ILLUSTRATION 9-1 LCM INVENTORY VALUATION

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1 ILLUSTRATION 9-1 LCM INVENTORY VALUATION APPLICATION OF LOWER OF COST OR MARKET CEILING COST Net Realizable (NRV) Replacement Cost NRV Normal Profit Margin FLOOR Select the Middle STEP 1: Determine the Designated Market Designated Market STEP2: Select the Lower of Cost or Designated Market Balance Sheet Inventory NET REALIZABLE VALUE (NRV)- estimated selling price less costs of completion and disposal (covers obsolete, damaged and shopworn goods). NRV LESS NORMAL PROFIT MARGIN- generally measured as a percentage of selling price (represents achievable gross profit even if replacement cost is lower.) NRV prevents overstatement of inventory and understatement of current period loss; NRV NPM prevents understatement of inventory and overstatement of current loss. 64

2 ILLUSTRATION 9-1 (continued) SITUATION A COST $30 Net Realizable $40 Replacement Cost $35 NRV Less Normal Profit $20 Market $35 Balance Sheet Inventory = $30 SITUATION B COST $30 Net Realizable $40 Replacement Cost $18 NRV Less Normal Profit $20 Market $20 Balance Sheet Inventory = $20 65

3 ILLUSTRATION 9-2 THE GROSS PROFIT METHOD THE GROSS PROFIT METHOD There is one general approach to estimating the cost of ending inventory using the gross profit method. It makes use of the gross profits on sales. If given the markup on cost, compute the gross profit on sales. Assume that the following information is given: Beginning inventory $ 60,000 Purchases 90,000 Sales 100,000 Markup on cost 25% You are to use the gross profit method to solve for the cost of ending inventory. 1. Compute gross profit on sales (if not given): Gross profit on Sales = 2. Compute cost of goods sold: Cost of Goods Sold = Sales = 25% = 25% = 20% 100% + 25% 125% (100 % Gross profit on Sales) = $100,000 (100% 20%) = $100,000 80% = $80,000 Markup on cost 100% + Markup on cost 3. Compute estimated cost of ending inventory: Cost of beginning inventory $ 60,000 Cost of purchases + 90,000 + Cost of goods available for sale 150,000 Cost of goods sold 80,000 Estimated cost of ending inventory $ 70,000 66

4 ILLUSTRATION 9-3 NUMERICAL EXAMPLE OF THE GROSS PROFIT AND CONVENTIONAL RETAIL METHODS Assume that the following information is given: Beginning Inventory Net Sales at Retail $280,000 At Cost $ 100,000 Average Cost per Unit $ 8.00 At Retail 125,000 Average Selling Price per Unit $10.00 Net Purchases At Cost $300,000 At Retail 360,000 Net Markups 15,000 Net Markdowns 10,000 GROSS PROFIT METHOD Gross Profit Percentage = $2/$10 = 20% Cost of goods sold = $280,000 (100% 20%) = $280,000 80% = $224,000 Ending inventory = $100,000 + $300,000 $224,000 = $176,000 CONVENTIONAL RETAIL METHOD Ending inventory at retail = $125,000 + $360,000 + $15,000 $280,000 = $210,000 Cost-to-retail ratio = $100,000 + $300,000 $125,000 + $360,000 + $15,000 = = 80% Ending inventory at average, LCM = 80% $210,000 = $168,000 $400,000 $500,000 67

5 ILLUSTRATION 9-4 NUMERICAL EXAMPLE OF THE LIFO RETAIL METHODS Assume the following information is given: Beginning Inventory Net Sales at Retail $280,000 At Cost $100,000 Price Index At Retail 125,000 Beginning 100 Net Purchases Ending 105 At Cost 300,000 Average Cost per Unit $8.00 At Retail 360,000 Average Selling Price per Unit $10.00 Net Markups 15,000 Net Markdowns 10,000 RETAIL LIFO (STABLE PRICES) Ending inventory at retail = $210,000 (see above). Cost-to-retail ratio = $300,000 = $300,000. $360,000 + $15,000 $365,000 = 82.19% Ending inventory at LIFO cost = $169,862 (see below). Cost Retail Ending inventory $210,000 Beginning inventory $100, ,000 New layer $ 85,000 At cost (82.19% $85,000) 69,862 Ending inventory at LIFO $169,862 DOLLAR-VALUE LIFO RETAIL (FLUCTUATING PRICES) Ending inventory at retail = $210,000 Cost-to-retail ratio = 82.19% (see above). Ending inventory at dollar-value LIFO = $164,725 (see below). Cost Retail Ending inventory deflated ($210, ) $200,000 Base layer $100, ,000 New layer $ 75,000 At cost (105% 82.19% $75,000) 64,725 Ending inventory at dollar-value LIFO $164,725 68

