*** Adult Truths *** - An Email Forward

1. *** Adult Truths *** - An Email Forward • How many times is it appropriate to say "What?" before you just nod and smile because you still didn't hear or understand a word they said? • I love the sense of camaraderie when an entire line of cars team up to prevent a jerk from cutting in at the front. • Shirts get dirty. Underwear gets dirty. Pants? Pants never get dirty, and you can wear them forever… • Sometimes I'll look down at my watch 3 consecutive times and still not know what time it is. • Even under ideal conditions people have trouble locating their car keys in a pocket, finding their cell phone, and Pinning the Tail on the Donkey – but I'd bet everyone can find and push the snooze button from 3 feet away, in about 1.7 seconds, eyes closed, first time, every time. • People who forward e-mail without deleting the tons of previous recipients should be shot and then tarred and feathered.

2. Chapter 9 inventories:additional valuation issuesSommers – ACCT 3311

3. LCM Approach Lower-of-cost-or-market approach to valuing inventory GAAP generally require the use of historical cost to value assets, but a departure from cost is necessary when the utility of an asset is no longer as great as its cost. The utility or benefits from inventory result from the ultimate sale of the goods. This utility could be reduced below cost due to deterioration, obsolescence, or changes in price levels. To avoid reporting inventory at an amount greater than the benefits it can provide, the lower-of-cost-or-market approach to valuing inventory was developed. This approach results in the recognition of losses when the value of inventory declines below its cost, rather than in the period in which the goods are ultimately sold.

4. Discussion Question Q9-2 Explain the rationale for the ceiling and floor in the lower-of-cost-or-market method of valuing inventories. The upper (ceiling) and lower (floor) limits for the value of the inventory are intended to prevent the inventory from being reported at an amount in excess of the net realizable value or at an amount less than the net realizable value less a normal profit margin. The maximum limitation, not to exceed the net realizable value (ceiling) covers obsolete, damaged, or shopworn material and prevents overstatement of inventories and understatement of the loss in the current period. The minimum limitation deters understatement of inventory and overstatement of the loss in the current period.

5. Determining Market Value Step 1Determine Designated Market Step 2Compare Designated Market with Cost CeilingNRV Not More Than DesignatedMarket Cost ReplacementCost Or Not Less Than Lower of CostOr Market NRV – NPFloor

6. Example 1: LCM Tatum Company has four products in its inventory. Information about the Dec 31, 2011, inventory is as follows: The normal gross profit percentage is 25% of cost. Determine the balance sheet inventory carrying value at Dec 31, 2011, assuming the LCM rule is applied to individual products.

7. Example 1: Continued

8. Example 1: Continued

9. Example 1: Continued

10. Example 1: LCM Tatum Company has four products in its inventory. Information about the Dec 31, 2011, inventory is as follows: The normal gross profit percentage is 25% of cost. Determine the balance sheet inventory carrying value at Dec 31, 2011, assuming the LCM rule is applied to individual products.

11. Example 1: Continued

12. Example 1: Continued

13. Example 1: Continued

14. Example 1: Continued

15. Example 1: Continued

16. Applying Lower of Cost or Market Lower of cost or market can be applied 3 different ways. • Apply LCM to each individual item in inventory. • Apply LCM to each class of inventory. • Apply LCM to the entire inventory as a group.

17. Example 2: LCM applications Almaden Hardware Store sells two distinct types of products, tools and paint products. Information pertaining to its 2011 year-end inventory is as follows: Determine balance sheet inventory carrying value at year-end, assuming the LCM rule is applied to individual products, then product type, and then total inventory.

18. Example 2: Continued

19. Evaluation of LCM Rule Some Deficiencies: • Expense recorded when loss in utility occurs. Profit on sale recognized at the point of sale. • Inventory valued at cost in one year and at market in the next year. • Net income in year of loss is lower. Net income in subsequent period may be higher than normal if expected reductions in sales price do not materialize. • LCM uses a “normal profit” in determining inventory values, which is a subjective measure.

20. Valuation at Net Realizable Value Permitted by GAAP under the following conditions: • a controlled market with a quoted price applicable to all quantities, and • no significant costs of disposal (rare metals and agricultural products) • or • too difficult to obtain cost figures (meatpacking).

21. Purchase Commitments • Generally seller retains title to the merchandise. • Buyer recognizes no asset or liability. • If material, the buyer should disclose contract details in footnote. • If the contract price is greater than the market price, and the buyer expects that losses will occur when the purchase is effected, the buyer should recognize a liability and a corresponding loss in the period during which such declines in market prices take place.

22. Purchase Commitments • Purchase commitments are contracts that obligate a company to purchase a specified amount of merchandise or raw materials at specified prices on or before specified dates. In July 2011, the Lassiter Company signed two purchase commitments. • The first requires Lassiter to purchase inventory for $500,000 by November 15, 2011. The inventory is purchased on November 14, and paid for on December 15. On the date of acquisition, the inventory had a market value of $425,000. Lassiter uses the perpetual inventory system and is a calendar year-end company.

