Chapter 9 inventories: additional valuation issues Sommers – Intermediate I

1. Chapter 9 inventories:additional valuation issuesSommers – Intermediate I

2. LCM Approach Lower-of-cost-or-market approach to valuing inventory GAAP generally require the use of historical cost to value assets, but a departure from cost is necessary when the utility of an asset is no longer as great as its cost. The utility or benefits from inventory result from the ultimate sale of the goods. This utility could be reduced below cost due to deterioration, obsolescence, or changes in price levels. To avoid reporting inventory at an amount greater than the benefits it can provide, the lower-of-cost-or-market approach to valuing inventory was developed. This approach results in the recognition of losses when the value of inventory declines below its cost, rather than in the period in which the goods are ultimately sold.

3. Discussion Question Q9-2 Explain the rationale for the ceiling and floor in the lower-of-cost-or-market method of valuing inventories.

4. Determining Market Value Step 1Determine Designated Market Step 2Compare Designated Market with Cost CeilingNRV Not More Than DesignatedMarket Cost ReplacementCost Or Not Less Than Lower of CostOr Market NRV – NPFloor

5. Example 1: LCM Tatum Company has four products in its inventory. Information about the Dec 31, 2011, inventory is as follows: The normal gross profit percentage is 25% of cost. Determine the balance sheet inventory carrying value at Dec 31, 2011, assuming the LCM rule is applied to individual products.

6. Example 1: Continued

7. Applying Lower of Cost or Market Lower of cost or market can be applied 3 different ways. • Apply LCM to each individual item in inventory. • Apply LCM to each class of inventory. • Apply LCM to the entire inventory as a group.

8. Example 2: LCM applications Almaden Hardware Store sells two distinct types of products, tools and paint products. Information pertaining to its 2011 year-end inventory is as follows: Determine balance sheet inventory carrying value at year-end, assuming the LCM rule is applied to individual products, then product type, and then total inventory.

9. Example 2: Continued

10. Evaluation of LCM Rule Some Deficiencies: • Expense recorded when loss in utility occurs. Profit on sale recognized at the point of sale. • Inventory valued at cost in one year and at market in the next year. • Net income in year of loss is lower. Net income in subsequent period may be higher than normal if expected reductions in sales price do not materialize. • LCM uses a “normal profit” in determining inventory values, which is a subjective measure.

11. Valuation at Net Realizable Value Permitted by GAAP under the following conditions: • a controlled market with a quoted price applicable to all quantities, and • no significant costs of disposal (rare metals and agricultural products) • or • too difficult to obtain cost figures (meatpacking).

12. Purchase Commitments • Generally seller retains title to the merchandise. • Buyer recognizes no asset or liability. • If material, the buyer should disclose contract details in footnote. • If the contract price is greater than the market price, and the buyer expects that losses will occur when the purchase is effected, the buyer should recognize a liability and a corresponding loss in the period during which such declines in market prices take place.

13. Purchase Commitments • Purchase commitments are contracts that obligate a company to purchase a specified amount of merchandise or raw materials at specified prices on or before specified dates. In July 2011, the Lassiter Company. signed two purchase commitments. • The first requires Lassiter to purchase inventory for $500,000 by November 15, 2011. The inventory is purchased on November 14, and paid for on December 15. On the date of acquisition, the inventory had a market value of $425,000. • The second requires Lassiter to purchase inventory for $600,000 by February 15, 2012. On December 31, 2011, the market value of the inventory items was $540,000. On February 15, 2012, the market value of the inventory items was $510,000. Lassiter uses the perpetual inventory system and is a calendar year-end company.

14. Purchase Commitments November 14, 2011 Inventory (market price) 425,000 Loss on purchase commitment 75,000 Accounts payable 500,000 December 15, 2011 Accounts payable 500,000 Cash 500,000 Single-period commitment December 31, 2011 Unrealized loss on commitment 60,000 Estliabon purch commitment 60,000 February 15, 2012 Inventory (market price) 510,000 Loss on purchase commitment 30,000 Estliab on purch commitment 60,000 Cash 600,000 Multi-period commitment

15. Inventory Estimation Techniques Estimate instead of taking physical inventory • Less costly • Less time consuming • Sometimes only option! Two popular methods are . . . • Gross Profit Method • Retail Inventory Method (next time)

16. Gross Profit Method The gross profit method estimates cost of goods sold, which is then subtracted from cost of goods available for sale to obtain an estimate of ending inventory. The estimate of cost of goods sold is found by multiplying sales by the historical ratio of cost to selling prices. The cost percentage is the reciprocal of the gross profit ratio. Relies on Three Assumptions: • Beginning inventory plus purchases equal total goods to be accounted for. • Goods not sold must be on hand. • The sales, reduced to cost, deducted from the sum of the opening inventory plus purchases, equal ending inventory.

