1 Inventories: Additional

Valuation Issues
L E A R N IN G O B J E C T IV E S

LEARNING OBJECTIVES
After studying this chapter, you should be able to:

1. Describe and apply the lower-of- 5. Determine ending inventory by applying

cost-or-net realizable value rule. the gross profit method.

2. Explain when companies value 6. Determine ending inventory by applying

inventories at net realizable value. the retail inventory method.

3. Explain when companies use the 7. Explain how to report and analyze
relative standalone sales value method inventory.
to value inventories.
4. Discuss accounting issues related to
purchase commitments.

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 LOWER-OF-COST-OR-NET REALIZABLE
VALUE (LCNRV)

A company abandons the historical cost principle when

the future utility (revenue-producing ability) of the
asset drops below its original cost.

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 LCNRV

Net Realizable Value

Estimated selling price in the normal course of business less
 estimated costs to complete and
 estimated costs to make a sale.

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 LCNRV

Illustration of LCNRV: Jinn-Feng Foods computes its

inventory at LCNRV (amounts in thousands).

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 LCNRV

Methods of Applying LCNRV

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 LCNRV

Methods of Applying LCNRV

 In most situations, companies price inventory on an item-
by-item basis.
 Tax rules in some countries require that companies use an
individual-item basis.
 Individual-item approach gives the lowest valuation for
statement of financial position purposes.
 Method should be applied consistently from one period to
another.

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 Recording Net Realizable Value

Illustration: Data for Ricardo Company

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

Loss
Loss Loss Due to Decline to NRV 12,000
Method
Method Inventory (€82,000 - €70,000)

12,000
COGS
COGS Cost of Goods Sold 12,000
Method
Method Inventory

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12,000 LO 1
 Recording Net Realizable Value

Partial Statement of Financial Position

Loss COGS
Method 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

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 Recording Net Realizable Value
Loss COGS
Income Statement Method Method
Sales € 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 decline of inventory to NRV 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
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 LCNRV

Use of an Allowance
Instead of crediting the Inventory account for net realizable
value adjustments, companies generally use an allowance
account.

Loss
Loss Method
Method

Loss Due to Decline to NRV 12,000

Allowance to Reduce Inventory to NRV
12,000

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 Use of an Allowance

Partial Statement of Financial Position

No
Allowance Allowance
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

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 LCNRV

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 realizable

value increases to €74,000 (an increase of €4,000). Ricardo
makes the following entry, using the loss method.

Allowance to Reduce Inventory to NRV 4,000

Recovery of Inventory Loss 4,000

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 Recovery of Inventory Loss

Allowance account is adjusted in subsequent periods, such

that inventory is reported at the LCNRV.
Illustration shows net realizable value evaluation for Vuko Company
and the effect of net realizable value adjustments on income.

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 Evaluation of LCM Rule

LCNRV rule suffers some conceptual deficiencies:

1. A company recognizes decreases in the value of the asset
and the charge to expense in the period in which the loss in
utility occurs—not in the period of sale.
2. Application of the rule results in inconsistency because a
company may value the inventory at cost in one year and at
net realizable value in the next year.
3. LCNRV values the inventory in the statement of financial
position conservatively, but its effect on the income statement
may or may not be conservative. Net income for the year in
which a company takes the loss is definitely lower. Net
income of the subsequent period may be higher than normal if
the expected reductions in sales price do not materialize.
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 LCNRV
P9-1: Remmers Company manufactures desks. Most of the
company’s desks are standard models and are sold on the basis of
catalog prices. At December 31, 2015, the following finished desks
appear in the company’s inventory.

Finished Desks A B C D
Catalog selling price € 500 € 540 € 900 € 1,200
FIFO cost per inventory list 12/31/15 470 450 830 960
Estimated cost to complete and sell 50 110 260 200

Instructions: At what amount should the desks appear in the

company’s December 31, 2015, inventory, assuming that the company
has adopted a lower-of-FIFO-cost-or-net realizable value approach for
valuation of inventories on an individual-item basis?
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 LCNRV
P9-1: Remmers Company manufactures desks. Most of the
company’s desks are standard models and are sold on the basis of
catalog prices. At December 31, 2015, the following finished desks
appear in the company’s inventory.

Finished Desks A B C D
Catalog selling price € 500 € 540 € 900 € 1,200
FIFO cost per inventory list 12/31/15 470 450 830 960
Estimated cost to complete and sell 50 110 260 200
Net realizable value 450 430 640 1,000
Lower-of-cost-or-NRV 450 430 640 960

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 VALUATION BASES

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.

