Chapter 9
Inventories: Special
Valuation Issues
Intermediate Accounting 10th edition
Nikolai Bazley Jones
An electronic presentation
by Norman Sunderman
Angelo State University
COPYRIGHT © 2007 Thomson South-Western, a part of The Thomson Corporation.
Thomson, the Star logo, and South-Western are trademarks used herein under license.
2
Lower of Cost or Market
The lower of cost or market rule
requires that a company write down its
inventory to market value when the
inventory’s utility has declined.
3
Definitions
Inventory: estimated selling price in
completed condition
$1,150
Less: estimated costs to complete and sell 150
Net realizable value-ceiling
$1,000
Less: normal profit
100
NRV less normal profit-floor
$900
Continue
4
Lower of Cost or Market
Selection of
Market Value
Ceiling (Net
Realizable Value)
Replacement Cost
Floor (Net
Realizable Value Normal Profit)
Comparison
to Cost
Use lower of
(a) cost or
(b) selected
market value
Reporting
the Results
Balance
sheet:
Inventory at
LCM
Income
statement:
Loss (if
recognized)
5
Lower of Cost or Market
A company’s unit of
inventory has the following
characteristics:
Selling price
$165
Packaging cost
10
Transportation cost 15
Profit margin
40
6
Lower of Cost or Market
Case 1
Selling price
$165
Cost of completion
(10)
Transportation cost (15)
Ceiling (NRV)
$140
Ceiling (NRV)
Normal profit
Floor
$140
(40)
$100
7
Lower of Cost or Market
Case 1
Selling price
$165
Cost of completion
(10)
Transportation cost (15)
Ceiling (NRV)
$140
Current
Replacement
Cost, $120
Cost
$110
What is
Market
market?
$120
Ceiling (NRV)
Normal profit
Floor
$140
(40)
$100
LCM is the
cost of
$110
8
Lower of Cost or Market
Case 2
Selling price
$165
Cost of completion
(10)
Transportation cost (15)
Ceiling (NRV)
$140
Current
Replacement
Cost, $150
Cost
$110
What
$140is
market?
Ceiling (NRV)
Normal profit
Floor
$140
(40)
$100
LCM is the
cost of
$110
9
Lower of Cost or Market
Case 3
Selling price
$165
Cost of completion
(10)
Transportation cost (15)
Ceiling (NRV)
$140
Current
Replacement
Cost, $75
Cost
$110
What
is $120
Mkt. =
market?
Ceiling
Normal profit
Floor
$140
(20)
$120
LCM is the
cost of
$110
10
Lower of Cost or Market
Try one more.
11
Lower of Cost or Market
Case 4
Selling price
$165
Cost of completion
(10)
Transportation cost (15)
Ceiling (NRV)
$140
Current
Replacement
Cost, $105
Cost
$110
What
$105is
market?
Ceiling
Normal profit
Floor
$140
(40)
$100
LCM is the
market of
$105
12
Lower of Cost or Market
Inventory
Category A:
Item 1
Item 2
Cost
Market Individual Items
$1,000
$ 700
1,200
1,300
$2,200 Loss$2,000
Category B:
recognition,
Item 3
$2,000 $600$2,400
Item 4
2,500
2,200
$4,500
$4,600
Total
$6,700
$6,600
Inventory valuation
$ 700
1,200
2,000
2,200
$6,100
13
Lower of Cost or Market
Inventory
Category A:
Item 1
Item 2
Cost
Market
$1,000
$ 700
1,200
1,300
$2,200 Loss$2,000
Category B:
recognition,
Item 3
$2,000 $200$2,400
Item 4
2,500
2,200
$4,500
$4,600
Total
$6,700
$6,600
Inventory valuation
Category
$2,000
4,500
$6,500
14
Lower of Cost or Market
Inventory
Category A:
Item 1
Item 2
Cost
Market
$1,000
$ 700
1,200
1,300
$2,200 Loss$2,000
Category B:
recognition,
Item 3
$2,000 $100$2,400
Item 4
2,500
2,200
$4,500
$4,600
Total
$6,700
$6,600
Inventory valuation
Total
$6,600
$6,600
15
Lower of Cost or Market
Recording the Reduction of Inventory to Cost
December 31, 2006
December 31, 2007
December 31, 2008
Cost
$20,000
25,000
30,000
Market
$20,000
22,000
28,000
Assume the company uses a
periodic system.
