Chapter 9

Inventories: Additional
Valuation Issues
LOWER-OF-COST-OR-NET REALIZABLE
VALUE

A company abandons the historical cost principle when the

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

Definition of Net Realizable Value

 Net realizable value (NRV) is the estimated selling
price in the ordinary course of business, less reasonably
predictable costs of completion, disposal, and
transportation.
 Definition of Net Realizable Value

Illustration: Assume that Mander Corp. has unfinished inventory

with a cost of $950, a sales value of $1,000, estimated cost of
completion of $50, and estimated selling costs of $200. Mander’s
net realizable value is computed as follows.

ILLUSTRATION 9-1
Computation of Net Realizable Value
Definition of Net Realizable Value
ILLUSTRATION 9-1

 Mander reports inventory on its balance sheet at $750.

 In its income statement, Mander reports a Loss Due to
Decline of Inventory to NRV of $200 ($950 − $750).
ILLUSTRATION 9-2
LCNRV Disclosures
Illustration of LCNRV

Regner Foods computes its inventory at LCNRV, as

ILLUSTRATION 9-3
shown in Illustration 9-3 (amounts in thousands). Determining Final
Inventory Value
 Methods of Applying LCNRV

ILLUSTRATION 9-4
Alternative Applications of LCNRV

Companies usually price inventory on an item-by-item basis.

 Recording NRV Instead of Cost

The following inventory data is for Ricardo Company.

Ending inventory (cost) $ 82,000

Ending inventory (at NRV) 70,000
Adjustment to LCNRV $ 12,000

Loss
Loss Loss Due to Decline in Inventory 12,000
Method
Method Inventory

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

12,000
Use of an Allowance

Instead of crediting the Inventory account for market adjustments,

companies generally use an allowance account, often referred to
as Allowance to Reduce Inventory to NRV.
Using an allowance account under the loss method, Ricardo
Company makes the following entry to record the inventory write-
down to NRV.

Loss Due to Decline of Inventory to NRV 12,000

Allowance to Reduce Inventory to NRV 12,000

ILLUSTRATION 9-7
Presentation of
Inventory Using an
Allowance Account
Recording NRV Instead of Cost

Balance Sheet
Loss COGS
Method Method
Current assets:
Cash $ 100,000 $ 100,000
Accounts receivable 350,000 350,000
Inventory 770,000 758,000
Less: allowance to market (12,000)
Prepaids 20,000 20,000
Total current assets 1,228,000 1,228,000
Recording NRV Instead of Cost
Loss COGS
Income Statement
Method Method
Sales $ 300,000 $ 300,000
Cost of goods sold 120,000 132,000
Gross profit 180,000 168,000
Operating expenses:
Selling 45,000 45,000
General and administrative 20,000 20,000
Total operating expenses 65,000 65,000
Other revenue and (expense):
Loss on inventory (12,000) -
Interest income 5,000 5,000
Total other (7,000) 5,000
Income from operations 108,000 108,000
Income tax expense 32,400 32,400
Net income $ 75,600 $ 75,600
 Use of an Allowance—Multiple Periods

In general, accountants adjust the allowance account balance at

the next year-end to agree with the discrepancy between cost and
the LCNRV at that balance sheet date.

ILLUSTRATION 9-8
Effect on Net Income of Reducing Inventory to NRV
LOWER-OF-COST-OR-MARKET

The use of the lower-of-cost-or-net realizable value method

works well to measure the decline in value of a company’s
inventory for most companies.
The FASB decided to grant an exception to the LCNRV approach
for companies that use the LIFO or retail inventory methods.
 Rather than comparing cost to net realizable value, under
the alternative approach, companies compare a
“designated market value” of the inventory to cost.
 The approach is commonly referred to as lower-of-cost-or-
market (LCM).
LOWER-OF-COST-OR-MARKET

This approach begins with replacement cost, then applies two

additional limitations to value ending inventory.
 Net realizable value (ceiling) and
 net realizable value less a normal profit margin (floor).

Net realizable value (NRV) is the estimated selling price in the

ordinary course of business, less reasonably predictable costs of
completion and disposal.

A company values inventory at the lower-of-cost-or-market, with

market limited to an amount that is not more than net realizable
value or less than net realizable value less a normal profit margin.
 LOWER-OF-COST-OR-MARKET

Illustration: Assume that Parker Corp. has unfinished inventory

with a sales value of $1,000, estimated cost of completion and
disposal of $300, and a normal profit margin of 10 percent of
sales. Parker determines the following net realizable value.

ILLUSTRATION 9-9
Computation of Net Realizable Value
LOWER-OF-COST-OR-MARKET ILLUSTRATION 9-10
Inventory Valuation—
Lower-of-Cost-or-Market

What is the rationale for the

Ceiling = NRV
Ceiling and Floor limitations?
Not
>

Replacement
Cost Market Cost
Cost Market
Not
<

Floor =
GAAP
GAAP NRV less Normal
LCM
LCM Profit Margin
LOWER-OF-COST-OR-MARKET

What is the rationale for the Ceiling and Floor limitations?