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 VALUATION BASES

Valuation Using Relative Standalone Sales

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

Illustration: Woodland Developers purchases land for $1 million

that it will subdivide into 400 lots. These lots are of different sizes
and shapes but can be roughly sorted into three groups graded A,
B, and C. As Woodland sells the lots, it apportions the purchase
cost of $1 million among the lots sold and the lots remaining on
hand. Calculate the cost of lots sold and gross profit.

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 VALUATION BASES

ILLUSTRATION 9-11
Determination of Gross Profit,
Using Relative Standalone Sales Value

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 GROSS PROFIT METHOD OF
ESTIMATING INVENTORY

Substitute Measure to Approximate Inventory

Relies on three assumptions:

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 ending inventory.

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 GROSS PROFIT METHOD

Illustration: Cetus Corp. has a beginning inventory of €60,000

and purchases of €200,000, both at cost. Sales at selling price
amount to €280,000. The gross profit on selling price is 30
percent. Cetus applies the gross margin method as follows.

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 GROSS PROFIT METHOD

Computation of Gross Profit Percentage

Illustration: In Illustration 9-13, the gross profit was a given. But
how did Cetus derive that figure? To see how to compute a gross
profit percentage, assume that an article cost €15 and sells for
€20, a gross profit of €5.

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 GROSS PROFIT METHOD

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 GROSS PROFIT METHOD

Illustration: Astaire Company uses the gross profit method to

estimate inventory for monthly reporting purposes. Presented below is
information for the month of May.
Inventory, May 1 € 160,000 Sales € 1,000,000
Purchases (gross) 640,000 Sales returns 70,000
Freight-in 30,000 Purchases discounts 12,000

Instructions:
(a) Compute the estimated inventory at May 31, assuming that the
gross profit is 25% of sales.
(b) Compute the estimated inventory at May 31, assuming that the
gross profit is 25% of cost.

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

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 selling price) € 1,000,000
Sales returns (at selling price) (70,000)
Net sales (at selling price) 930,000
Less: Gross profit (25% of €930,000) 232,500
Sales (at cost) 697,500
Approximate inventory, May 31 (at cost) € 120,500

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

Inventory, May 1 (at cost) € 160,000

Purchases (gross) (at cost) 640,000
25%
Purchase discounts = 20% of sales (12,000)
100% + 25%
Freight-in 30,000
Goods available (at cost) 818,000
Sales (at selling price) € 1,000,000
Sales returns (at selling price) (70,000)
Net sales (at selling price) 930,000
Less: Gross profit (20% of €930,000) 186,000
Sales (at cost) 744,000
Approximate inventory, May 31 (at cost) € 74,000

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 GROSS PROFIT METHOD

Evaluation of Gross Profit Method

Disadvantages
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

because it provides only an estimate.

IFRS requires a physical inventory as additional verification of

the inventory indicated in the records.

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 RETAIL INVENTORY METHOD

Method used by retailers to compile inventories at retail prices.

Retailer can use a formula to convert retail prices to cost.
Requires retailers to keep a record of:
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.

Methods
 Conventional Method (or LCNRV)
 Cost Method

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  For retailers, the term markup means an additional markup of the
original retail price.
 Markup cancellations are decreases in prices of merchandise that
the retailer had marked up above the original retail price.
 In a competitive market, retailers often need to use markdowns,
which are decreases in the original sales prices.
 Markdown cancellations occur when the markdowns are later
offset by increases in the prices of goods that the retailer had
marked down—such as after a one-day sale.
 Neither a markup cancellation nor a markdown cancellation can
exceed the original markup or markdown.

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 To illustrate these concepts, assume that Designer Clothing
Store recently purchased 100 dress shirts from Marroway,
Inc. The cost for these shirts was €1,500, or €15 a shirt.
Designer Clothing established the selling price on these
shirts at €30 a shirt. The shirts were selling quickly, so the
manager added a markup of €5 per shirt. This markup
made the price too high for customers, and sales slowed.
The manager then reduced the price to €32. At this point,
we would say that the shirts at Designer Clothing have had
a markup of €5 and a markup cancellation of €3.
 A month later, the manager marked down the remaining
shirts to a sales price of €23. At this point, an additional
markup cancellation of €2 has taken place, and a €7
markdown has occurred. If the manager later increases the
price of the shirts to €24, a markdown cancellation of €1
would occur.
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  Freight costs are part of the purchase cost.
 Purchase returns are ordinarily considered as
a reduction of the price at both cost and retail.
 Purchase discounts and allowances usually
are considered as a reduction of the cost of
purchases.

