chapter 09 (inter)

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9-1



9-2

C H A P T E R 9INVENTORIES:

ADDITIONAL VALUATION ISSUES

Intermediate AccountingIFRS EditionKieso, Weygandt, and Warfield



9-3

1. Describe and apply the lower-of-cost-or-net realizable value rule.2. Explain when companies value inventories at net realizable value.

3. Explain when companies use the relative sales value method to

value inventories.4. Discuss accounting issues related to purchase commitments.

5. Determine ending inventory by applying the gross profit method.

6. Determine ending inventory by applying the retail inventorymethod.

7. Explain how to report and analyze inventory.

Learning Objectives



9-4

Special

valuationsituationsRelative salesvaluePurchasecommitments

Lower-of-Cost-or-Net

RealizableValue (LCNRV)

ValuationBases

Gross ProfitMethod

RetailInventoryMethod

Presentationand Analysis

Net realizable

valueIllustration ofLCNRV

Application ofLCNRVRecording net

realizablevalueUse of anallowanceRecovery ofinventory lossEvaluation ofrule

Gross profit

percentageEvaluation ofmethod

Concepts

ConventionalmethodSpecial itemsEvaluation ofmethod

Presentation

Analysis

Inventories: Additional Valuation Issues



9-5

A company abandons the historical cost principlewhen the future utility (revenue-producing ability)of the asset drops below its original cost.

Lower-of-Cost-or-Net Realizable Value

LO 1 Describ e and apply the lower-of-cos t-or-net real izable value rule.

LCNRV



9-6

Net Realizable Value


Estimated selling price in the normal course ofbusiness less estimated costs to complete and

estimated costs to make a sale.Illustration 9-1




9-7

Net Realizable Value


Illustration 9-2LCNRV Disclosures




9-8

Illustration of LCNRV: Regner Foods computes itsinventory at LCNRV.


Illustration 9-3




9-9

Illustration 9-4

Methods of Applying LCNRV





9-10

Methods of Applying LCNRV



► In most situations, companies price inventory on anitem-by-item basis.

► Tax rules in some countries require that companies usean individual-item basis.

► Individual-item approach gives the lowest valuation forstatement of financial position purposes.

► Method should be applied consistently from one periodto another.



9-11

Cost of goods sold (before adj. to NRV) $ 108,000Ending inventory (cost) 82,000Ending inventory (at NRV) 70,000

Inventory 12,000

Loss due to decline to NRV 12,000

Inventory 12,000

Cost of goods sold 12,000

LossMethod

COGSMethod


Recording Net Realizable Value Instead of Cost




9-12

COGS LossMethod Method

Current assets:

Inventory 70,000$ 70,000$Prepaids 20,000 20,000 Accounts receivable 350,000 350,000 Cash 100,000 100,000

Total current assets 540,000 540,000

Statement of Financial Position Presentation



Partial Statement



9-13

COGS Loss

Method MethodSales 200,000$ 200,000$Cost of goods sold 108,000 120,000

Gross profit 92,000 80,000 Operating expenses:

Selling 45,000 45,000 General and administrative 20,000 20,000

Total operating expenses 65,000 65,000 Other income and expense:

Loss due to NRV on inventory 12,000 - Interest income 5,000 5,000

Total other (7,000) 5,000 Income from operations 20,000 20,000 Income tax expense 6,000 6,000 Net income 14,000$ 14,000$

Income Statement Presentation

LO 1




9-14

Use of an Allowance



Instead of crediting the Inventory account for net realizablevalue adjustments, companies generally use an

allowance account.

Allowance to reduce

inventory to NRV 12,000

Loss due to decline to NRV 12,000LossMethod



9-15

COGS LossMethod Method

Current assets:

Inventory 70,000$ 82,000$Allowance to reduce inventory (12,000)

Inventory at NRV 70,000 Prepaids 20,000 20,000 Accounts receivable 350,000 350,000 Cash 100,000 100,000

Total current assets 540,000 540,000

Statement of Financial Position Presentation



Partial Statement



9-16

Recovery of Inventory Loss



► Amount of write-down is reversed.

