Chapter 9
Inventories: Special
Valuation Issues
Intermediate Accounting 11th edition
Nikolai Bazley Jones
An electronic presentation
By Norman Sunderman
and Kenneth Buchanan
Angelo State University
COPYRIGHT © 2010 South-Western/Cengage Learning
2
Lower of Cost or Market
The lower of cost or market rule requires
that a company write down its inventory to
its market value when the inventory’s utility
has declined.
3
Lower of Cost or Market
4
Lower of Cost or Market
The reduction of the value of the inventory to market and
the recognition of a loss are appropriate for both a
company’s balance sheet and income statement. GAAP
defines assets as “probable future economic benefits.”
When the cost of the inventory exceeds the expected
benefits, the lower market value is a better measure of the
expected benefits. In other words, an unrecoverable cost is
not an asset. A company should recognize the decline in
value of the inventory as a reduction in the income of the
period in which the loss occurs.
5
IFRS vs. U.S. GAAP
 IFRS, like U.S. GAAP, require the use of the lower of
cost or market method to value inventory.
 However, market is defined as net realizable value and
should typically be applied to individual items.
 By defining market as net realizable value, IFRS
eliminate the need to use a ceiling and a floor.
 IFRS do not specify the income statement line item
under which the write-down should be recorded.
 While U.S. GAAP prohibits any reversal of a previous
write-down, IFRS do allow the reversal of a previous
write-down, which is then recognized in income.
6
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.
7
Product Financing
In a product financing arrangement, the company
“sells” the inventory to another company. Then, in a
related transaction, it agrees to purchase the
inventory (or a substantially identical item) back from
the other company at specified prices over specified
periods. Typically the inventory is not delivered to the
“buyer” and is repurchased at a higher price, the
difference being an interest charge.
The company may not record sales revenue but
instead must record the proceeds received as a
liability.
8
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
prices, and for which appropriate costs may
be difficult to obtain
9
Estimating Inventory
Two commonly used methods of
estimating inventory costs are (1)
the gross profit method and (2)
the retail inventory method.
10
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 cost
developed from a physical inventory or
perpetual inventory system.
Continued
11
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.
12
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%.
13
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
0.40
$ 52,000
14
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 32)
Estimated cost of goods sold
$130,000
(52,000)
$ 78,000
15
Gross Profit Method
Step 4: The estimated cost of goods sold is
subtracted from the actual cost of goods
available for sale to determine the
estimated cost of the ending inventory.
Beginning inventory
Net purchases
Cost of goods available for sale
Less: Estimated cost of goods sold:
Net sales
Estimated gross profit
Estimated cost of ending inventory
$ 10,000
90,000
$100,000
$130,000
(52,000)
(78,000)
$ 22,000
16
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.
17
Expressing Gross Profit Percentages
Divide gross profit by sales to
calculate profit as a percentage
of sales.
Gross Profit = Gross Profit as a
Sales
Percentage of Sales
18
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
Gross Profit as a
=
Cost + Gross Profit as a % of Cost
% of Sales
19
Retail Inventory Method
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.
20
Retail Inventory Method
Step 1: The total goods available for sale is
computed at both cost and retail value.
Beginning inventory
Purchases
Goods available for sale
Cost
Retail
$10,000
50,000
$60,000
$ 17,000
83,000
$100,000
21
Retail Inventory Method
Step 2:
Step
A 2:
cost-to-retail
A cost-to-retail
ratioratio
is computed.
is computed.
Beginning inventory
Purchases
Goods available for sale
Cost
Retail
$10,000
50,000
$60,000
$ 17,000
83,000
$100,000
Cost-to-retail ratio:
$ 60,000 = 0.60
$100,000
22
Retail Inventory Method
Step 3:
Step
The
2: ending
A cost-to-retail
inventory
ratio
at retail
is computed.
is
computed.
Beginning inventory
Purchases
Goods available for sale
Less: Sales
Ending inventory at retail
Cost
Retail
$10,000
50,000
$60,000
$ 17,000
83,000
$ 100,000
(80,000)
$ 20,000
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Retail Inventory Method
Step 4: The ending inventory at cost is computed.