6 ILLUSTRATION 9-5 RELATIONSHIP BETWEEN LIFO RETAIL AND DOLLAR-VALUE LIFO Exhibit 1 Dollar- LIFO Data Year 1 Year 2 Year 3 Year 4 Year 5 (a) December 31 inventory priced at year-end (current) acquisition cost amounts $ $11,663 $11,880 $12,533 (b) Price index (wholesale) (Year 1 is base year) (c) Inventories restated in base-year dollars (Line (a) line (b)) $10,500 $10,900 $10,800 $11,200 (d) Increments in base-year dollars during Year number +$500 +$400 $100 +$ Exhibit 2 Retail LIFO Data Year 1 Year 2 Year 3 Year 4 Year 5 (e) December 31 inventory priced at year-end (current) retail amounts $15,000 $16,068 $17,066 $17,172 $17,334 (f) Price index (retail) (Year 1 is base year) (g) Inventories restated in base-year retail dollars (Line (e) line (f)) $15,000 $15,600 $16,100 $15,900 $16,200 (h) Increments in base-year dollars during Year number +$600 +$500 $100 +$ (i) Percentage of cost to sales price

7 $ ILLUSTRATION 9-5 (continued) Legend Layer: at base-year at LIFO cost Index Exhibit 3 Diagrammatic Presentation of Dollar- LIFO: Data and Ending Inventory Calculations (Based on Exhibit 1 Data) Year 1 Year 2 Year 3 Year 4 Year 5 $ $520 $ $428 $ $520 $ $321 $ $520 $ $448 $ $321 $ $ Ending Inventory: (1) Stated at base-year dollars $10,500 $10,900 $10,800 $11,200 (2) Stated at Dollar- $10,520 $10,948 $10,841 $11,289 LIFO Layer: Index base-year % cost to LIFO cost Sales Exhibit 4 Diagrammatic Presentation of Retail LIFO: Data and Ending Inventory Calculations (Based on Exhibit 2 Data) Year 1 Year 2 Year 3 Year 4 Year 5 $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $15, $15, $15, $15, $15, $ 9, $ 9, $ 9, $ 9, $ 9, Ending Inventory: (1) Stated at base-year Retail $15,000 $15, $16, $15, $16, (2) Stated at Retail LIFO $ 9,000 $ 9, $ 9, $ 9, $ 9, Source: A Jay Hirsch, "Dollar- and Retail LIFO: A Diagrammatic Approach," The Accounting Review, (October, 1969), pp

8 ILLUSTRATION 9-6 SUMMARY OF INVENTORY VALUATION STANDARDS In 1953, the AICPA published in revised and rewritten final form ten statements related to inventory valuation that today still represent the basic accounting standards for the valuation and reporting of inventories.these standards are quoted below: STATEMENT 1. The term inventory is used herein to designate the aggregate of those items of tangible personal property which (1) are held for sale in the ordinary course of business, (2) are in process of production for such sale, or (3) are to be currently consumed in the production of goods or services to be available for sale. STATEMENT 2. A major objective of accounting for inventories is the proper determination of income through the process of matching appropriate costs against revenues. STATEMENT 3. The primary basis of accounting for inventories is cost, which has been defined generally as the price paid or consideration given to acquire an asset. As applied to inventories, cost means in principle the sum of the applicable expenditures and charges directly or indirectly incurred in bringing an article to its existing condition and location. STATEMENT 4. Cost for inventory purposes may be determined under any one of several assumptions as to the flow of cost factors (such as first-in first-out, average, and last-in first-out), the major objective in selecting a method should be to choose the one which, under the circumstances, most clearly reflects periodic income. STATEMENT 5. A departure from the cost basis of pricing the inventory is required when the utility of the goods is no longer as great as its cost. Where there is evidence that the utility of goods, in their disposal in the ordinary course of business, will be less than cost, whether due to physical deterioration, obsolescence, changes in price levels, or other causes, the difference should be recognized as a loss of the current period. This is generally accomplished by stating such goods at a lower level commonly designated as market. 71

9 ILLUSTRATION 9-6 (continued) STATEMENT 6. As used in the phrase lower of cost or market*, the term market means current replacement cost (by purchase or by reproduction, as the case may be) except that: (1) market should not exceed the net realizable value (i.e., estimated selling price in the ordinary course of business less reasonably predictable costs of completion and disposal); and (2) market should not be less than net realizable value reduced by an allowance for an approximately normal profit margin. STATEMENT 7. Depending on the character and composition of the inventory, the rule of cost or market, whichever is lower may properly be applied either directly to each item or to the total of the inventory (or, in some cases, to the total of the components of each major category). The method should be that which most clearly reflects periodic income. STATEMENT 8. The basis of stating inventories must be consistently applied and should be disclosed in the financial statements; whenever a significant change is made therein, there should be disclosure of the nature of the change and, if material, the effect on income. STATEMENT 9. Only in exceptional cases may inventories properly be stated above cost. For example, precious metals having a fixed monetary value with no substantial cost of marketing may be stated at such monetary value; any other exceptions must be justifiable by inability to determine appropriate approximate costs, immediate marketability at quoted market price, and the characteristic of unit interchangeability. Where goods are stated above costs, this fact should be fully disclosed. STATEMENT 10. Accrued net losses on firm purchase commitments for goods for inventory, measured in the same way as are inventory losses, should, if material, be recognized in the accounts and the amounts thereof separately disclosed in the income statement. *The terms cost or market, whichever is lower, and lower of cost or market are used synonymously in general practice. The committee does not express any preference for either of the two alternatives. 72