CHAPTER 9 Inventories: Additional Valuation Problems

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LECTURE OUTLINE This chapter describes inventory valuation problems and estimation techniques. The chapter can be covered in three to four class sessions. The fourth class session would generally be used to cover Appendix 9-A. Appendix 9-A describes the application of the LIFO retail method under two assumptions: (1) stable prices and (2) fluctuating prices. Most students have had only brief previous exposure to the chapter topics. For example, many students are aware of the LCM valuation rule for inventory but have not dealt with the ceiling and floor constraints. Similarly, many students were exposed to a retail inventory method (usually the conventional retail method) but have no experience with LIFO retail, and are unfamiliar with such complications as markups, markdowns, employee discounts, normal and abnormal spoilage, etc. Emphasize that the Chapter 9 inventory techniques do not represent complete departures from the FIFO, LIFO, and average cost bases of valuing inventory. For example, the LCM rule results in inventory being stated at the lower of FIFO cost or market," or "lower of average cost or market," etc. Similarly, the retail method can be adapted to approximate any of the major cost flow assumptions: FIFO, LIFO, or average cost.

The following lecture outline is appropriate for this chapter. A. Lower of Cost or Market (LCM).

1.

The general rule is that the historical cost principle is abandoned when the future utility of the asset is no longer as great as its original cost.

2.

The term "market" in the LCM rule means the cost to replace the item by purchase or reproduction. This is a measurement of entry value. a.

The market amount is limited by ceiling and floor restrictions that are based on measurements of exit value.

(1) The ceiling is equal to net realizable value: estimated selling price less estimated disposal cost. (2) The floor is equal to the ceiling less normal profit margin. b.

Point out the reasons for this lower of cost or "constrained market" rule:

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(1) A decline in the selling price of an item is not always accompanied by a decline in cost. That is, entry values do not always respond immediately and proportionately to changes in exit values. (See Warner and Whitehurst, bibliography reference 9.) (2) If an item has not lost its revenue-producing power, a writedown to replacement cost in the current period would understate current income and overstate income in the period of sale. 3.

Describe the two-step computational approach to LCM valuation: TEACHING TIP

Illustration 9-1 can be used to discuss the lower of cost or market technique. The 2step approach is demonstrated for two different examples. a.

First find the designated "market" figure: replacement cost, the ceiling, and the floor.

This is the middle value of

b.

Then find the lower of historical cost or "designated market."

4.

The LCM rule may be applied either (a) directly to each item or (b) to the total of the inventory or (c) in some cases, to the total of the components of each major category. As soon as the inventory is written down to market, the new basis is considered to be the cost basis for future periods.

5.

Recording market declines in inventory. Two possibilities:

6.

a.

Direct method—Show the inventory at market in both the balance sheet and the cost of goods sold section of the income statement. The disadvantage is that the market decline is buried in the cost of goods sold figure.

b.

Allowance method—Record the market decline with a debit to a loss account and a credit to an allowance account which is deducted from Inventory on the balance sheet. The allowance account must be adjusted each period.

The conceptual deficiencies of the LCM rule include:

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a.

Inconsistent treatment of recognizing a loss in the period when inventory values decrease but delaying inventory value increases until the period when inventory is sold.

b.

Application of the rule results in inconsistency because the inventory may be valued at cost in one year and at market in the next year.

c.

LCM inventory valuation results in a conservative inventory value on the balance sheet but it may have the opposite effect on the income statement in subsequent periods if expected sales price declines do not materialize.

d.

Subjectivity in calculating a "normal profit" that may present opportunities for income manipulation.

B. Other Valuation Bases.

1.

Valuation at net realizable value—Certain goods (such as minerals and agricultural products) that are sold in a controlled market with a quoted price applicable to all quantities and with no significant disposal costs may be reported at net realizable value.

2.

Valuation using the relative sales value method—When several different assets are acquired in a lump-sum purchase the joint cost can be allocated on the basis of relative sales value.

For example, suppose that two assets are acquired for $1,000. Asset 1 has a selling price of $700 and Asset 2 has a selling price of $800. $700 Allocated cost of Asset 1 = $1,500 x $1,000 = $467.

$800 Allocated cost of Asset 2 = $1,500 x $1,000 = $533.