16
See Example 9-1
on page 416.
17
Purchase Obligations
To lock in prices and assure sufficient quantities of
materials, companies often contract with suppliers
to purchase a specified quantity of materials in the
future at an agreed upon unit cost.
See page 424.
18
See page 343
19
Valuation Above Cost
In exceptional cases inventories properly
may be stated above cost.
 Precious metals having a fixed monetary
value with no substantial cost of marketing.
 Agricultural, mineral and other products,
units of which are interchangeable, and have
an immediate marketability at quoted price
for which appropriate costs may be difficult
to obtain.
20
Gross Profit Method
A company uses the gross profit method in the
following situations:
1. To determine the cost of the inventory at the
end of an interim period without taking a
physical count.
2. For the internal or external auditor to check
the reasonableness of an inventory value
developed from a physical inventory or
perpetual inventory system.
Continued
21
Gross Profit Method
A company uses the gross profit method in the
following situations:
3. To estimate the cost of inventory that is
destroyed by a casualty.
4. To estimate the cost of inventory from
incomplete records.
5. To develop a budget of cost of goods sold
and ending inventory from a sales budget.
22
Gross Profit Method
Step 1: The historical gross profit rate is
calculated by dividing the gross
profit of the prior period(s) by
the net sales of the prior
period(s).
Assume
40%.
23
Gross Profit Method
Step 2: The gross profit for the current
period is estimated by
multiplying the historical gross
profit rate by the actual net sales
for the period.
Net sales
Gross profit rate
Estimated gross profit
$130,000
.40
$ 52,000
24
Gross Profit Method
Step 3: The estimated gross profit is
subtracted from the actual net
sales to determine the estimated
cost of goods sold for the period.
Net sales
$130,000
Estimated gross profit (from
Slide 32)
(52,000 )
Estimated cost of goods sold $ 78,000
25
Gross Profit Method
Step 4: Subtract the estimated cost of
goods sold from the actual cost of
goods available for sale.
Beginning inventory
$ 10,000
Net purchases
90,000
Cost of goods available for sale
$100,000
Less: Estimated cost of goods sold
Net sales
$130,000
Estimated gross profit
(52,000) (78,000)
Estimated cost of ending inventory
$ 22,000
26
Enhancing the Accuracy of
the Gross Profit Method
1. A company should adjust the gross profit rate
for known changes in the relationship
between its gross profit and net sales.
2. A company may use a separate gross profit
rate for each department or type of inventory
that has a different markup percentage.
3. A company may use an average gross profit
rate based on several past periods to average
out period-to-period fluctuations.
27
Expressing Gross Profit
Percentages
Divide gross profit by
sales to calculate profit as
a percentage of sales.
Gross Profit
Sales
=
Gross Profit as a
Percentage of Sales
28
Expressing Gross Profit
Percentages
If the gross margin
percentage is expressed as a
percentage of cost it must be
converted to a gross margin
as a percentage of sales
Gross Profit as a % of Cost
=
Cost + Gross Profit as a % of Cost
Gross Profit as a
% of Sales
29
Another method of
estimating inventory is the
retail inventory method,
which is widely used
because it is allowed under
GAAP and for income tax
purposes.
30
Retail Inventory Method
Step 1: The total goods available for sale
is computed at both cost and
retail value.
Cost
Beginning inventory $ 10,000
Purchases
50,000
Goods available for sale$ 60,000
Retail
$ 17,000
83,000
$100,000
31
Retail Inventory Method
Step 2:
Step
2: A cost-to-retail
cost-to-retail ratio
ratioisiscomputed.
computed.
Cost
Retail
Beginning inventory
$ 10,000 $ 17,000
Purchases
50,000
83,000
Goods available for sale $ 60,000 $100,000
Cost-to-retail ratio:
$ 60,000 = 0.60
$100,000
32
Retail Inventory Method
Step 2:
Step
3: A
The
cost-to-retail
ending inventory
ratio is computed.
at retail is
computed.
Cost
Beginning inventory $ 10,000
Purchases
50,000
Goods available for sale $60,000
Less: Sales
Ending inventory at retail
Retail
$ 17,000
83,000
$100,000
(80,000)
$ 20,000
33
Retail Inventory Method
Step 4: The ending inventory at cost is
computed.