►Reversal limited to amount of original write-down.

Continuing the Ricardo example, assume the net realizablevalue increases to $74,000 (an increase of $4,000). Ricardomakes the following entry, using the loss method .

Recovery of inventory loss 4,000

Allowance to reduce inventory to NRV 4,000



9-17

Recovery of Inventory Loss



Allowance account is adjusted in subsequent periods,such that inventory is reported at the LCNRV.

Illustration 9-8

Inventory should not be reported at a value above original cost.



9-18

Decreases in the value of the asset and the charge to expense arerecognized in the period in which the loss in utility occurs —not in the

period of sale.Increases in the value of the asset (in excess of original cost)recognized only at the point of sale.

Inconsistency because a company may value inventory at cost in oneyear and at net realizable value in the next year.

LCNRV values inventory conservatively. Net income for the year inwhich a company takes the loss is definitely lower. Net income of thesubsequent period may be higher than normal if the expectedreductions in sales price do not materialize.

Some Deficiencies:


Evaluation of LCM Rule




9-19

P9-1: Remmers Company manufactures desks. Most of thecompany’s desks are standard models and are sold on the basis ofcatalog prices. At December 31, 2010, the following finished desksappear in the company’s inventory.

Instructions: At what amount should the desks appear in thecompany’s December 31, 2010, inventory, assuming that the companyhas adopted a lower-of-FIFO-cost-or-net realizable value approach forvaluation of inventories on an individual-item basis?

Finished Desks A B C DFIFO cost inventory at 12/31/10 470$ 450$ 830$ 960$Est. cost to complete and sell 50 110 260 200 Catalog selling price 500 540 900 1,200





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P9-1: Remmers Company manufactures desks. Most of thecompany’s desks are standard models and are sold on the basis ofcatalog prices. At December 31, 2010, the following finished desksappear in the company’s inventory.

Finished Desks A B C DFIFO cost inventory at 12/31/10 470$ 450$ 830$ 960$Est. cost to complete and sell 50 110 260 200 Catalog selling price 500 540 900 1,200

Net realizable value 450 430 640 1,000

Lower-of-cost-or-NRV 450 430 640 960





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Valuation Bases

LO 2 Explain wh en com panies value inv entories at net real izable value.

Special Valuation Situations

Departure from LCNRV rule may be justified in situations when

► cost is difficult to determine,

► items are readily marketable at quoted market prices, and

► units of product are interchangeable.

Two common situations in which NRV is the general rule :

► Agricultural assets

► Commodities held by broker-traders.



9-22

Valuation Bases


Agricultural Inventory

Biological asset (classified as a non-current asset ) is aliving animal or plant, such as sheep, cows, fruit trees, or

cotton plants.

► Biological assets are measured on initial recognitionand at the end of each reporting period at fair valueless costs to sell (NRV).

► Companies record gain or loss due to changes in NRVof biological assets in income when it arises.

NRV



9-23

Valuation Bases


Agricultural Inventory

Agricultural produce is the harvested product of abiological asset, such as wool from a sheep, milk from a

dairy cow, picked fruit from a fruit tree, or cotton from acotton plant.

► Agricultural produce are measured at fair value lesscosts to sell (NRV) at the point of harvest.

► Once harvested, the NRV becomes cost.

NRV



9-24

Valuation Bases


Illustration: Bancroft Dairy produces milk for sale to local cheese-makers. Bancroft began operations on January 1, 2011, bypurchasing 420 milking cows for € 460,000. Bancroft provides thefollowing information related to the milking cows.

Illustration 9-9



9-25

Valuation Bases


Bancroft makes the following entry to record the change in carryingvalue of the milking cows.

Unrealized Holding Gain or Loss —Income 33,800

Biological Asset —Milking Cows 33,800

Illustration 9-9



9-26

Valuation Bases



Biological Asset —Milking Cows 33,800

Reported in statement of financial position reports theBiological Asset —Milking Cows as a non-current asset at fairvalue less costs to sell (net realizable value).

