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Inventories: Additional Valuation Issues

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Title: Inventories: Additional Valuation Issues


1
  • Inventories Additional Valuation Issues

2
Objectives of this Chapter
  • I. Introduce Inventory estimation methods the
    gross profit method and the retail inventory
    method.
  • II. Determine ending inventory cost by applying
    the gross profit method.
  • III. Determine ending inventory cost by applying
    the retail inventory method.

3
Objectives of this Chapter (contd.)
  • IV. Compare the gross profit method and the
    retail inventory method.
  • V. Explain dollar-value LIFO retail method.
  • VI. Discuss accounting issues related to purchase
    commitments.

4
I. Estimating Inventory Gross Profit Method and
Retail Inventory Method
  • Reasons For some companies, inventory
    information is needed between accounting periods
    . Companies cannot afford to do physical
    inventory count every quarter.
  • Thus, either the gross profit method or the
    retail inventory method can be used to estimate
    value of ending inventory for interim reports.

5
Estimating Inventory Gross Profit Method and
Retail Inventory Method (contd.)
  • No physical count of inventory is needed for
    either method. The value of inventory is based
    on estimation.
  • Neither method is acceptable for annual financial
    reporting purposes.

6
Estimating Inventory Gross Profit Method and
Retail Inventory Method (contd.)
  • Both methods are acceptable for interim
    reporting.
  • The insurance adjusters may use the gross profit
    method to estimate the loss of inventory in case
    of fire or flood.

7
II. The Gross Profit Method
  • Data Required
  • Beginning Inventory (at cost)
  • Purchase (net) (at Cost)
  • Sales Price
  • Gross Margin Ratio
  • (Gross Margin/Sales Price)

8
Gross Profit MethodExample A
  • Beginning Inv. 60,000
  • Purchase (net) 200,000
  • Sales 280,000
  • Gross Margin Ratio 1 30
  • 1. Gross margin ratio is obtained from past
    years experience (assuming the ratio is stable
    over years).

9
Example A (contd.)
  • Using gross profit method to estimate the cost of
    ending inventory
  • Selling Price Cost
  • Beg. Inventory 60,000
  • Purchase (net) 200,000
  • Goods Available for Sale 260,000
  • Sales 280,000
  • Less gross margin1 (84,000)
  • Sales (at cost) 196,0002
  • Estimated Inv. (at cost) 64,000
  • 1. gross margin 280,000x30
  • 2. also equals 280,000x(1-30) 196,000

10
Gross Profit MethodExample B
  • What if the gross margin ratio is based on cost
    of goods sold (CGS) rather than on sales price?
  • Sales 100
  • CGS (80)
  • Gross Margin 20
  • Gross profit ratio (based on Sales) 20
  • Gross profit ratio (based on CGS) 25
  • Deriving CGS using sales and gross profit ratio
    based on sales 100 x (1 - 20) 80
  • Deriving CGS using sales and gross profit ratio
    based on CGS 100 ? (125) 80

11
Example B (contd.)
  • Sales CGS Gross Profit
  • CGS 25 x CGS
  • CGS x (125)
  • CGS Sales ? (125)

12
Comments on Gross Profit Method
  • If the relationship between the gross profit and
    selling price has been changed, the ratio should
    be adjusted accordingly.
  • A separate gross profit ratio should be applied
    to different inventory.

13
III. Retail Inventory Method
  • Terminology related to retail inventory method

  • Retail Price
  • Original retail price 110
  • Additional markup 5 115
  • Markup Cancellations 5 110
  • Markdowns 5 105
  • Markdown Cancellations 5 110
  • Net Markups Additional Markups - Markup
    Cancellations
  • Net Markdowns Markdowns - Markdown
    Cancellations

14
Retail Inventory Method (contd.)
  • Data required to apply retail method
  • Beg. Inv. (both cost and retail price)
  • Purchases (net) (cost and retail)
  • Sales (subtracting sales returns only)
  • Price adjustment data such as additional markups,
    markup cancellations, markdowns and markdown
    cancellations

