Inventory
Valuation at
Other Than
Cost
2
Learning Objectives
 Apply the lower-of-cost-or-market (LCM)
rule to reflect declines in the market value
of inventory.
 Use the gross profit method to estimate
ending inventory.
 Compute estimates of FIFO, LIFO, average
cost, and lower-of-cost-or-market inventory
using the retail inventory method.
3
Learning Objectives
 Determine the financial statement impact of
inventory recording errors.
EXPANDED MATERIAL
 Combine the retail inventory method and
dollar-value LIFO to compute ending
inventory using the dollar-value LIFO retail
method.
4
Learning Objectives
 Account for the impact of changing prices
on purchase commitments.
 Record inventory purchase transactions
denominated in foreign currencies.
5
Inventory Estimation Methods
Methods for valuing inventory at
other than cost
 Lower-of-Cost-or-Market Method
 Gross Profit Method
 Retail Inventory Method
 Dollar-Value LIFO Retail Method
6
Lower of Cost or Market (LCM)
What is
market?
7
Lower of Cost or Market (LCM)
In lower of cost or
market, market
means replacement
cost within limits.
8
Lower of Cost or Market (LCM)
• When goods remaining in inventory can be
replaced with identical goods at a lower
cost, the lower (market) cost must be used
to value the inventory.
• What are the replacement cost limits?
– Upper limit: Net realizable value.
– Lower limit: Net realizable value minus
a normal profit.
9
LCM Examples
A company’s unit of inventory
has the following
characteristics:
Selling price
$165
Packaging cost
10
Transportation cost
15
Profit margin
40
10
LCM Examples
Net
realizable
value
Selling price
$165
Cost of completion (10)
Transportation cost (15)
Ceiling (NRV)
$140
Ceiling (NRV)
Normal profit
Floor
$140
(40)
$100
Example
1
11
LCM Examples
Selling price
$165
Cost of completion (10)
Transportation cost (15)
Ceiling (NRV)
$140
Current
Replacement
Cost, $150
Ceiling (NRV)
Normal profit
Floor
Cost
$155
Market
$140
$140
(40)
$100
LCM is
market,
$140
12
LCM Examples
Example
2
Selling price
$165
Cost of completion (10)
Transportation cost (15)
Ceiling (NRV)
$140
Current
Replacement
Cost, $120
Ceiling (NRV)
Normal profit
Floor
Cost
$110
Market
$120
$140
(40)
$100
LCM is
cost, $110
13
LCM Example
Example
3
Selling price
$165
Cost of completion (10)
Transportation cost (15)
Ceiling (NRV)
$140
Current
Replacement
Cost, $75
Ceiling (NRV)
Normal profit
Floor
Cost
$110
Market
$100
$140
(40)
$100
LCM is
market,
$100
14
Recording LCM Revaluations
 LCM may be applied to each individual
inventory item or to the inventory as a
whole.
 If LCM is applied to individual items,
the difference between cost and market
is credited directly to Inventory.
 If LCM is applied to the inventory as a
whole, the difference is recorded in an
allowance account.
LCM--Example: Recording
Revaluation (data for valuation)
Item
A
Ind
Mkt
Original Total
Cost Market LCM LCM
Qty Cost
20
$10 $200 $11 $200 $220
B
10
$10
$100
$9
$90
$90
C
10
$10
$100
$8
$80
$80
D
20
$10
$200
$9
$180
$180
$550
$570
$600
15
LCM--Example: Recording
Revaluation (applied individually)
Item
A
Ind
Mkt
Original Total
Cost Market LCM LCM
Qty Cost
20
$10 $200 $11 $200 $220
B
10
$10
$100
$9
$90
$90
C
10
$10
$100
$8
$80
$80
D
20
$10
$200
$9
$180
$180
$550
$570
$600
$50
Journal Entry
Loss from Decline in Value of Inventory..... 50
Inventory............................................
50
16
LCM--Example: Recording
Revaluation (applied as a whole)
Item
A
Ind
Mkt
Original Total
Cost Market LCM LCM
Qty Cost
20
$10 $200 $11 $200 $220
B
10
$10
$100
$9
$90
$90
C
10
$10
$100
$8
$80
$80
D
20
$10
$200
$9
$180
$180
$550
$570
$600
$30
Journal Entry
Loss from Decline in Value of Inventory.............. 30
Allowance for Decline in Value of Inventory..