Reported as “Other income and expense” on the incomestatement .



9-27

Valuation Bases

LO 2

Illustration: Bancroft makes the following summary entry to recordthe milk harvested for the month of January.


Milk Inventory 36,000

Assuming the milk harvested in January was sold to a local cheese-maker for € 38,500, Bancroft records the sale as follows.

Cost of Goods Sold 36,000

Cash 38,500Sales 38,500

Milk Inventory 36,000



9-28

Valuation Bases


Commodity Broker-Traders

Generally measure their inventories at fair value less costs tosell (NRV), with changes in NRV recognized in income in the

period of the change.

► Buy or sell commodities (such as harvested corn, wheat,precious metals, heating oil).

► Primary purpose is to sell the commodities in the nearterm and generate a profit from fluctuations in price.

NRV



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(1) a controlled market with a quoted price applicable to all

quantities, and(2) no significant costs of disposal (rare metals and

agricultural products)

or(3) too difficult to obtain cost figures (meatpacking).

Permitted by GAAP under the following conditions:

Valuation Bases

Valuation Using Relative Sales Value

LO 3 Expla in when comp anies use the re lat ivesa les v a lue method to va lue inventor ies .



9-30

Used when buying varying units in a single lump-sum purchase.

Valuation Bases

Valuation Using Relative Sales Value

E9-9: Larsen Realty Corporation purchased a tract of unimproved land for$55,000. This land was improved and subdivided into building lots at anadditional cost of $30,000. These building lots were all of the same sizebut owing to differences in location were offered for sale at different pricesas follows. Operating expenses allocated to this project total $18,200.

Instructions: Calculate thenet income realized on thisoperation to date.

No. of Price Lots Unsold

Group Lots per Lot at Year-End

1 9 3,000$ 5

2 15 4,000 7

3 19 2,000 2




9-31

Valuation Bases

E9-9 (Relative Sales Value Method):No. of Price Selling Relative Total Cost Cost

Group Lots per Lot Price Sales Price Cost Allocated Per Lot

1 9 3,000$ 27,000$ $27,000/125,000 85,000$ 18,360$ 2,040$

2 15 4,000 60,000 60,000/125,000 85,000 40,800 2,720 3 19 2,000 38,000 38,000/125,000 85,000 25,840 1,360

125,000$ 85,000$

Lots Price Total Cost Total Cost Calculation of Net IncomeGroup Sold per Lot Sales Per Lot of Goods Sales 78,000$

1 4 3,000$ 12,000$ 2,040$ 8,160$ Cost of good sold 53,040

2 8 4,000 32,000 2,720 21,760 Gross profit 24,960

3 17 2,000 34,000 1,360 23,120 Expenses 18,200

78,000$ 53,040$ Net income 6,760$

x = x =

=x




9-32

► Generally seller retains title to the merchandise.

► Buyer recognizes no asset or liability.

► If material, the buyer should disclose contract details infootnote.

► If the contract price is greater than the market price , andthe buyer expects that losses will occur when thepurchase is effected, the buyer should recognize a liabilityand a corresponding loss in the period during which suchdeclines in market prices take place.

Valuation Bases

LO 4 Discuss account ing i ssu es re lated to purchase com mitm ents .

Purchase Commitments —A Special Problem



9-33

Valuation Bases


Illustration: St. Regis Paper Co. signed timber-cutting contractsto be executed in 2013 at a price of $10,000,000. Assume furtherthat the market price of the timber cutting rights on December31, 2012, dropped to $7,000,000. St. Regis would make the

following entry on December 31, 2012.

Unrealized Holding Gain or Loss —Income 3,000,000

Purchase Commitment Liability 3,000,000

Other income and expense in the Income statement.

Current liabilities on the statement of financial position.



9-34

Valuation Bases


Illustration: When St. Regis cuts the timber at a cost of $10million, it would make the following entry.

Purchases (Inventory) 7,000,000


Cash 10,000,000

Assume the government permitted St. Regis to reduce its contractprice and therefore its commitment by $1,000,000.