15
Retail Inventory MethodExample (assuming no
price adjustments)
  • Cost
    Retail
  • Beg. Inv. 14,000 20,000
  • Purchases (net) 63,0001 90,0002
  • 77,000 110,000
  • Sales 85,0003
  • Estimated End. Inv. 25,000
  • at retail
  • Cost ratio 77,000/110,00070
  • Estimated cost of end. inv. 25,000x7017,500
  • 1. Purchases - Pur. RA - Pur. Dis. Freight-in
  • 2. Purchases - Pur RA
  • 3. Gross sales-Sales Returns Employee Discounts

16
Retail Inventory MethodExample (with price
adjustments)
  • Cost
    Retail
  • Beg. Inv. 14,000 20,000
  • Purchases (net) 63,000 90,000
  • Goods Avail. 77,000 110,000
  • Additional Markups 5,000
  • Markup Cancel. (4,000)
  • Markdowns (1,500)
  • Markdowns Cancel. 200
  • Sales (85,000)
  • Estimated End. Inv. at Retail 24,700
  • Question What is the cost ratio?

17
Retail Inventory MethodExample (with price
adjustments)
  • Cost
    Retail
  • Beg. Inv. 14,000 20,000
  • Purchases (net) 63,000 90,000
  • Goods Avail. 77,000 110,000
  • Net Markups 1,000
  • Goods Avail. after net MU 111,000
  • Net Markdowns (1,300)
  • Goods Avail. after all price adj. 109,700
  • Sales (85,000)
  • End. Inv. at Retail 24,700
  • Sales Sales - Sales RA

18
Cost Ratios for Retail Method
  • 1) Average Method (consider all price adjust.)
  • Cost Ratio
  • 77,000 ? 109,700 70.19.
  • Esti. End. Inv. at cost
  • 24,700 x 70.19 17,336.93
  • 2) LCM approach (conventional retail method)
    (consider only net markups)
  • Cost Ratio
  • 77,000 ?111,000 69.37.
  • 24,700 x 69.37 17,134.39

19
Cost Ratios for Retail Method (contd.)
  • 3) FIFO approximation (excluding the beg. inv. in
    the computation of cost ratio)
  • Cost Ratio
  • (77,000-14,000)?(109,700-20,000)
  • 70.23.
  • Esti. Inv. at cost
  • 24,700 x 70.2317,346.81

20
Cost Ratios for Retail Method (contd.)
  • 4) LIFO approximation (computing two ratios,
    one for the beg. inv. and one for others)
  • Cost Ratio 1(for beg.inv.)
  • 14,000/20,00070
  • Cost Ratio 2(for other inv.)
  • (77,000-14,000)?(109,700-20,000)70.23
  • Esti. End. Inv. at cost
  • 1) 20,000 x 70 14,000
  • 2) 4,700a x 70.23 3,301
  • 17,301
  • a. 24,700-20,0004,700

21
Comments for Retail Method
  • A. Cost Retail
  • Purchases
  • Pur. Discounts ------1
  • Pur. R A
  • Freight-In ------1
  • 1. Pur. Discounts and freight-in are already
    considered in the retail price of purchases.

22
Comments for Retail Method (contd.)
  • B. Sales in the retail column should be gross
    sales - sales returns. This is because the
    retail prices for beg. inv. and purchases are
    based on gross sales, not net sales.
  • Also, if employee discounts have been
    subtracted from sales, they should be added back
    to sales.

23
Comments for Retail Method (contd.)
  • C. Spoilage
  • Cost Retail
  • Normal Spoilage1 ------
  • Abnormal Spoilage2
  • 1. In computing cost ratios, the normal spoilage
    will not be considered.
  • 2. In computing cost ratios, the abnormal
    spoilage will be considered.

