Ch. 9: Inventory Lower of Cost or Market

1. Ch. 9: Inventory Lower of Cost or Market The lower of cost or market is an exception to the historical cost principle. • Future potential of the asset < original cost: • Restate asset at market to replace cost. • Loss charged against revenues of the period.

2. Lower of Cost or Market Rules: Ceiling and Floor Market value is the replacement cost. - The replacement cost must lie between a ceiling amount and a floor amount. - Ceiling is the net realizable value (NRV= selling price less disposal cost). - Floor is net realizable value less a normal profit margin. • The “designated market value” is the “middle” value amongst the replacement cost, ceiling, and floor • Designated market value compared against the Cost value to determine if an LCM write-down is needed.

3. 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 $ B $88,000 $90,000 $100,000 $70,000 $ C $88,000 $90,000 $100,000 $90,000 $ D $88,000 $90,000 $87,000 $70,000 $

4. 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.)

5. Lower of Cost or Market Application The lower of cost or market may be applied: • Either directly to each item * most conservative approach * generally required for tax purposes • To each category, or • To the total of the inventory Whichever method is selected, it should be consistently applied.

6. LCM Example

7. What if the Market Value Recovers? Recording the Decline in Market Value For subsequent increases in inventory value: • US GAAP prohibits the reversal of writedowns • IFRS requires the reversal of writedowns

8. Other Valuation Issues • Valuation at Net Realizable Value • Controlled market with a quoted price for all quantities • No significant costs of disposal • Relative Sales Value – “Basket Purchase” • Purchase Commitments

9. Valuation Basis: Relative Sales Values • 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 • Cancellable contracts • No entry or disclosure required • Formal, non-cancelable contracts • No entry, but disclosure required • If execution of the contract expected to result in a loss, then must be recorded DR Unrealized loss CR Est liability on purchase commitment

14. Inventory Estimation Techniques • Inventory estimation 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

15. Gross Profit Method to Determine EI • The Gross Profit Method uses estimated COGS (= actual sales X 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 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: Est 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.

19. Retail Inventory Method 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)

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 ratio x Ending inventory at cost COGS