Unrealized Holding Gain or Loss —Income 1,000,000



9-35

Relies on Three Assumptions:

Gross Profit Method of Estimating Inventory

LO 5 Determine ending inventory by applying the gross prof i t method.

Substitute Measure to Approximate Inventory

(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 endinginventory.



9-36

Gross Profit Method


Illustration: Cetus Corp. has a beginning inventory of € 60,000and purchases of € 200,000, both at cost. Sales at selling priceamount to € 280,000. The gross profit on selling price is 30percent. Cetus applies the gross margin method as follows.

Illustration 9-13



9-37

Gross Profit Method


Computation of Gross Profit PercentageIllustration 9-16



9-38

E9-14: Astaire Company uses the gross profit method to estimateinventory for monthly reporting purposes. Presented below isinformation for the month of May.

Instructions:

(a) Compute the estimated inventory at May 31, assuming that thegross profit is 25% of sales .

(b) Compute the estimated inventory at May 31, assuming that thegross profit is 25% of cost .

Inventory, May 1 € 160,000

Purchases (gross) 640,000 Freight-in 30,000 Sales 1,000,000 Sales returns 70,000 Purchase discounts 12,000

Gross Profit Method

LO 5



9-39

E9-14 (Solution):

Inventory, May 1 (at cost) € 160,000

Purchases (gross) (at cost) 640,000

Purchase discounts (12,000)

Freight-in 30,000

Goods available (at cost) 818,000

Sales (at sell ing price) € 1,000,000

Sales returns (at selling price) (70,000)

Net sales (at selling price) 930,000Less gross profit (25% of € 930,000) 232,500

Sales (at cost) 697,500

Approximate inventory, May 31 (at cost) € 120,500

(a) Compute the estimated inventory assuming gross profit is 25% of sales .

Gross Profit Method




9-40

(b) Compute the estimated inventory assuming gross profit is 25% of cost .

E9-14 (Solution):

Inventory, May 1 (at cost) € 160,000

Purchases (gross) (at cost) 640,000

Purchase discounts (12,000)

Freight-in 30,000

Goods available (at cost) 818,000

Sales (at sell ing price) € 1,000,000

Sales returns (at selling price) (70,000)

Net sales (at selling price) 930,000Less gross profit (20% of € 930,000) 186,000

Sales (at cost) 744,000

Approximate inventory, May 31 (at cost) € 74,000

Gross Profit Method


25%100% + 25%

= 20% of sales



9-41

Disadvantages:

Gross Profit Method


Evaluation

(1) Provides an estimate of ending inventory.

(2) Uses past percentages in calculation.

(3) A blanket gross profit rate may not be representative.

(4) Normally unacceptable for financial reporting purposes.IFRS requires a physical inventory as additionalverification.



9-42

Retail Inventory Method

LO 6 Determine ending in ventory by applying the re tai l inventory method.

A method used by retailers, to value inventory without aphysical count, by converting retail prices to cost.

(1) Total cost and retail value of goods purchased.

(2) Total cost and retail value of the goods available for sale.

(3) Sales for the period.

Requires retailers to keep:

Conventional Method or Cost Method(based on LCNRV)



9-44



P9-9 Solution - CONVENTIONAL Method:Cost to

COST RETAIL Retail %Beg. inventory 52,000$ 78,000$Purchases 272,000 423,000 Freight in 16,600 Purchase returns (5,600) (8,000) Markups, net 7,000

Current year additions 283,000 422,000 Goods available for sale 335,000 500,000 67.00% Markdowns, net (3,600)

Normal spoilage (10,000) Sales (390,000)

Ending inventory at retail 96,400$

Ending inventory at Cost:96,400$ x 67.00% = 64,588$

= /



9-45



P9-9 Solution - Cost Method Cost toCOST RETAIL Retail %

Beg. inventory 52,000$ 78,000$Purchases 272,000 423,000 Freight in 16,600 Purchase returns (5,600) (8,000)

Markdowns, net (3,600) Markups, net 7,000

Current year additions 283,000 418,400 Goods available for sale 335,000 496,400 67.49% Normal spoilage (10,000)

Sales (390,000) Ending inventory at retail 96,400$

Ending inventory at Cost:96,400$ x 67.49% = 65,056$

= /



9-46

Special Items



Freight costs

Purchase returns

Purchase discounts and allowances

Transfers-in

Normal spoilage

Abnormal shortages

Employee discounts



9-47

SpecialItems



Illustration 9-22



9-48

Widely used for the following reasons:Evaluation

(1) To permit the computation of net income without a

physical count of inventory.(2) Control measure in determining inventory shortages.

