practical) best
way to recognize a decline in value on the books is:
Periodic LCM - Allowance
1. Reverse beginning inventory
Income Summary
Inventory
xx
xx
2. Record the Ending Inventory at cost as determined by some inventory cost flow
alternative (what system is assumed here?)
Inventory
Income Summary
xx
xx
3. Then recognize decline in value if market value is less than cost:
Loss due to Mkt Decline of Inventory
Allowance to Reduce Inv to Market Value
xx
xx
This adjusting entry avoids burying the decline in value in CGS, while yielding the same
net income. Inventory is shown at market on the BS and IS (in the CGS section). This
saves having to adjust inventory items in recording the decline. The Allowance is similar
to dealing with bad debts by percentage of accounts receivable – you are finding a
desired ending balance in the account at the end of the year.
Periodic: Direct
The direct periodic entries would look like this:
Income Summary
Inventory
xx
Inventory
Income Summary
xx
xx
xx
What if we were dealing with the perpetual inventory system:
Perpetual: LCM Allowance
Loss Due to Market Decline
Allowance to Reduce…..
xx
xx
Perpeutal: LCM Direct
With respect to the direct method?
COGS
xx
Inventory
xx
EXAMPLES (allowance method):
At the end of year 1, if we need $1,000 in the allowance, the journal entry would be:
At the end of year 2, if the necessary balance is $1,300, what is the entry?
What happens if the obsolete inventory is removed (dumped, sold, donated, etc.) by year
three and the balance needed in the Allowance is only $900?
Purchase commitments:
Product Financing:
Exercise 9-5
Valuation above cost:
The gross profit method of estimating ending inventory is used when you use the periodic
system and need to estimate ending inventory due to fire or other casualty loss or just for
comparison purposes to get a handle on losses from shoplifting in a periodic inventory
system. Why isn’t this necessary if a perpetual system is used?
This method is appropriate only if markups to arrive at selling price and the mix of
inventory items have stayed relatively stable because is uses last period’s gross margin
rate in the estimate.
Markups are stated in two ways: as a % of cost and as % on sales (also known as the
Gross Profit Percentage).
Need to be able to convert from % on cost to % on sales:
Gross Profit Percentage
=
Markup on cost
(GP is also known as Gross Margin) 100% + Markup on cost
and vice versa
Markup on Cost
=
Gross Profit %
100% - Gross Profit %
EXAMPLE
Beginning Inventory (at cost)
Purchases
Sales for the period
$60,000
90,000
100,000
25% markup on cost
So do the conversion for the above to GM%:
Now compute Estimated CGS% = (100% - GP%):
and so estimated CGS is equal to Sales x CGS%:
And then compute Estimated Ending Inventory:
Cost of Beginning Inventory
Cost of Purchases
Cost of Goods Available
Estimated Cost of Goods Sold
Estimated Cost of Ending Inventory
Retail inventory methods do a better job of approximating inventory without a physical
count than does the gross profit method, because they use current percentages rather than
relying on last year’s historical percentages. You can use these estimates for a control
device, you have a value to “shoot for” when taking a physical count – if there are big
discrepancies, then there is a problem. This also makes it easier to take the physical
count as you only have to record retail prices and can skip looking up actual cost for each
item. IRS will accept this method.
You need to keep records of:
1.
2.
3.
4.
Step 1: Total goods available for sale (cost and retail)
Step 2: Determine Cost to Retail Ratio using the Conventional (LCM) method
Cost =
Retail
BI + net Purchases + Freight In
BI + net Purchases + net Markups
See page 440 for what is included under each method.
Step 3: Get ending inventory at retail (subtract sales from retail value of goods available
for sale)
Step 4: Multiply ending inventory at retail by cost to retail ratio to get ending inventory
at cost.
See pages 438 – 443 for each specific inventory method calculation.
Effects of Inventory Errors (these are independent situations):
1.
2.
3.
4.
5.
6.
Beginning Inventory overstated
Beginning Inventory understated
Purchases overstated
Purchases understated
Ending inventory overstated
Ending inventory understated
1
2
3
4
5
6
Ex 1
Ex 2
Beginning Inventory
Purchases
Cost of Goods Available
Ending Inventory
Cost of Goods Sold
Sales
Cost of Goods Sold
Gross Margin
Expenses
Net Income
Therefore Retained
Earnings will be:
What errors will affect the next period?
And if no further errors occur in the next period, would there be any problems in the third
year?
What is the effect if there are two errors in the same period?
Example 1: Beginning inventory understated $200 and Ending Inventory overstated
$500
Example 2: Purchases understated by $300 and Ending Inventory understated by $400.