Chapter 9
Inventories: Additional
Valuations Issues
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1. Lower of Cost or Market

Required by GAAP*
◦ Inventory must be reported at LCM

Theory
◦ should not report inventory at a value higher
than benefits to be received from selling it

Stated reason: “conservative approach”
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1a. Lower of Cost or Market

Definition of market
◦ cost to replace the item (replacement cost)
◦ really “lower of cost or constrained market”

Ceiling
◦ market can’t exceed NRV
◦ NRV = selling price – selling costs

Floor
◦ market can’t be lower than NRV less normal profit
◦ floor = NRV – normal profit margin
Can apply to individual items, groups of items, or whole
inventory
 Does not apply to damaged or deteriorated goods

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1b. Lower of Cost or Market

Example
Selling price
Additional selling costs
Normal profit margin
Cost
Current replacement cost
Case A
$58
Case B
$37
Case C
$21
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$60
$10
40% (of selling price)
$36
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1c. Other Valuation Bases

Valuation at Net Realizable Value
◦ e.g., recognizing revenue at completion of
production

Valuation using Relative Sales Value
◦ basket purchase
◦ meat-packing plant
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2. Purchase Commitments
Generally seller retains title to merchandise
Buyer recognizes no asset or liability
If material, the buyer should disclose contract
details in footnote
 If contract price > the market price, and buyer
expects that losses will occur when purchase
made



◦ buyer should recognize liability and corresponding
loss in period when market declined

Omit Hedging
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3. Inventory Estimation Methods

Gross profit method
◦ based on relationship between sales and gross
profit
◦ not acceptable for financial reporting or taxes

Retail method
◦ used by large volume retailers
◦ dollar based method – not unit based method
◦ acceptable for financial reporting and taxes
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4. Gross Profit Method

Based on assumptions that
◦ gross profit is constant from period-to-period
◦ sales mix of products is constant

Used to estimate inventory value
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4a. Gross Profit Method

Example
Sales
Cost of goods sold
Gross profit




$200
$120
$ 80
GP % = 80/200 = 40%
CGS% = 120/200 = 60%
GP% on sales = 80/200 = 40%
GP% on cost = 80/120 = 66⅔%
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GP on Sales =
GP on Costs
1 + GP on Costs
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4a. Gross Profit Method

Example
A hurricane destroyed the entire inventory stored in a
warehouse. The following information is available from
the company’s records.
Beginning inventory
$220,000
Purchases
$400,000
Sales
$600,000
Historical gross profit rate
30%
Required: Estimate the cost of the destroyed inventory.
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4a. Gross Profit Method

Example — Solution
Beginning inventory (from records)
Plus: Net purchases (from records)
Cost of goods available for sale
Less: Cost of goods sold:
Net sales
Less: Estimated gross profit of 30%
Estimated cost of goods sold
Estimated cost of inventory destroyed
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$220,000
400,000
620,000
$600,000
(180,000)
(420,000)
$200,000
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5. Retail Method
Method is based on the pattern between
the cost and retail value of the goods
 Method requires:

1. total costs of goods purchased
2. total retail value of goods available for sale
3. total sales

Companies always keep 1 & 3
◦ with this method also must keep 2
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5a. Retail Method

Basic method
Cost
Beginning Inventory
Retail
600
1,000
Net Purchases
5,000
8,000
Goods Available for Sale
5,600
9,000
Cost Ratio: 5,600/9,000 = .62222
Sales
7,500
Ending Inventory at Retail
1,500
End Inv at Cost (1,500 x .62222)
933
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5c. Retail Method

Retail terminology
Term

Meaning
Initial markup
Original markup reflected in sales price
Additional markup
Additional increase in selling price after
original markup
Markup cancellation
Elimination of additional markup
Markdown
Reduction in selling price below original
selling price
Markdown cancellation
Elimination of markdown
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5b. Retail Method

Ratios – computed as:
cost of goods available for sale
retail value of goods available for sale

Based on how ratio computed, can be used
to approximate following methods:
◦
◦
◦
◦
average – include everything
LCM – exclude markdowns (conventional retail method)
FIFO – exclude beginning inventory
LIFO – compute separate ratio for each layer
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5d. Retail Method
Cost
Retail
Beginning Inventory
+
+
Purchases
+
+
Purchases Returns
-
-
Purchases Discounts
-
Freight-In
+
Net Markups
+
Net Markdowns
-
Available for Sale
X
X
Sales
-
Sales Returns and Allow.
+
Sales Discounts
+
Ending Inventory at Retail
X
Ending Inventory at Cost
X
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5e. Retail Method
Avg.
method
Cost
+
+
-
Beginning Inventory
Purchases
Purchases Returns and Allow.
Purchases Discounts
Freight-In
Net Markups
Net Markdowns
Available for Sale
Sales
Sales Returns and Allow.
Sales Discounts
Ending Inventory at Retail
X
Ending Inventory at Cost
X
Retail
+
+
-
+
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X
+
+
X
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5f. Retail Method
LCM
method
Cost
+
+
-
Beginning Inventory
Purchases
Purchases Returns and Allow.
Purchases Discounts
Freight-In
Net Markups
Net Markdowns
Available for Sale
Sales
Sales Returns and Allow.
Sales Discounts
Ending Inventory at Retail
X
Ending Inventory at Cost
X
Retail
+
+
-
+
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+
X
+
+
X
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5g. Retail Method
FIFO
method
Cost
+
+
-
Beginning Inventory
Purchases
Purchases Returns and Allow.
Purchases Discounts
Freight-In
Net Markups
Net Markdowns
Available for Sale
Sales
Sales Returns and Allow.
Sales Discounts
Ending Inventory at Retail
X
Ending Inventory at Cost
X
Retail
+
+
-
+
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+
X
+
+
X
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5h. Retail Method
•Example
Cost
Retail
Beginning Inventory
195,000
400,000
Net Purchases
300,000
450,000
Net Markups
50,000
Net Markdowns
<20,000>
Available for Sale
495,000
880,000
Net Sales
407,000
Ending Inventory at Retail
473,000
Ending Inventory at Cost
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