Chapter 9

1. Chapter 9 Inventories: Additional Valuations Issues

2. 1. Lower of Cost or Market • Required by GAAP* • Inventory must be reported at LCM • Theory • should not report inventory at a value higher than benefits to be received from selling it • Stated reason: “conservative approach”

3. 1a. Lower of Cost or Market • Definition of market • cost to replace the item (replacement cost) • really “lower of cost or constrained market” • Ceiling • market can’t exceed NRV • NRV = selling price – selling costs • Floor • market can’t be lower than NRV less normal profit • floor = NRV – normal profit margin • Can apply to individual items, groups of items, or whole inventory • Does not apply to damaged or deteriorated goods

4. 1b. Lower of Cost or Market • Example Selling price $60 Additional selling costs $10 Normal profit margin 40% (of selling price) Cost $36 Current replacement cost Case A $58 Case B $37 Case C $21

5. 1c. Other Valuation Bases • Valuation at Net Realizable Value • e.g., recognizing revenue at completion of production • Valuation using Relative Sales Value • basket purchase • meat-packing plant

6. 2. Purchase Commitments • Generally seller retains title to merchandise • Buyer recognizes no asset or liability • If material, the buyer should disclose contract details in footnote • If contract price > the market price, and buyer expects that losses will occur when purchase made • buyer should recognize liability and corresponding loss in period when market declined • Omit Hedging

7. 3. Inventory Estimation Methods • Gross profit method • based on relationship between sales and gross profit • not acceptable for financial reporting or taxes • Retail method • used by large volume retailers • dollar based method – not unit based method • acceptable for financial reporting and taxes

8. 4. Gross Profit Method • Based on assumptions that • gross profit is constant from period-to-period • sales mix of products is constant • Used to estimate inventory value

9. 4a. Gross Profit Method • Example Sales $200 Cost of goods sold $120 Gross profit $ 80 • GP % = 80/200 = 40% • CGS% = 120/200 = 60% • GP% on sales = 80/200 = 40% • GP% on cost = 80/120 = 66⅔% GP on Sales = GP on Costs 1 + GP on Costs

10. 4a. Gross Profit Method • ExampleA hurricane destroyed the entire inventory stored in a warehouse. The following information is available from the company’s records. Beginning inventory $220,000 Purchases $400,000 Sales $600,000 Historical gross profit rate 30% Required: Estimate the cost of the destroyed inventory.

11. 4a. Gross Profit Method • Example — Solution Beginning inventory (from records) $220,000 Plus: Net purchases (from records) 400,000 Cost of goods available for sale 620,000 Less: Cost of goods sold: Net sales $600,000Less: Estimated gross profit of 30% (180,000) Estimated cost of goods sold (420,000) Estimated cost of inventory destroyed $200,000

12. 5. Retail Method • Method is based on the pattern between the cost and retail value of the goods • Method requires: • total costs of goods purchased • total retail value of goods available for sale • total sales • Companies always keep 1 & 3 • with this method also must keep 2

13. 5a. Retail Method • Basic method

14. 5c. Retail Method • Retail terminology • Net markups and net markdowns

15. 5b. Retail Method • Ratios – computed as: cost of goods available for sale retail value of goods available for sale • Based on how ratio computed, can be used to approximate following methods: • average – include everything • LCM – exclude markdowns • FIFO – exclude beginning inventory • LIFO – compute separate ratio for each layer

16. 5d. Retail Method

17. 5e. Retail Method Avg. method

18. 5f. Retail Method LCM method

19. 5g. Retail Method FIFO method

20. 5h. Retail Method • Example