Beginning inventory
Purchases
Goods available for sale
Less: Sales
Ending inventory at retail
Ending inventory at cost
0.60 × $20,000
Cost
Retail
$10,000
50,000
$60,000
$ 17,000
83,000
$ 100,000
(80,000)
$ 20,000
$12,000
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Retail Inventory Method Terminology
Increased selling
price to $12
Original selling
price ($10)
Additional
Markup
Markup
Cost ($6)
25
Retail Inventory Method Terminology
Total Additional Markups
– Total Markup Cancellations
= Net Markup
Reduced selling
price to $10.25
Cost ($6)
Markup
Cancellation
26
Retail Inventory Method Terminology
Reduced selling
price to $9
Cost ($6)
Markup
Cancellation
Markdown
27
Retail Inventory Method Terminology
Total Additional Markdowns
– Total Markdown Cancellations
= Net Markdown
Increased selling
price to $9.60
Cost ($6)
Markdown
Cancellation
28
Retail Inventory Method
For methods using cost, such
as average cost, FIFO and
LIFO, the net markdowns
are included in calculating
the cost-to-retail ratio.
29
Retail Inventory Method — FIFO
The FIFO method excludes the
beginning inventory in determining the
cost-to-retail ratio.
FIFO
30
Retail Inventory Method — Average Cost
The average cost method includes the
beginning inventory in determining the
cost-to-retail ratio.
Average
Cost
31
Retail Inventory Method — LIFO
Separate
for the
the
The LIFOcost-to-retail
cost methodratios
excludes
beginning inventory
inventory in
and
the purchases
beginning
determining
the
must becost-to-retail
calculated for
the LIFO
ratio.
method.
LIFO
32
Retail Inventory Method — Lower of Average Cost or Market
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
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Conceptual Evaluation — Lower of Average Cost or Market
The lower of cost or market
Under other
method is accurate only if
conditions, the lower
either markups and
of average cost or
markdowns do not exist at
market produces an
the time or if all the markedinventory value that is
down items has been sold.
less than cost but only
approximates the
lower of cost or
market.
34
Dollar-Value LIFO Retail Method
Information for
following slides
35
Dollar-Value LIFO Retail Method
Step 1: Calculate the ending inventory at retail.
Beginning inventory
Purchases
Net markups
Net markdowns
Goods available for sale
Sales
Ending inventory at retail
Cost
$ 8,000
20,400
$28,400
Retail
$ 12,000
32,000
3,000
(1,000)
$ 46,000
(29,800)
$ 16,200
36
Dollar-Value LIFO Retail Method
Step 2: Compute ending inventory to base-year
retail prices by applying the base-year
conversion index.
Ending
Ending
Current-Year Price Index
Inventory at
= Inventory ×
Base-Year
Base-Year Price Index
at Retail
Retail Prices
$15,000
=
$16,200
×
100
108
37
Dollar-Value LIFO Retail Method
Step 3: 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……
Beginning inventory, 1/1/2010
Increase
$15,000
12,000
$ 3,000
38
Dollar-Value LIFO Retail Method
Step 4: The increase (decrease) in the inventory
at retail is converted to current-year retail
prices.
Layer Increase Increase at
Current-Year Price Index
at Current-Year Base-Year
=
×
Retail Prices
Retail
Base-Year Price Index
Prices
$3,240
=
$3,000
×
100
108
39
Dollar-Value LIFO Retail Method
Step 5: The increase (decrease) at current-year
retail prices is converted to cost.
$3,240 × 0.60 = $1,944
Step 6: The ending inventory at cost is computed
Cost of purchases
was $20,400the
in 2010
by adding
(subtracting)
increase
while purchases adjusted for net markups
(decrease)
at costwas
to$34,000
the beginning
and net markdowns
(32,000 +
inventory at$3,000
cost.– $1,000)
$20,400 ÷ $34,000 = 60%
$1,944 + $8,000 = $9,944
Beginning
inventory
at cost
40
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.
41
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.
42
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.
43
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.
44
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.
45
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.
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Chapter 9
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