24
Retail Inventory Method Special Items Included
  • Cost
    Retail
  • Beg. Inv. 14,000
    20,000
  • Purchases (net) 63,000
    90,000
  • Abnormal Spoilage (1,400) (2,000)
  • Goods Avail. 75,600
    108,000
  • Net Markups 1,000
  • Goods Avail. after net MU 109,000
  • Net Markdowns (1,300)
  • Goods Avail. after all price adj. 107,700
  • Sales 85,000
  • Sales returns (2,000)
    (83,000)
  • Employee Discounts
    (2,000)
  • Normal Spoilage (1,000)
  • End. Inv. at Retail 21,700

25
Retail Inventory Method Special Items
Included(contd.)
  • 1) Average Method (consider all price adjust.)
  • Cost Ratio
  • 75,600 ? 107,700 70.19.
  • Esti. End. Inv. at cost
  • 21,700 x 70.19 15,232.23
  • 2) LCM approach (conventional retail method)
    (consider only net markups)
  • Cost Ratio
  • 75,600 ?10,900 69.36.
  • 21,700 x 69.36 15,051.12

26
Another Example of Conventional Retail Inventory
Method Special Items Included (Illustration
9-3, KWW, 14th e)
27
IV. Comparison of Gross Profit Method and Retail
Inventory Method
  • Gross-Profit Method
  • Retail Inventory Method

1. Data required Cost and retail price of beg.
inv., purchases, sales price and price
adjustments.
1. Data required cost of beg. inv., purchases,
sales and gross profit ratio.
2. Any company can use this method to estimate
ending inventory.
2. Only retail store can apply this method to
estimate inventory.
28
Comparison of Gross Profit Method and Retail
Inventory Method (contd.)
Gross-Profit Method
Retail Inventory Method
3. Gross profit ratio is estimated from past
years experience (not updated with the price
adjustments of the current year).
3. Cost ratio can be calculated at different
stage and is updated with current years price
adjustment data.
29
Comparison of Gross Profit Method and The Retail
Method (contd.)
Gross-Profit Method
Retail Inventory Method
4. Not acceptable for the annual financial
reporting but acceptable for the interim report.
4. Not acceptable for the annual financial
reporting but acceptable for the interim report.
5. No physical count of inventory is needed.
5. No physical count of inventory is needed.
30
V. Dollar-Value LIFO Retail Method
  • Applying retail method to estimate cost of ending
    inventory and also considering price index when
    prices are fluctuating.

31
Dollar-Value LIFO Retail MethodExample
  • Cost Retail
  • Beg. Inv. -20x1 14,000 20,000
  • Purchases (net) 63,000 90,000
  • Goods Avail. 77,000 110,000
  • Net Markups 1,000
  • Goods Avail. after net MU 111,000
  • Net Markdowns (1,300)
  • Goods Avail. after all price adj. 109,700
  • Sales (85,000)
  • End. Inv. at Retail 24,700
  • Cost Ratio(CR) 1(for beg. inv.)14,000/20,00070
  • CR2 (for others)(77,000-14,000)/(109,700-20,000)
  • 70.23

32
Dollar-Value LIFO Retail MethodExample (contd.)
  • Assuming the price indices of 20x0 and 20x1 are
    100 and 112, respectively.
  • Procedures of applying Dollar-Value LIFO concept
    to Retail method (LIFO approximation)

33
Dollar-Value LIFO Retail MethodExample (contd.)
  • 1. Ending inventory at retail prices is deflated
    to base years price level
  • 24,700?112 22,054
  • 2. Forming Layers based on LIFO cost flows
    assumption
  • Beg. inv (retail) at base-year prices
  • (L1) 20,000
  • Inv. increase (retail) from beg. inv.
  • (L2) 2,054

34
Dollar-Value LIFO Retail MethodExample (contd.)
  • Ending Inv Layers Price Cost End. Inv.
  • at Base-year at Base-year Index Ratio at LIFO
  • Retail Prices Retail Prices () ()
    Cost
  • 22,054 20,000 100 70 14,000
  • 2,054 112 70.23 1,616
  • 15,615

35
Dollar-Value LIFO Retail MethodExample (contd.)
  • Subsequent years under Dollar-Value LIFO Retail
  • The D-V LIFO retail method follows the same
    procedures in subsequent years as the traditional
    D-V LIFO method. That is when a real increase in
    inventory occurs, a new layer is added.