23. Purchase Commitments November 14, 2011 Inventory (market price) 425,000 Loss on purchase commitment 75,000 Accounts payable 500,000 December 15, 2011 Accounts payable 500,000 Cash 500,000 Single-period commitment

24. Purchase Commitments • Purchase commitments are contracts that obligate a company to purchase a specified amount of merchandise or raw materials at specified prices on or before specified dates. In July 2011, the Lassiter Company signed two purchase commitments. • The first requires Lassiter to purchase inventory for $500,000 by November 15, 2011. The inventory is purchased on November 14, and paid for on December 15. On the date of acquisition, the inventory had a market value of $425,000. • The second requires Lassiter to purchase inventory for $600,000 by February 15, 2012. On December 31, 2011, the market value of the inventory items was $540,000. On February 15, 2012, the market value of the inventory items was $510,000. Lassiter uses the perpetual inventory system and is a calendar year-end company.

25. Purchase Commitments November 14, 2011 Inventory (market price) 425,000 Loss on purchase commitment 75,000 Accounts payable 500,000 December 15, 2011 Accounts payable 500,000 Cash 500,000 Single-period commitment December 31, 2011 Unrealized loss on commitment 60,000 Estliabon purch commitment 60,000 February 15, 2012 Inventory (market price) 510,000 Loss on purchase commitment 30,000 Estliab on purch commitment 60,000 Cash 600,000 Multi-period commitment

26. Inventory Estimation Techniques Estimate instead of taking physical inventory • Less costly • Less time consuming • Sometimes only option! Two popular methods are . . . • Gross Profit Method • Retail Inventory Method (next time)

27. Gross Profit Method The gross profit method estimates cost of goods sold, which is then subtracted from cost of goods available for sale to obtain an estimate of ending inventory. The estimate of cost of goods sold is found by multiplying sales by the historical ratio of cost to selling prices. The cost percentage is the reciprocal of the gross profit ratio. Relies on Three Assumptions: • Beginning inventory plus purchases equal total goods to be accounted for. • Goods not sold must be on hand. • The sales, reduced to cost, deducted from the sum of the opening inventory plus purchases, equal ending inventory.

28. Example 3: Gross Profit Method Royal Gorge Company uses the gross profit method to estimate ending inventory and cost of goods sold when preparing monthly financial statements required by its bank. Inventory on hand at the end of October was $58,500. The following information for the month of November was available from company records: Purchases $ 110,000 Freight-in3,000 Sales180,000 Sales returns 5,000 Purchases returns 4,000 In addition, the controller is aware of $8,000 of inventory that was stolen during November from one of the company’s warehouses. Calculate the estimated inventory at the end of November, assuming a gross profit ratio of 40%.

29. Example 3: Continued Beginning inventory (from records) $ 58,500 Plus: Net purchases ($110,000 – 4,000) 106,000 Freight-in (from records) 3,000 Cost of goods available for sale 167,500 Less: Cost of goods sold: Net sales ($180,000 – 5,000) $175,000 Less: Estimated gross profit of 40% (70,000) Estimated cost of goods sold (105,000) Estimated cost of inventory before theft 62,500 Less: Stolen inventory (8,000) Estimated ending inventory $ 54,500

30. Evaluation of Gross Profit Method Disadvantages: • Provides an estimate of ending inventory. • Uses past percentages in calculation. • A blanket gross profit rate may not be representative. • Normally unacceptable for financial reporting purposes. GAAP requires a physical inventory as additional verification.

31. Retail Inventory Method A method used by retailers, to value inventory without a physical count, by converting retail prices to cost. Requires retailers to keep: • Total cost and retail value of goods purchased. • Total cost and retail value of the goods available for sale. • Sales for the period. Methods • Conventional Method • LIFO • Dollar-value LIFO

32. Retail Inventory Method Explain the retail inventory method of estimating ending inventory. The retail inventory method first determines the amount of ending inventory at retail by subtracting sales for the period from goods available for sale at retail. Ending inventory at retail is then converted to cost by multiplying it by the cost-to-retail percentage.

33. The Retail Inventory Method This method was developed for retail operations like department stores. • Uses both the retail value and cost of items for sale to calculate a cost-to-retail percentage. Objective: Convert ending inventory at retail to ending inventory at cost. Terminology: • Initial markup - Original amount of markup from cost to selling price. • Additional markup - Increase in selling price subsequent to initial markup. • Markup cancellation - Elimination of an additional markup. • Markdown - Reduction in selling price below the original selling price. • Markdown cancellation - Elimination of a markdown.

34. LCM Practice Decker Company has five products in its inventory. Information about the December 31, 2011, inventory follows. Unit Unit Unit Replacement Selling ProductQuantityCostCostPrice A 1,000 $10 $12 $16 B 800 15 11 18 C 600 3 2 8 D 200 7 4 6 E 600 14 12 13 The selling cost for each product consists of a 15 percent sales commission. The normal profit percentage for each product is 40 percent of the selling price. Determine the balance sheet inventory carrying value at December 31, 2011, assuming the LCM rule is applied to individual products.

35. LCM Practice

36. LCM Practice

37. LCM Practice Decker Company has five products in its inventory. Information about the December 31, 2011, inventory follows. Unit Unit Unit Replacement Selling ProductQuantityCostCostPrice A 1,000 $10 $12 $16 B 800 15 11 18 C 600 3 2 8 D 200 7 4 6 E 600 14 12 13 The selling cost for each product consists of a 15 percent sales commission. The normal profit percentage for each product is 40 percent of the selling price. Determine the balance sheet inventory carrying value at December 31, 2011, assuming the LCM rule is applied to the entire inventory.

38. LCM Practice Inventory carrying value would be $30,390, the lower of aggregate inventory cost ($33,600) and aggregate inventory market ($30,390). The amount of the loss from inventory write-down is $3,210 ($33,600 – 30,390).