Intermediate
Financial Accounting I
Inventories: Additional
Valuation Issues
Objectives of this Chapter
I. Introduce Inventory estimation
methods: the gross profit method and
the retail inventory method.
II. Determine ending inventory cost by
applying the gross profit method.
III. Determine ending inventory cost by
applying the retail inventory method.
Inventories: Additional Issues
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Objectives of this Chapter (contd.)
IV. Compare the gross profit method and
the retail inventory method.
V. Explain dollar-value LIFO retail
method.
VI. Discuss accounting issues related to
purchase commitments.
Inventories: Additional Issues
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I. Estimating Inventory: Gross Profit
Method and Retail Inventory Method


Reasons: For some companies,
inventory information is needed between
accounting periods . Companies cannot
afford to do physical inventory count
every quarter.
Thus, either the gross profit method or
the retail inventory method can be used
to estimate value of ending inventory for
interim reports.
Inventories: Additional Issues
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Estimating Inventory: Gross Profit Method
and Retail Inventory Method (contd.)


No physical count of inventory is
needed for either method. The value
of inventory is based on estimation.
Neither method is acceptable for
annual financial reporting purposes.
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Estimating Inventory: Gross Profit Method
and Retail Inventory Method (contd.)


Both methods are acceptable for
interim reporting.
The insurance adjusters may use the
gross profit method to estimate the
loss of inventory in case of fire or
flood.
Inventories: Additional Issues
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II. The Gross Profit Method
Data Required:
 Beginning Inventory (at cost)
 Purchase (net) (at Cost)
 Sales Price
 Gross Margin Ratio
(Gross Margin/Sales Price)
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Example A
Gross Profit Method
Beginning Inv. = $60,000
Purchase (net) = $200,000
Sales
= $280,000
Gross Margin Ratio 1= 30%
1. Gross margin ratio is obtained from past
years’ experience (assuming the ratio is
stable over years).
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Example A (contd.)

Using gross profit method to estimate the cost
of ending inventory
Selling Price
Beg. Inventory
Purchase (net)
Goods Available for Sale
Sales
280,000
Less: gross margin1
(84,000)
Sales (at cost)
Estimated Inv. (at cost)
Cost
$60,000
200,000
260,000
196,0002
64,000
1. gross margin = 280,000x30%
2. also equals 280,000x(1-30%) = 196,000
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Example B

Gross Profit Method
What if the gross margin ratio is based on cost
of goods sold (CGS) rather than on sales price?
Sales
$100
CGS
(80)
Gross Margin
$20
Gross profit ratio (based on Sales)= 20%
Gross profit ratio (based on CGS) = 25%
 Deriving
CGS using sales and gross profit ratio
based on sales: $100 x (1 - 20%) = $80
 Deriving CGS using sales and gross profit ratio
based on CGS: $100  (1+25%) = $80
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Example B (contd.)
Sales = CGS + Gross Profit
= CGS + 25% x CGS
= CGS x (1+25%)
CGS = Sales  (1+25%)
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Comments on Gross Profit Method


If the relationship between the gross
profit and selling price has been
changed, the ratio should be adjusted
accordingly.
A separate gross profit ratio should be
applied to different inventory.
Inventories: Additional Issues
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III. Retail Inventory Method

Terminology related to retail inventory method:
Original retail price
Additional markup
Markup Cancellations
Markdowns
Markdown Cancellations
Mark et
$5
5
5
5
Retail Price
$110
115
110
105
110
= Additional Markups - Markup
Cancellations
 Net Markdowns = Markdowns - Markdown
Cancellations

Net Markups
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Retail Inventory Method (contd.)
Data required to apply retail method:

Beg. Inv. (both cost and retail price)

Purchases (net) (cost and retail)
Sales (subtracting sales returns only)
 Price adjustment data such as additional
markups, markup cancellations,
markdowns and markdown cancellations