C. Purchase Commitments.

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1.

Accounting for ordinary purchase orders which are subject to cancellation by the buyer or seller: These do not represent either an asset or a liability to the buyer. They are not recorded or reported in the financial statements.

2.

Accounting for formal purchase orders for which a firm price has been established: a.

If the market price exceeds the contracted price—disclose the existence of the contract in the notes, if material.

b.

If the market price is less than the contracted price —

(1) Debit a loss account and credit a liability account (Estimated Loss on Purchase Commitments). (2) Eliminate the liability account when the inventory is acquired. Record any additional price decline as an additional loss. Record any price recovery (up to the contract price) as a gain (Recovery of Loss). Point out that as a result of this procedure: (a) The loss is recorded in the period of price decline rather than in the period of acquisition. (b) The inventory is entered on the books at the lower of contract price or market as of the date of acquisition. 3.

Point out that accounting for purchase commitments (and other executory contracts) is controversial. Discuss the logic of recording a loss and a liability on assets that have not yet been acquired. To whom is such a liability owed? (See Henderson and Peirson, bibliography reference 7; Gujarathi and Biggs, bibliography reference 4.)

D. The Gross Profit Method.

1.

This method is used when an estimate of a firm's inventory is required. The resulting estimate is acceptable for interim reporting purposes but not generally for annual reporting.

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2.

3.

Point out that four items of information are sufficient to estimate the cost of ending inventory:

a.

Cost of beginning inventory.

b.

Cost of purchases for the period.

c.

Sales during the period.

d.

Markup, expressed either as a percentage of cost or as a percentage of sales.

Point out that in this context the terms "gross margin," "gross profit," and "markup" are synonymous. Discuss the distinction between markup expressed as a percentage of cost and markup expressed as a percentage of sales. Describe how the percentage markup is computed.

For example, an item that costs $60 and is sold for $75 has a gross profit or markup of $15. Markup as a Percentage of Sales $15 Markup = Selling Price = $75 = 20%.

Markup as a Percentage of Cost Markup $15 = Cost = $60 = 25%.

4.

Describe how to convert a markup on cost to a markup on sales.

a.

From markup cost to markup on sales. markup on cost = markup on sales 1 + markup on cost

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b.

From markup sales to markup on cost. markup on sales 1 – markup on sales = markup on cost

TEACHING TIP

Discuss the steps in solving gross profit problems as demonstrated by the example in Illustration 9-2.

5.

Appraisal of the gross profit method. a.

It provides an estimate based on past percentages.

b.

Use of a blanket gross profit rate is not appropriate when a company handles different lines of merchandise with widely varying rates of gross margin.

E. The Retail Inventory Method. TEACHING TIP

The gross profit and conventional retail methods can be demonstrated with the numerical example given in Illustration 9-3.

1.

Like the gross profit method, the retail method provides an estimate of ending inventory. Unlike the gross profit method, the retail method produces estimates that may be acceptable for financial statement purposes.

2.

More detailed records are required for the retail method than for the gross profit method. Under the retail method records must be kept of the following. a.

Beginning inventory at cost and at retail.

b.

Purchases for the period at cost and at retail.

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3.

c.

Sales during the period at retail.

d.

The cost and/or retail amounts of special items such as markups, markdowns, employee discounts, spoilage, etc. Discuss the meaning of each of these items.

Variations of the retail method: a.

Point out that the retail method can be adapted for use with: (1) any of the major inventory cost flow assumptions: FIFO, LIFO, or Average. (2) either of the inventory valuation methods: cost or LCM. (3) either of the LIFO approaches: stable prices (unit LIFO) or fluctuating prices (dollar-value LIFO). Discussed in Appendix 9-A.

b.

Therefore several variations are possible, although not all of the possible combinations are in accordance with GAAP (i.e., LIFO should be reported at cost and not at LCM). The textbook illustrates three of the possible variations: (1) Average at LCM (conventional retail). (2) LIFO at cost with stable prices (LIFO retail). Discussed in Appendix 9-A. (3) LIFO at cost with fluctuating prices (dollar-value LIFO retail). Discussed in Appendix 9-A.

4.

Point out that there are three basic steps in computing all retail inventory problems: a.