30
17
18
Gross Profit Method
The gross profit method is an
estimation technique to determine
the inventory count...
 when a physical
count is not
practical, and
 as a validity
check.
19
Gross Profit Method Steps
 Determine gross profit percentage.
 Determine estimated sales.
 Determine estimated cost of goods
sold.
 Determine estimated goods available
for sale.
 Determine estimated inventory.
Gross Profit Method-Example: Basic Data
20
Use the following information to estimate ending
inventory:
•
•
•
•
•
•
•
•
Gross Profit Percentage
50% of sales
Accounts Receivable Collections
$ 5,000
Ending Accounts Receivable
$ 1,000
Beginning Accounts Receivable
$ 2,000
Beginning Inventory
$ 6,000
Payments to Suppliers
$ 10,000
Ending Accounts Payable
$ 3,000
Beginning Accounts Payable
$ 1,000
Gross Profit Method-Solution
Step No.1
Determine Gross Profit Percentage
Given as 50%, and management does not
feel any changes are warranted.
21
Gross Profit Method-Solution
22
Step No.2
Determine Estimated Sales
Accounts receivable collections
Add ending accounts receivable
Deduct beginning accounts receivables
Estimated sales
$ 5,000
1,000
$ 6,000
(2,000)
$ 4,000
Gross Profit Method-Solution
23
Step No. 3
Determine Estimated Cost of Goods Sold
Estimated sales
Times gross profit percentage
Estimated cost of goods sold
$ 4,000
x 50%
$ 2,000
Gross Profit Method-Solution
Step No. 4
Determine Estimated
Goods Available for Sale
Beginning inventory
$ 6,000
Add payments to suppliers
$10,000
Add ending accounts payable
3,000
$13,000
Deduct beginning accts. pay.
(1,000)
Estimated purchases
12,000
Estimated goods available for sale
$18,000
24
Gross Profit Method-Solution
Step No.5
Determine Estimated Inventory
Estimated goods available for sale
Estimated cost of goods sold
Estimated inventory
$18,000
2,000
$16,000
25
Gross Profit Method
Sales
Estimated
Cost of
Goods
Sold
Cost of Goods
Available for
Sale
Estimated
Cost of
Goods
Sold
Estimated
Gross
Profit
Estimated
Ending
Inventory
26
27
Salad Oil Swindle
Tino DeAngelis rented a petroleum
tank farm in Bayonne, New Jersey.
28
Salad Oil Swindle
He convinced auditors, investors, and
investment bankers that the tanks
contained $100 million in vegetable oil.
29
Salad Oil Swindle
The tanks actually were primarily filled
with sea water. There was very little
vegetable oil in the tanks.
30
Salad Oil Swindle
Tino would pump vegetable oil from one
tank to another, depending on his advance
knowledge of the auditor’s verification plan.
31
Retail Inventory Method
1. Determine goods available for sale at
cost and retail.
2. Determine cost percentage.
3. Determine ending inventory at retail.
4. Determine ending inventory at cost.
Retail Inventory Method-Different Cost Methods
Lower-of-Cost-or-Market
Approximation: Markups but
not markdowns are included in
the calculation
of goods
Average Cost
Method:
available
Markupsfor
andsale.
markdowns
are included in
calculation of goods
available for sale.