Inventories: Additional Issues
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Retail Inventory Method
Example (assuming no price adjustments)
Beg. Inv.
Purchases (net)
Cost
$14,000
63,0001
77,000
Retail
$20,000
90,0002
110,000
85,0003
$25,000
Sales
Estimated End. Inv.
at retail
Cost ratio = 77,000/110,000=70%
Estimated cost of end. inv. = 25,000x70%=17,500
1. Purchases - Pur. R&A - Pur. Dis. + Freight-in
2. Purchases - Pur R&A
3. Gross sales-Sales Returns +Employee Discounts
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Retail Inventory Method
Example (with price adjustments)
Cost
$14,000
63,000
77,000
Beg. Inv.
Purchases (net)
Goods Avail.
Additional Markups
Markup Cancel.
Markdowns
Markdowns Cancel.
Sales
Estimated End. Inv. at Retail
Retail
$20,000
90,000
110,000
5,000
(4,000)
(1,500)
200
(85,000)
$24,700
Question: What is the cost ratio?
Inventories: Additional Issues
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Retail Inventory Method
Example (with price adjustments)
Cost
$14,000
63,000
77,000
Beg. Inv.
Purchases (net)
Goods Avail.
Net Markups
Goods Avail. after net MU
Net Markdowns
Goods Avail. after all price adj.
Sales*
End. Inv. at Retail
Retail
$20,000
90,000
110,000
1,000
111,000
(1,300)
109,700
(85,000)
$24,700
*Sales = Sales - Sales R&A
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Cost Ratios for Retail Method
1) Average Method (consider all price adjust.)
Cost Ratio
= 77,000  109,700 = 70.19%.
Esti. End. Inv. at cost
= $24,700 x 70.19% = $17,336.93
2) LCM approach (conventional retail
method) (consider only net markups)
Cost Ratio
= 77,000 111,000 = 69.37%.
24,700 x 69.37% = 17,134.39
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Cost Ratios for Retail Method (contd.)
3) FIFO approximation (excluding the beg.
inv. in the computation of cost ratio)
Cost Ratio
= (77,000-14,000)(109,700-20,000)
=70.23%.