Compute ending inventory at retail. This step is the same regardless of which variation (LIFO cost or average LCM, etc.) is used. The Feminine Executive Apparel illustration on text page 466 provides a good example of the major items (normal and abnormal shortage, employee discounts, etc.) which may arise in the computation of ending inventory at retail.

b.

Compute the cost-to-retail ratio. This step will vary depending on which variation of the retail method is used. The following formulas may be used:

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(1) Conventional retail (average LCM) ratio = At Cost At Retail

Beginning Purchase Returns, Abnormal Inventory + Purchases – Allowances, Discounts + Freight-in – Spoilage Beginning Purchase Returns, Abnormal Net Markups + Purchases – – Inventory Allowances, Discounts Spoilage +

F. Financial Statement Presentation of Inventories. disclosed:

The following items must be

1.

The composition of manufactured inventory (raw materials, work in process, and finished goods).

2.

Unusual or significant financing arrangements including related party transactions, firm purchase commitments, involuntary LIFO liquidation, etc.

3.

The inventory costing methods used.

4.

The consistency of costing methods from one period to another.

5.

Supplementary price-level information is voluntary.

G. APPENDIX 9-A. LIFO Retail Methods TEACHING TIP

Illustration 9-4 can be used to demonstrate the LIFO retail method using both stable and fluctuating prices.

1.

The methods are: a.

LIFO retail (LIFO at cost with stable prices)

b.

Dollar-value LIFO retail (LIFO at cost with fluctuating prices)

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2.

Emphasize the following when teaching the two LIFO retail approaches: a.

The beginning inventory cost and retail data are excluded from computation of the cost-to-retail ratio.

b.

Both net markups and net markdowns are considered in obtaining the cost-to-retail ratio.

c.

It is assumed that the markups and markdowns apply only to the goods purchased during the current period and not to the beginning inventory.

d.

The LIFO computation proceeds by separate layers for each year.

3. The three basic steps in computing the cost of ending inventory using LIFO retail methods are: a.

Compute ending inventory at retail.

b.

Compute the cost-to-retail ratio. (1) LIFO retail stable or fluctuating prices) ratio =

At Purchase Returns, Abnormal Cost Purchases – Allowances, Discounts + Freight-in – Spoilage Purchase Returns, Abnormal At Purchases – – + Net Markups Allowances, Discounts Spoilage Retail Net Markdowns

c.

–

Apply the cost-to-retail ratio to the ending inventory at retail to obtain the ending inventory at LIFO cost. (1) LIFO retail (stable prices): The computation proceeds by separate layers for each year. (a) When ending inventory at retail is larger than beginning inventory at retail, an inventory layer has been added. 1) Subtract the beginning inventory at retail and write the beginning inventory at cost. 2) Multiply the current cost-to-retail ratio by the new layer at retail to obtain the inventory increase at cost.

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3) Add 1) and 2) to obtain the ending inventory at LIFO cost. (b) When ending inventory at retail is less than beginning inventory at retail, a portion of the beginning layers has been liquidated. Previous layers must be reduced in a LIFO flow starting with the last layer added. (2) Dollar-value LIFO retail (fluctuating prices): The computation proceeds by separate layers for each year. (a) Use the current price index to deflate the ending inventory at retail to the ending inventory at base-year retail prices. (b) Separate the ending inventory at base-year prices [from step (a)] into layers for each year. (c) For each layer from step (b), multiply the amount by the appropriate cost-to-retail ratio and by the appropriate price index to obtain the amount of each layer at LIFO cost. (d) Add each layer from step (c) to obtain the total ending inventory at LIFO cost. Any decrease in inventory layers is "peeled off" at prices in existence when the layers were previously added. TEACHING TIP

The relationship between the dollar-value and retail LIFO methods can be shown with Illustrations 9-5. This example illustrates the use of the methods over five periods and includes an inventory decrease in one period. Illustration 9-6 contains the 1953 AICPA statements related to inventory valuation. 5.

Appraisal of the Retail Inventory Method. a.

The method permits: (1) the computation of net income without a physical count of inventory. (2) a control measure in determining inventory shortages. (3) regulation of quantities of merchandise on hand. (4) a basis for information needed for insurance purposes.

b.

The method has an averaging effect on varying rates of gross margin. Problems may arise when the averages being used are not reflective of underlying conditions. 9-11