17. Example 3: Gross Profit Method Royal Gorge Company uses the gross profit method to estimate ending inventory and cost of goods sold when preparing monthly financial statements required by its bank. Inventory on hand at the end of October was $58,500. The following information for the month of November was available from company records: Purchases $ 110,000 Freight-in3,000 Sales180,000 Sales returns 5,000 Purchases returns 4,000 In addition, the controller is aware of $8,000 of inventory that was stolen during November from one of the company’s warehouses. Calculate the estimated inventory at the end of November, assuming a gross profit ratio of 40%.

18. Example 3: Continued Beginning inventory (from records) Plus: Net purchases Freight-in (from records) Cost of goods available for sale Less: Cost of goods sold: Net sales Less: Estimated gross profit of 40% Estimated cost of goods sold Estimated cost of inventory before theft Less: Stolen inventory Estimated ending inventory

19. Evaluation of Gross Profit Method Disadvantages: • Provides an estimate of ending inventory. • Uses past percentages in calculation. • A blanket gross profit rate may not be representative. • Normally unacceptable for financial reporting purposes. GAAP requires a physical inventory as additional verification.

20. Retail Inventory Method A method used by retailers, to value inventory without a physical count, by converting retail prices to cost. Requires retailers to keep: • Total cost and retail value of goods purchased. • Total cost and retail value of the goods available for sale. • Sales for the period. Methods • Conventional Method • LIFO • Dollar-value LIFO

21. Retail Inventory Method Explain the retail inventory method of estimating ending inventory. The retail inventory method first determines the amount of ending inventory at retail by subtracting sales for the period from goods available for sale at retail. Ending inventory at retail is then converted to cost by multiplying it by the cost-to-retail percentage.

22. The Retail Inventory Method This method was developed for retail operations like department stores. • Uses both the retail value and cost of items for sale to calculate a cost-to-retail percentage. Objective: Convert ending inventory at retail to ending inventory at cost. Terminology: • Initial markup - Original amount of markup from cost to selling price. • Additional markup - Increase in selling price subsequent to initial markup. • Markup cancellation - Elimination of an additional markup. • Markdown - Reduction in selling price below the original selling price. • Markdown cancellation - Elimination of a markdown.

23. Inventory Notation Beginning Balance Purchases Cost of Goods Available for Sale Ending Balance Cost of Goods Sold ? ?

24. Example 4: Conventional Retail Method Sparrow Company uses the retail inventory method to estimate ending inventory and cost of goods sold. Data for 2011 are as follows: Cost Retail Beginning inventory $ 90,000 $180,000 Purchases 355,000 580,000 Freight-in 9,000 Purchase returns 7,000 11,000 Net markups 16,000 Net markdowns 12,000 Normal spoilage 3,000 Abnormal spoilage 4,800 8,000 Sales 540,000 Sales returns 10,000 The company records sales net of employee discounts. Discounts for 2011 totaled $4,000. Estimate Sparrow’s ending inventory and cost of goods sold for the year using the conventional retail inventory method

25. Example 4: Conventional

26. Inventory Disclosures (CVS from MD&A) Inventory Our inventory is stated at the lower of cost or market on a first-in, first-out basis using the retail method of accounting to determine cost of sales and inventory in our CVS/pharmacy stores, weighted average cost to determine cost of sales and inventory in our mail service and specialty pharmacies and the cost method of accounting on a first-in, first-out basis to determine inventory in our distribution centers. Under the retail method, inventory is stated at cost, which is determined by applying a cost-to-retail ratio to the ending retail value of our inventory. Since the retail value of our inventory is adjusted on a regular basis to reflect current market conditions, our carrying value should approximate the lower of cost or market. In addition, we reduce the value of our ending inventory for estimated inventory losses that have occurred during the interim period between physical inventory counts.

27. LIFO Retail Inventory Method When applying LIFO, if inventory increases during the year, none of the beginning inventory is assumed sold. Ending inventory includes the beginning inventory plus the current year’s layer. To determine layers, we compare ending inventory at retail to beginning inventory at retail and assume that no more than one inventory layer is added if inventory increases. Each layer carries its own cost-to-retail percentage that is used to convert each layer from retail to cost.

28. Example 5: LIFO Retail Inventory Crosby Company owns a chain of hardware stores throughout the state. The company uses a periodic inventory system and the retail inventory method to estimate ending inventory and cost of goods sold. The following data are available for the three months ending March 31, 2011: Cost Retail Beginning inventory $ 160,000 $ 280,000 Net purchases 607,760 840,000 Net markups 20,000 Net markdowns 4,000 Net sales 800,000 Estimate the LIFO cost of ending inventory and cost of goods sold for the three months ending March 31, 2011. Assume stable retail prices during the period.