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  Transfers-in from another department are reported in the same
way as purchases from an outside enterprise.
 Normal shortages (breakage, damage, theft, shrinkage) should
reduce the retail column because these goods are no longer
available for sale. Such costs are reflected in the selling price
because a certain amount of shortage is considered normal in a
retail enterprise. As a result, companies do not consider this amount
in computing the cost-to-retail percentage. Rather, to arrive at
ending inventory at retail, they show normal shortages as a
deduction similar to sales.
 Abnormal shortages, on the other hand, are deducted from both
the cost and retail columns and reported as a special inventory
amount or as a loss. To do otherwise distorts the cost-to-retail ratio
and overstates ending inventory.
 Employee discounts (given to employees to encourage loyalty,
better performance, and so on) are deducted from the retail column
in the same way as sales. These discounts should not be
considered in the cost-to-retail percentage because they do not
reflect an overall change in the selling price.
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  The cost/retail ratio makes up one of the main
components used to calculate the retail inventory
method. Two methods exist for calculating the cost/retail
ratio.
 The first method, called the conventional retail method
includes markups but excludes markdowns. This method
results in a lower ending inventory value.
 To approach the lower of cost or NRV consider
markdown as a current loss and not included in
calculating the cost to retail ratio, omitting the
markdown makes the cost to retail ratio lower
which lead to the lower of cost or NRV.
 The second method, simply called the retail method,
uses both markups and markdowns to calculate the
ratio. This method results in a higher-ending inventory
value.
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9-34
 RETAIL INVENTORY METHOD

Illustration: The following data pertain to a single department for

the month of October for Fuque Inc. Prepare a schedule computing
retail inventory using the Conventional and Cost methods.

COST RETAIL
Beg. inventory, Oct. 1 £ 52,000 £ 78,000
Purchases 272,000 423,000
Freight in 16,600
Purchase returns 5,600 8,000
Additional markups 9,000
Markup cancellations 2,000
Markdowns (net) 3,600
Normal spoilage and breakage 10,000
Sales 390,000
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 RETAIL INVENTORY METHOD

CONVENTIONAL Method: Cost to

COST RETAIL Retail %
Beginning inventory £ 52,000 £ 78,000
Purchases 272,000 423,000
Purchase returns (5,600) (8,000)
Freight in 16,600
Markups, net 7,000
Current year additions 283,000 422,000
Goods available for sale 335,000 500,000 67.0%
Markdowns, net (3,600)
Normal spoilage and breakage (10,000)
Sales (390,000)
Ending inventory at retail £ 96,400

Ending inventory at Cost:

£ 96,400 x 67.0% = £ 64,588

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 RETAIL INVENTORY METHOD

COST Method: Cost to

COST RETAIL Retail %
Beginning inventory £ 52,000 £ 78,000
Purchases 272,000 423,000
Purchase returns (5,600) (8,000)
Freight in 16,600
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 and breakage (10,000)
Sales (390,000)
Ending inventory at retail £ 96,400

Ending inventory at Cost:

£ 96,400 x 67.49% = £ 65,060

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 RETAIL INVENTORY METHOD

Special Items Relating to Retail Method

 Freight costs
 Purchase returns
 Purchase discounts and allowances
 Transfers-in
When sales are recorded
 Normal shortages
gross, companies do not
 Abnormal shortages recognize sales discounts.

 Employee discounts

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 RETAIL INVENTORY METHOD

Special
Items

ILLUSTRATION 9-22
Conventional Retail
Inventory Method—
Special Items Included

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 RETAIL INVENTORY METHOD

Evaluation of Retail Inventory Method

Used for the following reasons:
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 by

departments or class of merchandise with similar gross profits.

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 PRESENTATION AND ANALYSIS

Presentation of Inventories
Accounting standards require disclosure of:
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,
raw materials, work in progress, and finished goods).

3) Carrying amount of inventories carried at fair value less

costs to sell.

4) Amount of inventories recognized as an expense during the

period.
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 PRESENTATION AND ANALYSIS

Presentation of Inventories
Accounting standards require disclosure of:
5) Amount of any write-down of inventories recognized as
an expense in the period and the amount of any reversal
of write-downs recognized as a reduction of expense in
the period.

6) Circumstances or events that led to the reversal of a

write-down of inventories.

7) Carrying amount of inventories pledged as security for

liabilities, if any.

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