32
Retail Inventory Method-Example
Use the following information to estimate ending
inventory:
Cost
Retail
Beginning inventory
$1,000
$2,000
Purchases
5,000
8,000
Markups
2,000
Sales
6,000
Markdowns
600
33
Retail Inventory Method--Solution34
for LCM Approximation
Step No.1
Determine Goods Available for Sale at Cost and
Retail--LCM Approximation
Cost
Retail
Beginning inventory
$1,000 $ 2,000
Purchases
5,000
8,000
Markups
2,000
Goods available for sale $6,000 $12,000
Retail Inventory Method--Solution35
for LCM Approximation
Step No. 2
Determine Cost Percentage
Goods available for sale at cost
Divided by goods available for
sale
Cost percentage
$ 6,000
12,000
50%
Retail Inventory Method--Solution36
for LCM Approximation
Step No.3
Determine Ending Inventory at Retail
Goods available for sale
Less sales
Less markdowns
Ending inventory at retail
$12,000
(6,000)
(600)
$ 5,400
Retail Inventory Method--Solution
for LCM Approximation
37
Step No.4
Determine Ending Inventory at Cost
Ending Inventory at Retail
Times Cost Percentage
Ending Inventory at Cost
$5,400
x 50%
$2,700
Retail Inventory Method--Solution38
for Average Cost Method
Step No.1
Determine Goods Available for Sale
Cost
Retail
Beginning inventory
$1,000 $ 2,000
Purchases
5,000
8,000
Markups
2,000
Markdowns
(600)
Goods available for sale
$6,000
$11,400
Retail Inventory Method--Solution39
for Average Cost Method
Step No. 2
Determine Cost Percentage
Goods available for sale at cost
$ 6,000
Divided by goods available for
sale at retail
11,400
Cost percentage
52.6%
Retail Inventory Method--Solution40
for Average Cost Method
Step No. 3
Determine Ending Inventory at Retail
Goods available for sale
Less sales
Less markdowns
Ending inventory at retail
$11,400
(6,000)
(600)
$ 4,800
Retail Inventory Method--Solution41
for Average Cost Method
Step No.4
Determine Ending Inventory at Cost
Ending inventory at retail
Times cost percentage
Ending inventory at cost
$4,800
x 52.6%
$2,525
Retail Inventory Method
Goods
Available for
Sale: At Retail
Beginning
Inventory
+
Purchases
= Goods
Available
for Sale
To calculation of cost
percentage
Continued
Less
Sales
Estimated
Ending
Inventory
at Retail
42
Retail Inventory Method
To calculation of cost
percentage
Goods
Available for
Sale: At Cost
Beginning
Inventory
+
Purchases
= Goods
Available
for Sale
Continued
43
Retail Inventory Method
Estimated Ending
Inventory at Retail
Cost Percentage:
Cost/Retail
x
Cost Percentage
Estimated Ending
Inventory at Cost
44
Retail Inventory Method
 Freight-in is added to the cost of purchases.
 Purchase discounts are subtracted from the
cost of purchases.
 Purchase returns are subtracted from both the
cost and retail amount of purchases.
 Purchase allowances normally are subtracted
only from the cost of purchases.
 Sales returns are subtracted from retail sales.
 Sales discounts and sales allowances are not
subtracted from retail sales.
45
Dollar-Value LIFO Retail
Inventory Method Steps
1. Determine inventory at base-year retail
prices.
2. Determine dollar-value LIFO inventory
layers at retail.
3. Determine dollar-value LIFO inventory
layers at cost.
46
Dollar-Value LIFO Retail
Inventory Method--Example
47
Use the following data to estimate
Ending Inventory for 2000, 2001, and
2002 (assume 1999 is the base year).
Year
1999
2000
2001
2002
Inventory at
Year-End
Incremental
Year-End
Price Index Cost Percentage Retail Prices
1.00
.60
$60
1.05
.62
$69
1.10
.64
$77
1.12
.65
$71
Dollar-Value LIFO Retail
Inventory Method--Example
Inv @
Inv @
BaseEoY Price Year
Year Retail Index Retail