29. Example 5: Continued

30. Inventory Disclosures (Walmart from MD&A) Inventories The Company values inventories at the lower of cost or market as determined primarily by the retail method of accounting, using the last-in, first-out (“LIFO”) method for substantially all of the Walmart U.S. segment’s merchandise inventories. The retail method of accounting results in inventory being valued at the lower of cost or market since permanent markdowns are currently taken as a reduction of the retail value of inventory. The Sam’s Club segment’s merchandise is valued based on the weighted-average cost using the LIFO method. Inventories for the WalmartInternational operations are primarily valued by the retail method of accounting and are stated using the first-in, first-out (“FIFO”) method. At January 31, 2011 and 2010, our inventories valued at LIFO approximated those inventories as if they were valued at FIFO.

31. Inventory Disclosures (Walmart from MD&A) Inventories (Continued) Under the retail method, inventory is stated at cost, which is determined by applying a cost-to-retail ratio to each merchandise grouping’s retail value. The FIFO cost-to-retail ratio is based on the initial margin of beginning inventory plus the fiscal year purchase activity. The cost-to-retail ratio for measuring any LIFO reserves is based on the initial margin of the fiscal year purchase activity less the impact of any markdowns. The retail method requires management to make certain judgments and estimates that may significantly impact the ending inventory valuation at cost, as well as the amount of gross profit recognized. Judgments made include recording markdowns used to sell through inventory and shrinkage. When management determines the salability of inventory has diminished, markdowns for clearance activity and the related cost impact are recorded at the time the price change decision is made. Factors considered in the determination of markdowns include current and anticipated demand, customer preferences and age of merchandise, as well as seasonal and fashion trends. Changes in weather patterns and customer preferences related to fashion trends could cause material changes in the amount and timing of markdowns from year to year.

32. Dollar-Value LIFO Retail • We need to eliminate the effect of any price changes before we compare the ending inventory with the beginning inventory.

33. Example 6: Dollar-Value LIFO Retail Method Smith-Kline Company maintains inventory records at selling prices as well as at cost. For 2011, the records indicate the following data: Cost Retail Beginning inventory $ 80 $ 125 Purchases 671 1,006 Freight-in on purchases 30 Purchase returns 1 2 Net markups 4 Net markdowns 8 Net sales 916 Assuming the price level increased from 1.00 at January 1 to 1.10 at December 31, 2011, use the dollar-value LIFO retail method to approximate cost of ending inventory and cost of goods sold.

34. Example 6: Continued

35. Example 6: Continued Cost of goods available for sale (including beginning inventory) $780 Less estimated ending inventory at cost 130 Estimated cost of goods sold $650

36. Evaluation of Retail Inventory Method Widely used for the following reasons: • To permit the computation of net income without a physical count of inventory. • Control measure in determining inventory shortages. • Regulating quantities of merchandise on hand. • Insurance information. Some companies refine the retail method by computing inventory separately by departments or class of merchandise with similar gross profits.

37. IFRS RELEVANT FACTS - Similarities • IFRS and GAAP account for inventory acquisitions at historical cost and evaluate inventory for lower-of-cost-or-market subsequent to acquisition. • Who owns the goods—goods in transit, consigned goods, special sales agreements—as well as the costs to include in inventory are essentially accounted for the same under IFRS and GAAP.

38. IFRS RELEVANT FACTS - Differences • The requirements for accounting for and reporting inventories are more principles-based under IFRS. That is, GAAP provides more detailed guidelines in inventory accounting. • A major difference between IFRS and GAAP relates to the LIFO cost flow assumption. GAAP permits the use of LIFO for inventory valuation. IFRS prohibits its use. FIFO and average-cost are the only two acceptable cost flow assumptions permitted under IFRS. Both sets of standards permit specific identification where appropriate. • In the lower-of-cost-or-market test for inventory valuation, IFRS defines market as net realizable value. GAAP, on the other hand, defines market as replacement cost subject to the constraints of net realizable value (the ceiling) and net realizable value less a normal markup (the floor). IFRS does not use a ceiling or a floor to determine market.

39. IFRS RELEVANT FACTS - Differences • Under GAAP, if inventory is written down under the lower-of-cost-or-market valuation, the new basis is now considered its cost. As a result, the inventory may not be written back up to its original cost in a subsequent period. Under IFRS, the write-down may be reversed in a subsequent period up to the amount of the previous write-down. Both the write-down and any subsequent reversal should be reported on the income statement. • IFRS requires both biological assets and agricultural produce at the point of harvest to be reported at net realizable value. GAAP does not require companies to account for all biological assets in the same way. Furthermore, these assets generally are not reported at net realizable value. Disclosure requirements also differ between the two sets of standards.