ACTG 3110

Chapter 9 - Inventories: Additional Valuation Issues

Lower of Cost or Market Valuation

• “Market”– Generally replacement cost– Should not exceed the net realizable value or

“ceiling”– Should not be lower than the net realizable

value less a normal markup or “floor”

• Market is the middle of the three values above

Lower of Cost or Market Valuation

• Application– By item (most conservative)– By classification– To total inventory

• When item is written down, the “market value” becomes its cost for future periods

Methods of Recording LCM Adjustments

• Direct inventory reduction– Reduce inventory account– No holding loss separately stated– Holding loss recorded in cost of goods sold

• Allowance Method– “Allowance to reduce inventory to market” is a contra-inventory

account

– Inventory stated at initial cost

– Holding loss is recorded on income statement

– Holding gains allowed up to previous balance

Valuation Bases

• Valuation at Net Realizable Value– Selling costs less estimated costs to complete and sell– Must meet two conditions including having a controlled

market• Valuation using Relative Sales Value

– Used to separate costs within a basket purchase• Purchase Commitments

– Not on balance sheet or income statement normally– Must be disclosed if material– If contract price will result in a loss, the loss must be

recorded when the market price decline occurs

Gross Margin Method

• Used to estimate inventory

• Assumes gross margin is constant in the short run

• Not GAAP for annual reports, but can be used for interim reporting

• Steps– Estimate the gross margin rate– Compute cost of goods available for sale– Determine gross margin from gross margin rate X sales

Gross Margin Method

• Steps (continued)– Compute cost of goods sold by subtracting

gross margin from sales– Compute ending inventory by subtracting cost

of goods sold from costs available for sale

• Limitations - only as good as the estimates

• Applications - casualty losses such as tornadoes, fires, floods, etc.

Retail Inventory Method

• Acceptable for financial reporting

• Used by merchandisers

• Inventory is assigned both a cost and a retail price

• Inventory is taken by retail cost

• “Cost” of ending inventory is backed into

Retail Inventory Method

• Definitions– Markups– Additional markups– Markup cancellations– Markdowns– Markdown cancellations

• Inventory is kept in dollars, not units

Retail Inventory Method

• Cost ratio determination:– Average cost = beginning inventory + purchases

– Conventional or Average Cost LCM - does not include markdowns

• Reflects the most conservative percentage because markdowns are written off

• Freight in only included in cost column• Purchases discounts only affect cost column• Purchases returns affect both cost and retail

Retail Inventory Method• Abnormal shortages should be deducted from both

the cost and retail columns and reported as a special inventory amount or as a loss

• Normal shortages only affect the retail inventory• Sales returns and allowances are proper

adjustments to sales• Employee discounts are deducted from sales but

not included in the cost-to-retail percentage

Presentation and Analysis

• Inventory is presented in the balance sheet- generally in current assets

• A company can use different costing methods for different elements of inventory

• Analysis of inventory – inventory turnover– Cost of goods sold/inventory– Tells us how many times the inventory was sold during

the year– Can convert to average days to sell by dividing the

inventory turnover into 365 days