Esti. Inv. at cost
= $24,700 x 70.23%=17,346.81

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Cost Ratios for Retail Method (contd.)
4) LIFO approximation (computing two ratios,
one for the beg. inv. and one for others)
 Cost Ratio 1(for beg.inv.)
=14,000/20,000=70%
 Cost Ratio 2(for other inv.)
= (77,000-14,000)(109,700-20,000)=70.23%
 Esti. End. Inv. at cost
= 1) 20,000 x 70% = 14,000
2) 4,700a x 70.23% = 3,301
17,301
a. 24,700-20,000=4,700
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Comments for Retail Method
A.
Purchases
Pur. Discounts
Pur. R & A
Freight-In
Cost
$$$$
$$$$
$$$$
$$$$
Retail
$$$$
------1
$$$$
------1
1. Pur. Discounts and freight-in are already
considered in the retail price of
purchases.
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Comments for Retail Method (contd.)
B. Sales in the retail column should be
gross sales - sales returns. This is
because the retail prices for beg. inv.
and purchases are based on gross
sales, not net sales.
Also, if employee discounts have been
subtracted from sales, they should be
added back to sales.
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Comments for Retail Method (contd.)
C. Spoilage
Normal Spoilage1
Abnormal Spoilage2
Cost Retail
------ $$$$
$$$$ $$$$
1. In computing cost ratios, the normal
spoilage will not be considered.
2. In computing cost ratios, the abnormal
spoilage will be considered.
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Retail Inventory Method – Special
Items Included
Cost
$14,000
63,000
(1,400)
75,600
Goods Avail. after all price adj.
Retail
$20,000
90,000
(2,000)
108,000
1,000
109,000
(1,300)
107,700
Sales
85,000
Sales returns
(2,000)
Employee Discounts
Normal Spoilage
End. Inv. at Retail Inventories: Additional Issues
(83,000)
(2,000)
(1,000)
$21,700
Beg. Inv.
Purchases (net)
Abnormal Spoilage
Goods Avail.
Net Markups
Goods Avail. after net MU
Net Markdowns
24
Retail Inventory Method –Special
Items Included(contd.)
1) Average Method (consider all price adjust.)
Cost Ratio
= 75,600  107,700 = 70.19%.
Esti. End. Inv. at cost
= $21,700 x 70.19% = $15,232.23
2) LCM approach (conventional retail
method) (consider only net markups)
Cost Ratio
= 75,600 10,900 = 69.36%.
21,700 x 69.36% = $15,051.12
5Inventories: Additional Issues
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Another Example of Conventional Retail Inventory Method
– Special Items Included (Illustration 9-3, KWW, 14th e)
Inventories: Additional Issues
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IV. Comparison of Gross Profit Method
and Retail Inventory Method
Gross-Profit Method
Retail Inventory Method
1. Data required: cost
of beg. inv.,
purchases, sales
and gross profit
ratio.
2. Any company can
use this method to
estimate ending
inventory.
1. Data required: Cost
and retail price of
beg. inv., purchases,
sales price and price
adjustments.
2. Only retail store can
apply this method to
estimate inventory.
Inventories: Additional Issues
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Comparison of Gross Profit Method
and Retail Inventory Method (contd.)
Gross-Profit Method
Retail Inventory Method
3. Gross profit ratio is 3. Cost ratio can be
estimated from past
calculated at
years’ experience
different stage and
(not updated with
is updated with
the price
current year’s price
adjustments of the
adjustment data.
current year).
Inventories: Additional Issues
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Comparison of Gross Profit Method
and The Retail Method (contd.)
Gross-Profit Method
Retail Inventory Method
4. Not acceptable for 4. Not acceptable for
the annual financial
the annual financial
reporting but
reporting but
acceptable for the
acceptable for the
interim report.
interim report.
5. No physical count of 5. No physical count of
inventory is needed.
inventory is needed.
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V. Dollar-Value LIFO Retail Method

Applying retail method to estimate
cost of ending inventory and also
considering price index when prices
are fluctuating.
Inventories: Additional Issues
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Example
Dollar-Value LIFO Retail Method
Cost
$14,000
63,000
77,000
Retail
Beg. Inv. -20x1
$20,000
Purchases (net)
90,000
Goods Avail.
110,000
Net Markups
1,000
Goods Avail. after net MU
111,000
Net Markdowns
(1,300)
Goods Avail. after all price adj.
109,700
Sales
(85,000)
End. Inv. at Retail
$24,700
Cost Ratio(CR) 1(for beg. inv.)=14,000/20,000=70%
CR2 (for others)=(77,000-14,000)/(109,700-20,000)
=70.23%
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Dollar-Value LIFO Retail Method
Example (contd.)

Assuming the price indices of 20x0 and
20x1 are 100% and 112%, respectively.
Procedures of applying Dollar-Value
LIFO concept to Retail method (LIFO
approximation):
Inventories: Additional Issues
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Dollar-Value LIFO Retail Method
Example (contd.)
1. Ending inventory at retail prices is deflated to
base year’s price level:
$24,700112% = $22,054
2. Forming Layers based on LIFO cost flows
assumption:
Beg. inv (retail) at base-year prices
(L1)
$20,000
Inv. increase (retail) from beg. inv.
(L2)
2,054
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Dollar-Value LIFO Retail Method
Example (contd.)
Ending Inv
Layers Price Cost End. Inv.
at Base-year at Base-year Index Ratio at LIFO
Retail Prices Retail Prices
(%)
(%)
Cost
$22,054
$20,000
$2,054
100
70 $14,000
112 70.23
1,616
$15,615
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Dollar-Value LIFO Retail Method
Example (contd.)

Subsequent years under Dollar-Value
LIFO Retail
The D-V LIFO retail method follows the
same procedures in subsequent years
as the traditional D-V LIFO method.
That is when a real increase in
inventory occurs, a new layer is
added.
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Dollar-Value LIFO Retail Method
Example (contd.)