(3) Regulating quantities of merchandise on hand.

(4) Insurance information.



Some companies refine the retail method by computing inventory separately bydepartments or class of merchandise with similar gross profits.



9-49

Accounting standards require disclosure of:

Presentation and Analysis

LO 7 Expla in how to repor t and analyze inventory.

Presentation of Inventories

(1) Accounting policies adopted in measuring inventories,

including the cost formula used (weighted-average, FIFO).(2) Total carrying amount of inventories and the carrying amount

in classifications (merchandise, production supplies, rawmaterials, work in progress, and finished goods).

(3) Carrying amount of inventories carried at fair value less coststo sell.

(4) Amount of inventories recognized as an expense during theperiod.



9-50

Accounting standards require disclosure of:



Presentation of Inventories

(5) Amount of any write-down of inventories recognized as an

expense in the period and the amount of any reversal ofwrite-downs recognized as a reduction of expense in theperiod.

(6) Circumstances or events that led to the reversal of a write-down of inventories.

(7) Carrying amount of inventories pledged as security forliabilities, if any.



9-51



Common ratios used in the management and evaluation ofinventory levels are inventory turnover and average days

to sell the inventory .

Analysis of Inventories



9-52

Measures the number of times on average a companysells the inventory during the period.



Inventory Turnover Ratio

Illustration 9-25

Illustration: In its 2009 annual report Tate & Lyle plc (GBR)reported a beginning inventory of £562 million, an ending inventoryof £538 million, and cost of goods sold of £2,019 million for theyear.



9-53

Measure represents the average number of days’ salesfor which a company has inventory on hand.



Average Days to Sell Inventory

365 days / 3.67 times = every 99.5 days

Average Days to Sell

Illustration 9-25



9-54

The requirements for accounting for and reporting inventories are more

principles-based under IFRS. That is, U.S. GAAP provides moredetailed guidelines in inventory accounting.

Who owns the goods —goods in transit, consigned goods, special salesagreements —as well as the costs to include in inventory are essentiallyaccounted for the same under IFRS and U.S. GAAP.

U.S. GAAP permits the use of LIFO for inventory valuation. IFRSprohibits its use. FIFO and average cost are the only two acceptablecost flow assumptions permitted under IFRS. Both sets of standardspermit specific identification where appropriate.



9-55

In the lower-of-cost-or-market test for inventory valuation, IFRS defines

market as net realizable value. U.S. GAAP, on the other hand, definesmarket as replacement cost subject to the constraints of net realizablevalue (the ceiling) and net realizable value less a normal markup (thefloor). IFRS does not use a ceiling or a floor to determine market.

Under U.S. GAAP, if inventory is written down under the LCM valuation,the new basis is now considered its cost. As a result, the inventory maynot be written back up to its original cost in a subsequent period. UnderIFRS, the write-down may be reversed in a subsequent period up to theamount of the previous write-down. Both the write-down and anysubsequent reversal should be reported on the income statement.



9-56

Unlike property, plant, and equipment, IFRS does not permit the option

of valuing inventories at fair value. As indicated above, IFRS requiresinventory to be written down, but inventory cannot be written up aboveits original cost.

As indicated, IFRS requires both biological assets and agriculturalproduce at the point of harvest to be reported to net realizable value.U.S. GAAP does not require companies to account for all biologicalassets in the same way. Furthermore, these assets generally are notreported at net realizable value. Disclosure requirements also differbetween the two sets of standards.



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