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Inventories: Additional Valuation Issues

Inventories: Additional Valuation Issues. 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.

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Inventories: Additional Valuation Issues

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  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. Inventories: Additional Issues

  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. Inventories: Additional Issues

  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. Inventories: Additional Issues

  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. Inventories: Additional Issues

  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. Inventories: Additional Issues

  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) Inventories: Additional Issues

  8. Gross Profit MethodExample A Beginning Inv. = $60,000 Purchase (net) = $200,000 Sales = $280,000 Gross Margin Ratio1= 30% 1. Gross margin ratio is obtained from past years’ experience (assuming the ratio is stable over years). Inventories: Additional Issues

  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 Inventories: Additional Issues

  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  (1+25%) = $80 Inventories: Additional Issues

  11. Example B (contd.) Sales = CGS + Gross Profit = CGS + 25% x CGS = CGS x (1+25%) CGS = Sales  (1+25%) Inventories: Additional Issues

  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. Inventories: Additional Issues

  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 Inventories: Additional Issues

  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 Inventories: Additional Issues

  15. Retail Inventory MethodExample (assuming no price adjustments) Cost Retail Beg. Inv. $14,000 $20,000 Purchases (net) 63,000190,0002 77,000 110,000 Sales 85,0003 Estimated End. Inv. $25,000 at retail Cost ratio = 77,000/110,000=70% Estimated cost of end. inv. = 25,000x70%=17,500 1. Purchases - Pur. R&A - Pur. Dis. + Freight-in 2. Purchases - Pur R&A 3. Gross sales-Sales Returns +Employee Discounts Inventories: Additional Issues

  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? Inventories: Additional Issues

  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 R&A Inventories: Additional Issues

  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 Inventories: Additional Issues

  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 70.23%=17,346.81 Inventories: Additional Issues

  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.) =14,000/20,000=70% • 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) 4,700ax 70.23% = 3,301 17,301 a. 24,700-20,000=4,700 Inventories: Additional Issues

  21. Comments for Retail Method A. CostRetail 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. Inventories: Additional Issues

  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. Inventories: Additional Issues

  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. Inventories: Additional Issues

  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 Inventories: Additional Issues

  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 5Inventories: Additional Issues

  26. Another Example of Conventional Retail Inventory Method – Special Items Included (Illustration 9-3, KWW, 14th e) Inventories: Additional Issues

  27. Gross-Profit Method Retail Inventory Method IV. Comparison of Gross Profit Method and 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. Inventories: Additional Issues

  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 year’s price adjustment data. Inventories: Additional Issues

  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. Inventories: Additional Issues

  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. Inventories: Additional Issues

  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.)=14,000/20,000=70% CR2 (for others)=(77,000-14,000)/(109,700-20,000) =70.23% Inventories: Additional Issues

  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): Inventories: Additional Issues

  33. Dollar-Value LIFO Retail MethodExample (contd.) 1. Ending inventory at retail prices is deflated to base year’s 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 Inventories: Additional Issues

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

  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. Inventories: Additional Issues

  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-year’s dollars(20x0), the ending inventory of 20x2 is $42,960 120% = $35,800 Inventories: Additional Issues

  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 PricesRetail 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 Inventories: Additional Issues

  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). Inventories: Additional Issues

  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. Inventories: Additional Issues

  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 Inventories: Additional Issues

  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 Inventories: Additional Issues

  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). Inventories: Additional Issues

  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” Inventories: Additional Issues

  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 Inventories: Additional Issues

  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 Inventories: Additional Issues

  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 Inventories: Additional Issues

  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. Inventories: Additional Issues

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