Inventories: Additional Valuation Issues

Chapter

Chapter 9-1

Lower-of-Cost-or-Market
LCM
A company abandons the historical cost principle when the future utility (revenue-producing ability) of the asset drops below its original cost.
Lower of Cost or Market value determined Market = Replacement Cost if reasonable or other calculated amounts if not reasonable Loss should be recorded when loss occurs, not in the period of sale.

Chapter 9-2

Lower-of-Cost-or-Market
Ceiling and Floor
Why FASB start with Replacement Cost (RC) for Market?
RC allows a consistent rate of gross profit.
Decline in the RC usually = decline in selling price.

If reduction in RC fails to indicate reduction in utility, then two additional valuation limitations are used:

Ceiling - net realizable value (selling price minus selling/disposal costs) Floor - net realizable value less a normal profit margin.

Chapter 9-3

Lower-of-Cost-or-Market
E9-2

Chapter 9-4

Lower-of-Cost-or-Market
Recording LCM
Ending inventory (cost) Ending inventory (LCM) Adjustment to LCM Allowance Method Direct Method Loss on inventory Allowance on inventory Cost of goods sold Inventory 65,000 65,000 $ 415,000 350,000 $ 65,000 65,000 65,000

Chapter 9-5

Lower-of-Cost-or-Market
Balance Sheet Presentation
Allowance Current assets: Cash Accounts receivable Inventory Less: inventory allowance Prepaids Total current assets $ 100,000 350,000 770,000 (65,000) 20,000 1,175,000 20,000 1,175,000 $ 100,000 350,000 705,000 Direct

Chapter 9-6

Lower-of-Cost-or-Market
Income Statement Presentation
Sales Cost of goods sold Gross profit Operating expenses: Selling General and administrative Total operating expenses Other revenue and expense: Loss on inventory Interest income Total other Income from operations Income tax expense Net income
Chapter 9-7

Allowance $ 300,000 120,000 180,000 45,000 20,000 65,000 65,000 5,000 (60,000) 55,000 16,500 $ 38,500 $ $

Direct 300,000 185,000 115,000 45,000 20,000 65,000 5,000 5,000 55,000 16,500 38,500

Lower-of-Cost-or-Market

E9-4, P9-3

Chapter 9-8

Inventory Estimation Techniques

Why do we estimate?
Data lost to unforeseen circumstances fire, insurance
F/S needed during the year and physical inventory not available Auditor testing for reasonableness Forecasting and budgeting

Chapter 9-9

Inventory Estimation Techniques - Retail Inventory Method

A method used primarily by retailers
Accepted by IRS and FASB for reporting inventory Requires retailers to keep:
(1) the total cost and retail value of goods purchased, (2) the total cost and retail value of the goods available for sale, and (3) the sales for the period.
Chapter 9-10

Retail Inventory Method

Step 1: Calculate Ending inventory info at retail: BI + Purch Sales = EI Note: CGAS = BI + Purch Step 2: Calculate a Cost to retail %: CGAS / CGAS Step 3: Estimate EI : EI = EI * CGAS / CGAS
Chapter 9-11

Retail Inventory Method

Main differences in 3 Retail Inventory Methods: 1) Average Cost Retail cost includes markups, markdowns to determine Cost-to-Retail% 2) LCM ( conventional retail) Exclude markdowns in determining Cost-toRetail% 3) LIFO Determine Cost-to-Retail% for beginning and current period inventory layers (based on Avg. cost method)

Chapter 9-12

Retail Inventory Method

Include Additional items that affect CostRetail% and EI at retail prices (discussed in handout).

Chapter 9-13

Retail Inventory Method

E 9-19 (adapted)

Chapter 9-14

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 holding losses in the period during which such declines in market prices take place. No holding gains are recognized.
Chapter 9-15

Purchase Commitments
See BE 9-5 & 6

Chapter 9-16

Inventory Estimation Techniques - Gross Profit Method

Provides an estimate of ending inventory.

Only acceptable for interim (generally quarterly) reporting purposes.

Relies on Three Assumptions:

(1) Beginning inventory plus purchases equal total goods to be accounted for. (2) Goods not sold must be on hand.

(3) The sales, reduced to cost, deducted from the sum of the opening inventory plus purchases, equal ending inventory.
Chapter 9-17

Gross Profit Method

Computation of Gross Profit Percentage
Illustration 9-17

Chapter 9-18

Gross Profit Method

BE 9-7, E9-12

Chapter 9-19

U.S. GAAP permits the use of LIFO for inventory valuation. iGAAP prohibits its use. In the lower-of-cost-or-market test for inventory valuation, iGAAP defines market as net realizable value. U.S. GAAP defines market as replacement cost subject to the constraints.

In U.S. GAAP, inventory written down under the lower-of-cost-ormarket valuation may not be written back up to its original cost in a subsequent period. Under iGAAP, the write-down may be reversed in a subsequent period.

Chapter 9-20