1
Chapter 8
Inventories:
Special Valuation
Issues
An electronic presentation
by Douglas Cloud
Pepperdine University
2
Objectives
1. Understand the lower of cost or market
method.
2. Explain the conceptual issues regarding the
lower of cost or market method.
3. Understand purchase obligations and product
financing arrangements.
4. Explain the valuation of inventory above cost.
5. Use the gross profit method.
Continued
3
Objectives
6. Understand the retail inventory method.
7. Explain the conceptual issues regarding the
retail inventory method.
8. Understand the dollar-value LIFO retail method.
9. Understand the effects of inventory errors on
the financial statements.
4
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.
5
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)
6
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
7
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
8
Lower of Cost or Market
Case 1
Selling price
$165
Cost of completion
(10 )
Transportation cost
(15 )
Ceiling (NRV)
$140
Current
Current
Replacement Replacement
Cost, $120
Cost, $120
Ceiling (NRV)
Normal profit
Floor
Cost
$110
Market
$120
$140
(40 )
$100
LCM is the
cost of
$110
9
Lower of Cost or Market
Case 2
Selling price
$165
Cost of completion
(10 )
Transportation cost
(15 )
Ceiling (NRV)
$140
Current
Current
Replacement Replacement
Cost, $150
Cost, $150
Ceiling (NRV)
Normal profit
Floor
Cost
$110
What
Mkt. =is$140
market?
$140
(40 )
$100
LCM is the
cost of
$110
10
Lower of Cost or Market
Case 3
Selling price
$165
Cost of completion
(10 )
Transportation cost
(15 )
Ceiling (NRV)
$140
Current
Current
Replacement Replacement
Cost, $75
Cost, $75
Ceiling
Normal profit
Floor
Cost
$110
What
Mkt. =is$120
market?
$140
(20 )
$120
LCM is the
cost of
$110
11
Lower of Cost or Market
Try one more.
12
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=is$105
Mkt.
market?
Ceiling (NRV)
Normal profit
Floor
$140
(40 )
$100
LCM is the
market of
$105
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 $600$2,400
Item 4
2,500
2,200
$4,500
$4,600
Total
$6,700
$6,600
Inventory valuation
Individual Items
$ 700
1,200
2,000
2,200
$6,100
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 $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
15
Lower of Cost or Market
Inventory
Category A:
Item 1
Item 2
Cost
Market
Total
$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
$6,600
$6,600
16
Lower of Cost or Market
Recording the Reduction of Inventory to Cost
December 31, 2003
December 31, 2004
December 31, 2005
Cost
$20,000
25,000
30,000
Market
$20,000
22,000
28,000
Assume the company uses a
periodic system.
17
Lower of Cost or Market
Direct Method—December 31, 2004
To close beginning inventory:
Income Summary
Inventory
To record ending inventory:
Inventory
Income Summary
20,000
20,000
22,000
An adjusting entry for the loss
is not required.
22,000
18
Lower of Cost or Market
Direct Method—December 31, 2005
To close beginning inventory:
Income Summary
Inventory
To record ending inventory:
Inventory
Income Summary
22,000
22,000
28,000
An adjusting entry for the loss
is not required.
28000
19
Lower of Cost or Market
Allowance Method—December 31, 2004
To close beginning inventory:
Income Summary
20,000
Inventory
20,000
To record ending inventory:
Inventory
25,000
Income Summary
25,000
To record inventory at market:
Loss Due to Market Valuation
3,000
Allow. to Reduce Inventory to Market
3,000
20
Lower of Cost or Market
Allowance Method—December 31, 2005
To close beginning inventory:
Income Summary
25,000
Inventory
25,000
To record ending inventory:
Inventory
30,000
Income Summary
30,000
To record inventory at market:
Allowance to Reduce Inventory to Market 1,000
Loss Recovery Due to Market
Valuation
1,000
21
Purchase Obligations and Product
Financing Arrangements
A company entered
into a noncancelable
commitment to
purchase inventory at a
fixed price of $500,000
and the market price at
the end of the year is
$450,000.
22
Purchase Obligations and Product
Financing Arrangements
Year-end adjusting entry:
Loss on Purchase Commitments
Accrued Loss on Purchase
Commitments
When the goods are purchased:
Inventory (or Purchases)
Accrued Loss on Purchase
Commitments
Accounts Payable
50,000
50,000
450,000
50,000
500,000
23
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.
24
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
25
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.
26
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%.
27
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
28
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
Estimated gross profit (from
Slide 27)
Estimated cost of goods sold
$130,000
(52,000 )
$ 78,000
29
Gross Profit Method
Step 4: Subtract the estimated cost of goods
sold from the actual cost of goods
available for sale.
Beginning inventory
Net purchases
Cost of goods available for sale
Less: Estimated cost of goods
sold (from Slide 28)
Estimated cost of ending inventory
$ 10,000
90,000
$100,000
(78,000 )
$ 22,000
30
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.
31
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
32
Retail Inventory Method
Step 2: A cost-to-retail ratio is computed.
Cost
Beginning inventory
$ 10,000
Purchases
50,000
Goods available for sale $ 60,000
Cost-to-retail ratio:
$ 60,000 = 0.60
$100,000
Retail
$ 17,000
83,000
$100,000
33
Retail Inventory Method
Step 3:
2: A
The
cost-to-retail
ending inventory
ratio isatcomputed.
retail is
computed.
Cost
Beginning inventory
$ 10,000
Purchases
50,000
Goods available for sale $ 60,000
Less: Sales
Retail
$ 17,000
83,000
$100,000
(80,000)
Ending inventory at retail
$ 20,000
34
Retail Inventory Method
Step 4: The ending inventory at cost is
computed.