1999 $60 ÷ 1.00 = $60
48
DollarValue
Incr. Incr. LIFO
Layer Cost Retail
Layers Index %
Cost
Dollar-Value LIFO Retail
Inventory Method--Example
Inv @
Inv @
BaseEoY Price Year
Year Retail Index Retail
1999 $60 ÷ 1.00 = $60
49
DollarValue
Incr. Incr. LIFO
Layer Cost Retail
Layers Index %
Cost
$60
x 1.00 x 0.60 = $36
Dollar-Value LIFO Retail
Inventory Method--Example
Inv @
Inv @
BaseEoY Price Year
Year Retail Index Retail
1999 $60 ÷ 1.00 = $60
2000 $69 ÷ 1.05 = $66
50
DollarValue
Incr. Incr. LIFO
Layer Cost Retail
Layers Index %
Cost
$60
x 1.00 x 0.60 = $36
Dollar-Value LIFO Retail
Inventory Method--Example
Inv @
Inv @
BaseEoY Price Year
Year Retail Index Retail
1999 $60 ÷ 1.00 = $60
2000 $69 ÷ 1.05 = $66
51
DollarValue
Incr. Incr. LIFO
Layer Cost Retail
Layers Index %
Cost
$60
$60
6
$66
x 1.00 x 0.60 = $36
x 1.00 x 0.60 = $36
x 1.05 x 0.62 =
4
$40
Dollar-Value LIFO Retail
Inventory Method--Example
Inv @
Inv @
BaseEoY Price Year
Year Retail Index Retail
1999 $60 ÷ 1.00 = $60
2000 $69 ÷ 1.05 = $66
2001 $77 ÷ 1.10 = $70
52
DollarValue
Incr. Incr. LIFO
Layer Cost Retail
Layers Index %
Cost
$60
$60
6
$66
x 1.00 x 0.60 = $36
x 1.00 x 0.60 = $36
x 1.05 x 0.62 =
4
$40
Dollar-Value LIFO Retail
Inventory Method--Example
Inv @
Inv @
BaseEoY Price Year
Year Retail Index Retail
1999 $60 ÷ 1.00 = $60
2000 $69 ÷ 1.05 = $66
2001 $77 ÷ 1.10 = $70
53
DollarValue
Incr. Incr. LIFO
Layer Cost Retail
Layers Index %
Cost
$60
$60
6
$66
$60
6
4
$70
x 1.00 x 0.60 = $36
x 1.00 x 0.60 = $36
x 1.05 x 0.62 =
4
$40
x 1.00 x 0.60 = $36
x 1.05 x 0.62 =
4
x 1.10 x 0.64 =
3
$43
Dollar-Value LIFO Retail
Inventory Method--Example
Inv @
Inv @
BaseEoY Price Year
Year Retail Index Retail
2001 $77 ÷ 1.10 = $70
2002 $71 ÷ 1.12 = $63
54
DollarValue
Incr. Incr. LIFO
Layer Cost Retail
Layers Index %
Cost
$60
6
4
$70
x 1.00 x 0.60 = $36
x 1.05 x 0.62 =
4
x 1.10 x 0.64 =
3
$43
Dollar-Value LIFO Retail
Inventory Method--Example
Inv @
Inv @
BaseEoY Price Year
Year Retail Index Retail
2001 $77 ÷ 1.10 = $70
2002 $71 ÷ 1.12 = $63
55
DollarValue
Incr. Incr. LIFO
Layer Cost Retail
Layers Index %
Cost
$60
6
4
$70
$60
3
$63
x 1.00 x 0.60 = $36
x 1.05 x 0.62 =
4
x 1.10 x 0.64 =
3
$43
x 1.00 x 0.60 = $36
x 1.05 x 0.62 =
2
$38
Foreign Currency Transactions-Terminology
• Foreign Currency Transaction: For a U.S.
company, a transaction denominated in a
currency other than the U.S. dollar.
• Spot Rate: The exchange rate at which
currencies can be traded immediately.
56
Foreign Currency Transactions-Example: Scenario
On March 1, Able, a U.S. company, buys
inventory worth 1 million DM from Kraus, a
German company. Payment is due on April
30. Able closes its books every month. Using
the following exchange rates, prepare all
necessary journal entries:
March 1 Rate: $.58/DM
March 31 Rate: $.60/DM
April 30 Rate: $.59/DM
57
Foreign Currency Transactions-Example: Solution
March 1
Inventory..................... 580,000
Accounts Payable....
580,000
Calculation:
DM payable
Exchange rate
Accounts payable
1,000,000
x
.58
$ 580,000
58
Foreign Currency Transactions-Example: Solution
March 31
Exchange Loss................ 20,000
Accounts Payable.........
20,000
Calculations:
Accounts payable (3/1)
Accounts payable (3/31)
($1,000,000 x 0.60)
Exchange loss
$580,000
600,000
$ 20,000
59
Foreign Currency Transactions-Example: Solution
60
April 30
Accounts Payable............... 600,000
Exchange Gain................
10,000
Cash................................
590,000
Calculations:
Accounts payable (3/31)
Cash ($1,000,000 x 0.59)
Foreign exchange gain
$600,000
590,000
$ 10,000
61
The End