Using the information on page 27 and
assuming the retail value of 20x2 ending
inventory at current price is $42,960.
The 20x2 price index is 120% (20x0
price index is 100%) and the cost ratio of
20x2 is 75%.
In base-year’s dollars(20x0),
the ending inventory of 20x2 is
$42,960 120% = $35,800
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Dollar-Value LIFO Retail Method
Example (contd.)
Ending Inv.
Layers Price Cost End. Inv
at Base-Year at Base-Year Index Ratio at LIFO
Retail Prices Retail Prices (%) (%)
Cost
$35,8001 L1
L2
L3
$20,000
2,054
13,746
100
70 $14,000
112 70.23
1,616
120
75 12,371
$27,987
1.Current cost of ending Inv. of 20x2:
$42,9601.12 = $35,800
L1(layer 1) = 20x0
L2 = 20x1
Inventories: Additional Issues
L3 = 20x2
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VI. Purchase Commitments


Purchase contract may be signed a few
months (or years) before the actual delivery
date (i.e., George Pacific) to secure the
supply of inventory.
Losses are recognized for any purchase
commitments outstanding at the end of a
period when market price is less than
contract price (i.e., applying a LCM rule in
the valuation of purchase commitments).
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Example 1- Contract Period within Fiscal Year



Geteway Co. signed a purchase
commitment of $20,000 on 4/30/x5 to buy
goods which would be delivered on
9/30/x5.
4/30/x5
No entry required.
Disclosure of this firm commitment is
required at the end of a reporting period if
the amount is significant.
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Example 1 (contd.)
Case 1: When the market price of
these goods equal or greater than the
contract price of $20,000 on 9/30/x5,
the journal entry on 9/30/x5, the
delivery date, would be:
9/30/x5
Purchases
20,000
Cash
20,000

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Example 1 (contd.)
 Case
2: The market price is $18,000
on 9/30/x5. The journal entry would
be:
Purchases
Loss on
Pur. Commitment
18,000
2,000
Cash
Inventories: Additional Issues
20,000
41
Purchase Commitments
Example 2 - Contract Period Extends
beyond Fiscal Year

Geteway Co. signed a firm purchase
commitment of $50,000 on 4/15/x5 for
goods to be delivered on 10/2/x6. The
market price of the contracted goods
was $49,000 on 12/31/x5. The
purchased commitment loss must be
recognized in the year end when the
loss first occurred (i.e., 12/31/x5).
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Example 2 (contd.)
 The
following entry would be prepared on
12/31/x5 and disclosure is required when the
amount is significant regardless whether a loss
is expected or not:
Estimated Loss on
Purchase Commitments*
1,000
Estimated Liability on
Purchase Commitments
1,000
* Reported in the income statement under
“Other expenses
and
losses”
Inventories:
Additional
Issues
43
Example 2 (contd.)
At the delivery date (i.e., 10/2/x6):
 Case
1: The market price remained
$1,000 below the contract price, the
following journal entry would be
prepared on 10/2/x6:
Purchases
Estimated Lia.
on Pur. Commit.
Cash
49,000
1,000
Inventories: Additional Issues
50,000
44
Example 2 (contd.)

Case 2: The market price was $3,000
below the contract price on 10/2/x6:
Purchases
47,000
Estimated Lia.
on Pur. Commitments
1,000
Loss on Pur. Commit.
2,000
Cash
Inventories: Additional Issues
50,000
45
Example 2 (contd.)

Case 3: the market was only $600 below
the contract price 0n 10/2/x6:
Purchases*
49,000
Estimated Lia.
on Pur. Commit. 1,000
Cash
50,000
*$49,000 became the new cost for the
purchase commitment on 12/31/x5
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Hedging of Purchase Commitments
with Future Sales Contracts
 In order to offset the potential future
loss on purchase commitments, a firm
can enter a future sales contract at the
same quantity of inventory purchased in
a purchase commitment.
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