Agenda

1. Agenda • Quiz 3 (Chapter 7) due Wednesday 2/18 • Midterm 2 next Monday 2/23 (ch. 18, 7-9) • Project 2 due Wednesday 2/25 • Inventory • Dollar Value LIFO • Lower of Cost or Market (LCM) • Relative Sales Value • Ending Inventory Estimation Techniques • Gross Profit Method • Retail Inventory Method

2. Ch. 9 Lower of Cost or Market The lower of cost or market is an exception to the historical cost principle. When the future potential of the asset is less than its original cost: • Restate asset at market to replace cost. • The loss must be charged against revenues of the period.

3. Lower of Cost or Market: Ceiling and Floor The lower of cost or market (LCM) rules: • Market value is the replacement cost. • The replacement cost must lie between a ceiling amount and a floor amount. • (therefore if RC < floor, use floor as Market value) • (therefore if RC > ceiling, use ceiling as Market value) • i.e. choose the “middle” value amongst the replacement cost, ceiling, and floor to be the Market value to compare against the Cost value. • The ceiling is the net realizable value (NRV) (selling price less disposal cost). • IFRS requires reporting inventory at the lower of NRV or cost (therefore US GAAP and IFRS will only be equal when the replacement cost is greater than the NRV) • The floor is net realizable value less a normal profit margin. • For subsequent increases in inventory value: • US GAAP prohibits the reversal of writedowns • IFRS requires the reversal of writedowns

4. Inventory Valuation—Lower of Cost or Market

5. Lower of Cost or Market: Ceiling and Floor: Example Item Replacement Historical Ceiling Floor Final Cost Cost Inv $ A $88,000 $80,000 $120,000 $104,000 $80,000 B $88,000 $90,000 $100,000 $70,000 $88,000 C $88,000 $90,000 $100,000 $90,000$90,000 D $88,000 $90,000 $87,000 $70,000 $87,000

6. Lower of Cost or Market The lower of cost or market may be applied: • Either directly to each item, • To each category, or • To the total of the inventory Whichever method is selected, it should be consistently applied.

7. Recording the Decline in Market Value Under the direct method: DR. COGS CR. Inventory Under the indirect (allowance) method: DR. Loss CR. Allowance (contra- inventory acct.)

8. LCM Example

9. Valuation Basis: Relative Sales Values • Relative sales values are an appropriate basis, when basket purchases are made. • Basket purchases involve a group of varying units. • The purchase price is paid as a lump sum amount. • The lump sum price is allocated to units on the basis of their relative sales values.

10. Relative Sales Values: Example Kirby Company buys three different lots (A, B and C) in a basket purchase, paying $300,000 for all three. The lots were sold as follows: A ($75,000); B ($150,000) and C ($200,000) for a total of $425,000. What is the cost of A, B and C and the gross profit for each lot?

11. Relative Sales Values: Example Lot Sales Allocated Gross Value Cost Profit A $75,000 ($75,000/$425,000) x $ 300,000 = $ 52,941 $ 22,059 B $150,000 $105,882 $ 44,118 C $200,000$ 141,176 $ 58,824 Totals $425,000 $300,000 $125,000

12. Relative Sales Values: Example 2

13. Purchase Commitments • Formal, non-cancelable purchase contracts are not recognized in the accounts but should be disclosed. • If the contract is cancellable, or renegotiable, then you don’t need to recognize any loss • If it is expected that execution of the contract will result in a loss, then recognition of the loss is appropriate.

14. Inventory Estimation Techniques • Inventory estimation used when: • Used if a fire or other catastrophe destroys either inventory or inventory records • Used if taking a physical inventory is impractical • Used by auditors when they only need an estimate of the company’s inventory • 2 methods to estimate inventory: • Gross profit method • Retail Inventory method

15. Gross Profit Method to Determine EI • The Gross Profit Method uses estimated COGS (this is calculated by taking actual sales X the average gross profit on sales) to determine estimated ending inventory • Example: On 10/16/07, Whitsunday Company’s warehouse burned and its inventory was completely destroyed. The accounting records were kept in the office building and escaped harm. The following information was available as of 10/16/07: Net sales $426,000 Beginning inventory 80,000 Net purchases 300,000 Average gross profit on sales 20% Use the above information to estimate the ending inventory lost in the fire using the gross profit method.

