Inven - Est - 1 INVENTORY Alternative Valuation Methods Remember! 3 spaces = LCM 4 spaces = DV LIFO...

Inven - Est - 1

INVENTORYAlternative Valuation Methods

Remember!3 spaces = LCM

4 spaces = DV LIFO Retail11 spaces = FISH!!

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10-

LOWER OF COST OR MARKET(LCM)

Inventories must be carried at original costoriginal cost or current “market” value, whichever is lower.

LCM is a departure from historical cost and is a conservative accounting method.

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LOWER OF COST OR MARKET

Application Procedure

COST “MARKET”

GAAP

Lower of Cost

or Market

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““Market”Market” is the current replacement cost of an item in inventory.

Constraints on “market”

– Net Realizable Value (NRV) = “CEILING”“CEILING” • Estimated selling price less the costs of completion and disposal. • Market cannot be more than this amount.

– NRV less “normal profit margin = “Floor”“Floor” • Market cannot be less than this amount

Lower of Cost or Market (LCM)

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Ceiling

NRV

Not More Than

ReplacementCost

NotLessThan

NRV less NormalProfit Margin

Floor

COST MARKET“Constrained”

GAAP

Lower of Costor Market

LOWER OF COST OR MARKET

Application Procedure

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LOWER OF COST OR MARKET“Constrained Market” Value

If replacement cost falls betweenbetween the ceiling and floor, select replacement costselect replacement cost as market.

If replacement cost is belowbelow the floor, select the floorselect the floor as market.

If replacement cost is aboveabove the ceiling, select the ceilingselect the ceiling as market.

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“MARKET” CONSTRAINTSRationale

Ceiling Prevents overstatement of ending inventory and failure to recognize full extent of loss in the current year

Floor Prevents recognizing large inventory losses in one year followed by abnormally large profits in the following year

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APPLICATION OF LCM

Compare cost and market separately for each itemitem of inventory.

Compare cost and market separately for each classificationclassification of inventory.

Compare total costtotal cost with total markettotal market for the entire inventory.

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REPORTING LCM

Direct Inventory Reduction Method– Record and report inventory holding loss each accounting period.

Inventory Allowance Method– Record holding loss in a contra inventory account, “Allowance to Reduce Inventory to LCM.”

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ESTIMATING INVENTORY

Because of the cost and time required to take a complete physical inventory, it is sometimes necessary to estimate the cost of ending inventory.

Two popular methods are . . .– Gross Margin Method– Retail Method

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GROSS MARGIN METHOD

Assumes that the historical gross margin rate is reasonably constant in the short run.

We must know the following:– Net sales for the period.– Cost of beginning inventory.– Net purchases for the period.– The historical gross margin rate.

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GROSS MARGIN METHOD

• Estimate historical Gross margin %

• Compute Cost of goods available• Beg. inventory + Net purchases

• Compute CGS % = 100% - Gross margin %• % must be based on sales

• Compute estimated CGS = Sales x CGS %

• Compute estimated Ending inventory • Cost of goods available – Estimated CGS

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RETAIL METHOD

This method was developed for retail operations like department stores.

Uses both the retail value and cost of items for sales to calculate a cost to retail ratiocost to retail ratio.

Convert ending inventory at retail to ending inventory at cost.

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RETAIL METHOD

To use this method we must know:

– Sales for the period.

– Beginning inventory at retail and cost.

– Net purchases at retail and cost.

– Adjustments to the original retail price:• Additional markups and markdowns, markup and markdown cancellations, employee discounts

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RETAIL METHODMARKUPS AND MARKDOWNS

• Markup - Increase in sales price above the original sales price.

• Markup Cancellation - cancellation of some or all of an additional markup.

• Markdown - reduction in original sales price.

• Markdown Cancellation - increase in sales price after a markdown.

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RETAIL METHODSTEPS TO FOLLOW

• Determine cost of goods availableavailable in retail and cost terms• Appropriate consideration of markups and markdowns

• Calculate the cost/retail percentage.

• Subtract sales from retail value of goods available = ending inventory at retail.

• Cost/retail percentage x ending inventory at retail = estimated ending inventory at cost

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RETAIL METHOD“Conventional” Method

Approximates Average Cost (LCM)

Cost of beginning inventory + net purchases

Retail value of beginning inventory + net purchases + NET markups

Costratio

=

NET markdowns are NOT considered

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Can be used in financial statements and for income tax purposes.

Of value for interim financial reporting.

Company must still take a physical inventory periodically.

Provides an overall test for reasonableness of inventory counts.

RETAIL METHODAN EVALUATION

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Dollar Value LIFO (DV LIFO) is the onlyonly acceptable method of converting retail data to a LIFO basis.

We previously discussed DV LIFO

Remember how we established a LIFO base for the first year, and added or deducted layers for each subsequent year.

RETAIL METHODDollar-Value LIFO BASIS

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RETAIL METHOD DOLLAR-VALUE LIFO BASIS

1. Compute ending inventory in both retail

and cost terms • Appropriate consideration of markups

and markdowns

2. Calculate the cost/retail %

COST % IGNORES BEGINNING INVENTORY

Cost of net purchases Cost ratio = Retail value of net purchases + net markups - net markdowns

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3. Convert to LIFO Retail Cost• Compute ending inventory at base

retail prices Utilize an internal or external conversion

price index for the appropriate period

• Determine changes in layers using base retail prices

• Use appropriate cost/retail ratios to convert to Dollar-value LIFO retail

RETAIL METHOD DOLLAR-VALUE LIFO BASIS

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INVENTORY. . . Enough Said!