Cost
Retail
Beginning inventory
$ 10,000 $ 17,000
Purchases
50,000
83,000
Goods available for sale $ 60,000 $100,000
Less: Sales
$20,000 x 0.60 (80,000)
Ending inventory at retail
Ending inventory at cost $12,000
$ 20,000
35
Retail Inventory Method
Terminology
Increased selling
price to $11
Original selling
price ($10)
Additional
Markup
Markup
Cost ($6)
36
Retail Inventory Method
Terminology
Reduced selling
price to $10.25
Markup
Cancellation
Cost ($6)
Net markup = Total additional markups - total
markup cancellations
37
Retail Inventory Method
Terminology
Reduced selling
price to $9
Cost ($6)
Markup
Cancellation
Markdown
38
Retail Inventory Method
Terminology
Net markdown = Total additional markdowns - total
markdown cancellations
Increased selling
price to $9.60
Cost ($6)
Markdown
Cancellation
39
Retail Inventory Method—FIFO
The fifo method excludes the
beginning inventory in determining
the cost-to-retail ratio.
FIFO
40
Retail Inventory Method—FIFO
Purchases
Net markups
Net markdowns
Cost
$40
$40
Beginning inventory
20
Goods available$40
for sale
$60
= 0.533
Less sales
$75
Ending inventory at retail
Retail
$ 80
5
(10 )
$ 75
35
$110
(66 )
$ 44
Ending inventory at FIFO cost (0.533 x $44) = $23.45
41
Retail Inventory Method—
Average Cost
The average cost method includes
the beginning inventory in
determining the cost-to-retail ratio.
Average
Cost
42
Retail Inventory Method—
Average Cost
Cost
$20
40
Retail
$ 35
80
5
(10 )
$110
(66 )
$ 44
Beginning inventory
Purchases
Net markups
Net markdowns
Goods available for sale
$60
Less sales
$60
Ending inventory
at retail
= 0.545
$110
Ending inventory, average cost (0.545 x $44) = $23.98
43
Retail Inventory Method—LIFO
lifo cost
method excludes
AThe
separate
cost-to-retail
ratio is the
also
beginning
inventory
determining
computed
for eachinlayer
in the
the
cost-to-retail
ratio.
beginning
inventory.
LIFO
44
Retail Inventory Method—LIFO
Cost
$20
40
Beginning inventory
Purchases
Net markups
$20
Net markdowns
= 0.57
$35
40
Goods available$40
for sale
$60
= 0.533
$75
Less sales
Ending inventory at LIFO at retail
$35 x 0.57 (beginning inventory layer)
$ 9 x 0.533 (added layer)
Ending inventory at LIFO cost
Retail
$ 35
80
+
5
(10 )
75
=
$110
(66 )
$ 44
$20.00
4.80
$24.80
45
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
46
Retail Inventory Method—LCM
Beginning inventory
Purchases
Net markups
Cost
$20
40
$60
Net markdowns
Goods available for$60
sale
$60
= 0.50
Less sales
$120
Ending inventory at retail
Retail
$ 35
80
5
$120
(10 )
$110
(66 )
$ 44
Ending inventory at LCM (0.50 x $44) = $22
47
Conceptual Evaluation—LCM
The lower of cost or market
method is accurate only if
either markups
and other conditions the
Under
markdowns do not exist
loweratofthe
average cost or
time or if all the marked-down
market produces an inventory
inventory hasvalue
been sold.
that is less than cost, but
only approximates the lower of
cost or market.
48
Dollar-Value LIFO Retail Method
Calculate the ending inventory at retail.
Beginning inventory
Purchases
Net markups
Net markdowns
Goods available for sale
Sales
Ending inventory at retail
Cost
Retail
$ 8,000
20,400
$12,000
32,000
3,000
(1,000 )
$46,000
(29,800 )
$16,200
49
Dollar-Value LIFO Retail Method
Compute ending inventory to base-year
retail prices by applying the base-year
conversion index.
Ending Inventory
Ending
Current-Year Price Index
at Base-Year = Inventory at x
Base-Year Price Index
Retail Prices
Retail
$15,000
=
$16,200
x
100
108
50
Dollar-Value LIFO Retail Method
The increase (decrease) in the inventory at
retail is computed by comparing the ending
inventory with the beginning inventory.
Ending inventory at base-year
retail price……………………. $15,000
12,000
Beginning inventory, 1/1/2004..
$ 3,000
Increase
51
Dollar-Value LIFO Retail Method
The increase (decrease) in the inventory at
retail is converted to current-year retail
prices.
Layer Increase at Increase at
Current-Year Price Index
Current-Year = Base-Year x
Base-Year Price Index
Retail Prices
Retail Prices
$3,240
=
$3,000
x
108
100
52
Dollar-Value LIFO Retail Method
The increase (decrease) at current-year
retail prices is converted to cost.
$3,240 x .60 = $1,944
The ending inventory at cost is computed
by adding (subtracting) the increase
Cost of purchases was $20,400 in
(decrease) at cost to the beginning
2004 while purchases adjusted for net
inventory
at cost.
markups and
net markdowns was
$34,000 (32,000 + $3,000 - $1,000)
$1,944 + $8,000 = $9,944
$20,400 ÷ $34,000
= 60%
Beginning
inventory at cost
53
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.
54
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.
55
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.
56
Effects 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.
57
Effects 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.
58
Effects 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.
59
Chapter 8
The End
60