36
Dollar-Value LIFO Retail MethodExample (contd.)
  • Using the information on page 27 and assuming the
    retail value of 20x2 ending inventory at current
    price is 42,960. The 20x2 price index is 120
    (20x0 price index is 100) and the cost ratio of
    20x2 is 75.
  • In base-years dollars(20x0),
  • the ending inventory of 20x2 is
  • 42,960 ?120 35,800

37
Dollar-Value LIFO Retail MethodExample (contd.)
  • Ending Inv. Layers Price Cost End. Inv
  • at Base-Year at Base-Year Index Ratio at LIFO
  • Retail Prices Retail Prices () ()
    Cost
  • 35,8001 L1 20,000 100 70 14,000
  • L2 2,054 112 70.23 1,616
  • L3 13,746 120 75 12,371
  • 27,987
  • 1. Current cost of ending Inv. of 20x2
  • 42,960?1.12 35,800
  • L1(layer 1) 20x0 L2 20x1 L3 20x2

38
VI. Purchase Commitments
  • Purchase contract may be signed a few months (or
    years) before the actual delivery date (i.e.,
    George Pacific) to secure the supply of
    inventory.
  • Losses are recognized for any purchase
    commitments outstanding at the end of a period
    when market price is less than contract price
    (i.e., applying a LCM rule in the valuation of
    purchase commitments).

39
Example 1- Contract Period within Fiscal Year
  • Geteway Co. signed a purchase commitment of
    20,000 on 4/30/x5 to buy goods which would be
    delivered on 9/30/x5.
  • 4/30/x5 No entry required.
  • Disclosure of this firm commitment is required
    at the end of a reporting period if the amount is
    significant.

40
Example 1 (contd.)
  • Case 1 When the market price of these goods
    equal or greater than the contract price of
    20,000 on 9/30/x5, the journal entry on 9/30/x5,
    the delivery date, would be
  • 9/30/x5
  • Purchases 20,000
  • Cash 20,000

41
Example 1 (contd.)
  • Case 2 The market price is 18,000 on 9/30/x5.
    The journal entry would be
  • Purchases 18,000
  • Loss on
  • Pur. Commitment 2,000
  • Cash 20,000

42
Purchase CommitmentsExample 2 - Contract
Period Extends beyond Fiscal Year
  • Geteway Co. signed a firm purchase commitment of
    50,000 on 4/15/x5 for goods to be delivered on
    10/2/x6. The market price of the contracted
    goods was 49,000 on 12/31/x5. The purchased
    commitment loss must be recognized in the year
    end when the loss first occurred (i.e.,
    12/31/x5).

43
Example 2 (contd.)
  • The following entry would be prepared on
    12/31/x5 and disclosure is required when the
    amount is significant regardless whether a loss
    is expected or not
  • Estimated Loss on
  • Purchase Commitments 1,000
  • Estimated Liability on
  • Purchase Commitments 1,000
  • Reported in the income statement under Other
    expenses and losses

44
Example 2 (contd.)
  • At the delivery date (i.e., 10/2/x6)
  • Case 1 The market price remained 1,000 below
    the contract price, the following journal entry
    would be prepared on 10/2/x6
  • Purchases 49,000
  • Estimated Lia.
  • on Pur. Commit. 1,000
  • Cash 50,000

45
Example 2 (contd.)
  • Case 2 The market price was 3,000 below the
    contract price on 10/2/x6
  • Purchases 47,000
  • Estimated Lia.
  • on Pur. Commitments 1,000
  • Loss on Pur. Commit. 2,000
  • Cash 50,000

46
Example 2 (contd.)
  • Case 3 the market was only 600 below the
    contract price 0n 10/2/x6
  • Purchases 49,000
  • Estimated Lia.
  • on Pur. Commit. 1,000
  • Cash 50,000
  • 49,000 became the new cost for the purchase
    commitment on 12/31/x5

47
Hedging of Purchase Commitments with Future Sales
Contracts
  • In order to offset the potential future loss on
    purchase commitments, a firm can enter a future
    sales contract at the same quantity of inventory
    purchased in a purchase commitment.
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