Objectives: Be able to illustrate your understanding of and record transactions related
1. Valuation bases: Lower of Cost or Market (LCM)
net realizable value
2. Purchase commitments
3. Estimation techniques:
a. Gross Profit Method
b. Retail Inventory Method
(conventional and LIFO)
Background: our general rule is that the historical cost principle is abandoned when the future utility of the asset is no longer as great as its original cost.
Note: Inventory techniques, however, do not represent complete departures from the FIFO, LIFO, and average cost bases of valuing inventory.
For example, the LCM rule results in inventory being stated at the “lower of FIFO cost or market,” or "lower of average cost or market," etc.
Similarly, the retail method can be adapted to approximate any of the major cost flow assumptions: FIFO, LIFO, or average cost.
Objective 1: Valuation bases
LCM: A departure from cost is required when the utility of the goods is longer as great as its cost. Utility is defined as the ability to generate revenue through normal sale.
Step 1: Choose the middle value of the following three amounts and call it Designated market value:
Net realizable value = estimated selling price less estimated costs to completion and disposal. Represents the maximum and attempts to prevent overstatement of inventory, i.e., the ceiling.
Market = replacement cost
Net realizable value less profit = represents minimum and attempts to prevent understatement of inventory, i.e., the floor.
Step 2: Compare Cost to the Designated market value. Choose the lower of the two and that becomes your LCM.
Example: NRV = Rs40, Market = Rs25, NRV-profit = Rs20,
Cost = Rs30
Thus, LCM = Rs25
Deficiencies in LCM:
1. Inconsistent treatment: it recognizes a loss in the period when inventory value decreases but delays inventory value increases until the period when inventory is sold.
2. Inconsistent treatment: inventory may be valued at cost in one year and at market in the next.
3. Conservative?: LCM inventory valuation results in a conservative inventory value on the balance sheet, however, it may have the opposite effect on the income statement in subsequent periods if expected sales price declines do not materialize.
4. Subjective: income manipulation is possible when calculating "normal profit."
Other valuation bases:
1. Net realizable value: certain goods (e.g. minerals) which are sold in a controlled market with a quoted price and with no significant disposal costs may be reported at NRV.
2. Standard costs: manufactured inventories may be reported at standard costs (predetermined) of the material, labor and overhead inputs.
3. Relative sales value method: used with lump-sum purchases. Allocate the joint cost based on relative sales value.
E.G. 2 assets are acquired for Rsl,000. Asset 1 has a selling price of Rs700 and Asset 2 has a selling price of Rs800.
Allocated cost of Asset 1 = Rs700/Rs1500 x Rs1000 = Rs467
Allocated cost of Asset 2 = Rs800/Rs1500 x Rs1000 = Rs533
Objective 2: Purchase commitments
Key issue is full disclosure
1. Accounting for ordinary purchase orders which are subject to cancellation by the buyer or seller: these do not represent either an asset or a liability to the buyer. They are not recorded or reported in the financial statements.
2. Accounting for formal purchase orders for which a firm price has been established (controversial):
a. If MP>CP: disclose in footnotes.
b. If MP is less than CP (i.e., market price falls below contract price):
(i) Debit loss account and credit liability
Est. loss………………….30,000 Est. Liability……………….30,000
(ii) Eliminate liability when inventory is acquired. May have record additional price decline beyond estimated liability
Est. Liability………………30,000 Cash…………………………100,000
or record price recovery up to contract price as a gain (recovery of loss)
Unrealized holding gain or loss….10,000
Objective 3: Estimation techniques
Gross Profit Method: used when an estimate of a firm's inventory is required. It is acceptable for interim reporting but not general annual reporting (FASB recommends retail for interim).
We need 4 items of information to estimate EI:
1. cost of beginning inventory
2. cost of purchases for the period
3. sales during the period
4. markup (% of cost or % of sales)
Note: in this context, the terms gross margin, gross profit and markup are synonymous.
Concept of Markup:
E.G. an item costs Rs60 and is sold for Rs75 has a gross profit or markup of Rs15.
Markup as a % of sales (will always be lower):
markup/SP = Rs15/75 = 20%
Markup as a % of cost( if given alone, must covert to gross profit on sales):
markup/cost = Rs15/60 = 25%
Formula for converting markup on cost to markup or gross profit on sales:
% markup on cost/(100% + % markup on cost)
Example of Gross Profit Method
BI = Rs60,000
Purchases = Rs90,000
Sales = Rs100,000
Markup on cost = 25%
1. Determine markup on sales (or gross profit on sales)
25%/(100% + 25%) = 20%
2. Determine cost of goods sold:
Sales x (100% - gross profit on sales 20%) = 80%
Rs100,000 x 80% = Rs80,000
3. Use inventory model to determine ending inventory:
1. Beginning inventory Rs60,000
2. + Purchases + Rs90,000
- 3. Sales at cost -Rs80,000
Ending inventory Rs70,000
Retail Inventory Method: another estimate of ending inventory. Unlike GPM, however, this method produces estimates that may be acceptable for financial statement purposes.
We need the following:
1. Beginning inventory at cost and at retail
2. Purchases for period at cost and at retail
3. Sales during the period
4. The cost and/or retail amounts of markups, markdowns, employee discounts, spoilage.
Retail value of goods available for sale
Ending inventory at retail
x cost to retail ratio
Ending inventory at cost
Variations of retail method: it can be used with
1. Conventional retail (LCM approach): considers markups only in computing ratio so reflects the lowest value.
And, in Appendix
2. LIFO retail (cost approach): considers both markups and markdowns and excludes beginning inventory.
3. Dollar-value LIFO retail: same as LIFO retail but considers changing prices.
There are 3 basic steps in computing all retail inventory problems:
1. Compute EI at retail. This step is the same regarless of which variation is used.
2. Compute the cost to retail ratio. This step will vary depending on which variation of the retail method is used.
3. Apply the cost to retail ratio (from #2) to EI at retail (from #1) to obtain EI at cost or at LCM. The step will vary depending on which variation of the retail method is used.
4. If fluctuating prices (dollar-value LIFO retail), have to deflate EI arrived at in #3, layer it to base layer and new layer and then restate at appropriate dollar values.
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