Cost
Beginning inventory $ 10,000
Purchases
50,000
Goods available for sale $60,000
Less: Sales
Ending inventory at retail
Ending inventory at cost
$12,000
0.60 x $20,000
Retail
$ 17,000
83,000
$100,000
(80,000)
$ 20,000
34
Retail Inventory Method
Terminology
Increased selling
price to $11
Original
selling price
($10)
Cost ($6)
Additional
Markup
Markup
35
Retail Inventory Method
Terminology
Reduced selling
price to $10.25
Markup
Cancella
-tion
Cost ($6)
Net markup =Total additional markups total markup cancellations
36
Retail Inventory Method
Terminology
Reduced selling
price to $9
Cost ($6)
Markup
Cancella
-tion
Markdown
37
Retail Inventory Method
Terminology
Net markdown =Total additional markdowns total markdown cancellations
Increased selling
price to $9.60
Cost ($6)
Markdown
Cancellation
38
Retail Inventory Method
For methods using cost,
such as average cost,
FIFO and LIFO, the net
markdowns are included
in calculating the ratio.
39
Retail Inventory Method-Average Cost
The average cost method includes
the beginning inventory in
determining the cost-to-retail
ratio.
Average
Cost
40
Retail Inventory Method-Average Cost
Cost
$20
40
Beginning inventory
Purchases
Net markups
Net markdowns
Goods available for sale $60
Less sales
Ending inventory at retail
$60
= 0.545
$110
Retail
$ 35
80
5
(10)
$110
(66)
$ 44
Ending inventory, average cost (0.545 x $44) =
$23.98
41
Retail Inventory Method-LCM
The lower of cost or market method
includes the beginning inventory, but
excludes any net markdowns in
determining the cost-to-retail ratio.
Lower of
Cost or
Market
42
Conceptual Evaluation-LCM
The lower of cost or market
method is accurate only if
Under other
either markups and
conditions the lower
markdowns do not exist at
of average cost or
the time or if all the markedmarket produces an
down inventory has been
inventory value that is
sold.
less than cost, but
only approximates the
lower of cost or
market.
43
Retail Inventory Method--LCM
Cost
$20
40
Beginning inventory
Purchases
Net markups
$60
$60
= 0.50
Net markdowns
$120
Goods available for sale $60
Less sales
Ending inventory at retail
Retail
$ 35
80
5
$120
(10)
$110
(66)
$ 44
Ending inventory at LCM (0.50 x $44) = $22
44
Effects of Inventory Errors
A purchase on credit is omitted from both the
Purchases account and ending inventory and is
not recorded in the succeeding year.
Current Year
Income Statement
Income is correct.
Balance Sheet
Ending inventory and
Accounts Payable are
understated.
45
Effects of Inventory Errors
A purchase on credit is omitted from both the
Purchases account and ending inventory and is
not recorded in the succeeding year.
Succeeding Year
Income Statement
Income is overstated
and cost of goods sold
is understated.
Balance Sheet
Accounts Payable is
understated and
Retained Earnings is
overstated.
46
Effects of Inventory Errors
A purchase on credit is omitted from the
Purchases account but ending inventory is
correct.
Current Year
Income Statement
Income is overstated
and cost of goods sold
is understated.
Balance Sheet
Accounts Payable is
understated and
Retained Earnings is
overstated.
47
Effect of Inventory Errors
A purchase on credit is omitted from the
Purchases account but ending inventory
is correct.
Succeeding Year
Income Statement
No effect.
Balance Sheet
Accounts Payable is
understated and
Retained Earnings is
overstated.
48
Effect of Inventory Errors
Ending inventory is over(under)stated
due to quantity and/or costing errors,
but the Purchases account is correct.
Current Year
Income Statement
Income is
over(under)stated and
cost of goods sold is
under(over)stated.
Balance Sheet
Ending inventory and
Retained Earnings are
over(under)stated.
49
Effect of Inventory Errors
Ending inventory is over(under)stated due to
quantity and/or costing errors, but the
Purchases account is correct.
Succeeding Year
Income Statement
Income is
under(over)stated and
cost of goods sold is
over(under)stated.
Balance Sheet
No effect.
50
Chapter 9
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