16. Gross Profit Method to Determine EI Net sales $426,000 Beginning inventory 80,000 Net purchases 300,000 Average gross profit on sales 20% Beginning inventory $80,000 Net purchases 300,000 Cost of goods available for sale 380,000 Estimated cost of goods sold: Net sales 426,000 less: estimated gross profit (85,200)(340,800) Estimated ending inventory $39,200

17. Gross Profit Method Example 2 On December 31, 2007 Carr Company's inventory burned. Sales and purchases for the year had been $1,400,000 and $980,000, respectively. The beginning inventory (Jan. 1, 2007) was $170,000; in the past Carr's gross profit has averaged 40% of selling price. Compute the estimated cost of inventory burned. BI __________ + Net Purchases __________ = COGA __________ • Estimated COGS: Net Sales ____________ less estimated gross profit ____________ __________ Estimated Ending inventory __________

18. Retail Inventory Method This inventory estimation technique is used when: • a fire or other catastrophe destroys either inventory or inventory records • taking a physical inventory is impractical • auditors only need an estimate of the company’s inventory • Appropriate for retail concerns with: • high volume sales and • different types of merchandise • Assumes an observable pattern between cost and prices. • Steps: • Determine ending inventory at retail price • Convert this amount to a cost basis using a cost-to-retail ratio BI (at retail) + Net Purchases (at retail) – Net sales = EI (at retail) EI (at retail) X Cost-to-Retail ratio = estimated “EI” (at cost)

19. Retail Inventory Method At CostAt Retail Beginning Inventory XX XX + Purchases (net) XXXX = [Cost of] Goods Available XX ÷ XX = cost/retail ratio -[Cost of Goods] Sold XX = Ending Inventory XX XX

20. Retail Inventory Method: Example Given for the year 2002: at costat retail Beginning inventory $2,000 $3,000 Purchases (Net) $10,000 $15,000 Sales (Net) $12,000 What is ending inventory, at retail and at cost?

21. Retail Inventory Method: Example at costat retail • Beginning inventory $ 2,000 $ 3,000 • Purchases (Net) $10,000 $15,000 • Goods available for sale $12,000 $18,000 • less: Sales (Net) ($12,000) • Ending inventory (at retail) $6,000 • Times: cost to retail ratiox 2/3 • Ending inventory at cost $4,000

22. Retail Inventory Method with Markups, Markdowns and Cancellations Two Retail inventory methods for dealing with markups, markdowns, and cancellations: • Conventional (or LCM) method • Ignores markdowns and markdown cancellations for the cost-to-retail ratio • Cost method • Includes markdowns and markdown cancellations for the cost-to-retail ratio

23. Retail Inventory – Conventional (LCM) Method with Markups, Markdowns and Cancellations Given: at cost at retail • Goods available for sale $20,500 $36,000 • Markups $ 3,000 • Markup cancellations $ 1,000 • Markdowns $ 2,500 • Markdown cancellations $ 2,000 What is the cost-to-retail ratio using the conventional (or LCM) method?

24. Retail Inventory – Conventional (LCM) Method with Markups, Markdowns and Cancellations at cost at retail • Goods available $20,500 $36,000 • Markups $ 3,000 • Markup cancellations ($ 1,000) • Goods available (adj.) $20,500 $ 38,000 • Cost-to-retail ratio ($20,500/ $38,000) = 53.9% • Ignores markdowns and markdown cancellations

25. Retail Inventory – Cost Method with Markups, Markdowns and Cancellations Given: at cost at retail • Goods available $20,500 $36,000 • Markups $ 3,000 • Markup cancellations $ 1,000 • Markdowns $ 2,500 • Markdown cancellations $ 2,000 What is the cost-to-retail ratio using the Cost method?

26. Retail Inventory – Cost Method with Markups, Markdowns and Cancellations at cost at retail • Goods available $ 20,500 $36,000 • Markups $ 3,000 • Markup cancellations ($ 1,000) • Markdowns ($ 2,500) • Markdown cancellations $2,000 • Goods available (adj.) $20,500 $ 37,500 • Cost-to-retail ratio ($20,500/ $37,500) = 54.7% • Include markdowns and markdown cancellations in cost-to-retail ratio

27. Retail Inventory – Conventional (LCM) and Cost Methods With the data above, if Sales are $29,000, calculate ending inventory using: • LCM (Conventional) Method • Cost Method

28. Markups, Markdowns and Cancellations: Example

29. Markups, Markdowns Retail Inv. Ex. 2 When you undertook the preparation of the financial statements for Vancey Company at January 31, 2007, the following data were available: At Cost At Retail Inventory, February 1, 2006 $70,800 $98,500 Markdowns 35,000 Markups 63,000 Markdown cancellations 20,000 Markup cancellations 10,000 Purchases 219,500 294,000 Sales 345,000 Purchases returns and allowances 4,300 5,500 Sales returns and allowances 10,000 Compute the ending inventory at cost as of January 31, 2007, using the retail method which approximates lower of cost or market (conventional method). Your solution should be in good form with amounts clearly labeled.

30. Markups, Markdowns Retail Inv. Ex. 2 At Cost At Retail Beginning inventory, 2/1/06 $ 70,800 $ 98,500 Purchases $219,500 $294,000 Less purchase returns 4,300 215,200 5,500 288,500 Totals $286,000 387,000 Add markups (net) 53,000 Totals 440,000 Deduct markdowns (net) 15,000 Sales price of goods available 425,000 Sales less sales returns 335,000 Ending inventory, 1/31/07 at retail $ 90,000 Ending inventory at cost: Ratio of cost to retail = $286,000 ÷ $440,000 = 65%; $90,000 × 65% = $58,500 $ 58,500