 Ceiling – prevents overstatement of the value of obsolete,
damaged, or shopworn inventories.
 Floor – deters understatement of inventory and
overstatement of the loss in the current period.
 How Lower-of-Cost-or-Market Works
ILLUSTRATION 9-12
Determining Final Inventory Value

$65,000

Regner makes the following entry (using the loss method) to

record the decline in value.
Loss Due to Decline of Inventory to Market 65,000
Allowance to Reduce Inventory to Market 65,000
 Methods of Applying Lower-of-Cost-or-
Market

ILLUSTRATION 9-13
Alternative Applications of Lower-of-Cost-or-Market
LOWER-OF-COST-OR-MARKET

Evaluation of LCNRV and Lower-of-Cost-or-

Market Rule
Conceptual 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.
 Application of these rules uses a “normal profit” in determining
inventory values, which is a subjective measure.
OTHER VALUATION APPOACHES

Valuation at Net Realizable Value

Permitted by GAAP under the following conditions:

(1) a controlled market with a quoted price applicable to all

quantities, and

(2) no significant costs of disposal

or

(3) The product is available for immediate delivery.

(4) too difficult to obtain cost figures.

OTHER VALUATION APPOACHES

Valuation Using Relative Sales Value

Used when buying varying units in a single lump-sum purchase
(Bucket 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.
 OTHER VALUATION APPOACHES

ILLUSTRATION 9-14
Allocation of Costs, Using Relative Sales Value

ILLUSTRATION 9-15
Determination of Gross Profit, Using Relative Sales Value
OTHER VALUATION APPOACHES

Purchase Commitments—A Special Problem

► Generally seller retains title to the merchandise.

► Buyer recognizes no asset or liability.

► If material, the buyer should disclose contract details in

note in the financial statements.
► 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 losses
in the period during which such declines in market prices
take place.
OTHER VALUATION APPOACHES

Illustration: St. Regis Paper Co. signed timber-cutting contracts

to be executed in 2018 at a price of $10,000,000. Assume further
that the market price of the timber cutting rights on December
31, 2017, dropped to $7,000,000. St. Regis would make the
following entry on December 31, 2017.

Unrealized Holding Gain or Loss—Income 3,000,000

Estimated Liability on Purchase Commitment 3,000,000

Other expenses and losses in the Income statement.

Current liabilities on the balance sheet.

OTHER VALUATION APPOACHES

Illustration: When St. Regis cuts the timber at a cost of $10

million, it would make the following entry.

Purchases (Inventory) 7,000,000

Est. Liability on Purchase Commitment 3,000,000
Cash 10,000,000

Assume the Congress permitted St. Regis to reduce its contract

price and therefore its commitment by $1,000,000.

Est. Liability on Purchase Commitment 1,000,000

Unrealized Holding Gain or Loss—Income 1,000,000
GROSS PROFIT METHOD OF
ESTIMATING INVENTORY

Substitute Measure to Approximate Inventory

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.
 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.

ILLUSTRATION 9-17
Application of Gross Profit Method
 GROSS PROFIT METHOD

Computation of Gross Profit Percentage

Illustration: In Illustration 9-17, 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.

ILLUSTRATION 9-18
Computation of Gross Profit Percentage
GROSS PROFIT METHOD ILLUSTRATION 9-19
Formulas Relating to
Gross Profit

ILLUSTRATION 9-20
Application of Gross Profit Formulas
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

Purchases (gross) 640,000
Freight-in 30,000
Sales 1,000,000
Sales returns 70,000
Purchase 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.
 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
 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) 25% 640,000
= 20% of sales
Purchase discounts 100% + 25% (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 (20% of $930,000) 186,000
Sales (at cost) 744,000
Approximate inventory, May 31 (at cost) $ 74,000
GROSS PROFIT METHOD

Evaluation of Gross Profit Method

Disadvantages:

(1) It is an estimate.

(2) It generally relies on past percentages in determining the

markup.

(3) Care must be exercised when applying a blanket gross

profit rate when there are varying gross profits.

Normally unacceptable for financial reporting purposes. GAAP

requires a physical inventory as additional verification.
 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:
(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
Methods
 Conventional
 Conventional
 Cost
 Cost
 LIFO
 LIFO Retail
Retail
 Dollar-value
 Dollar-value LIFO
LIFO
 RETAIL INVENTORY METHOD

Illustration: Fuque Inc. uses the retail inventory method to

estimate ending inventory for its monthly financial statements. The
following data pertain to a single department for the month of
October.

COST RETAIL Instructions:

Beg. inventory, Oct. 1 $ 52,000 $ 78,000
Purchases 272,000 423,000 Prepare a schedule
Freight in 16,600 computing retail
Purchase returns 5,600 8,000 inventory using the
Additional markups 9,000 following methods:
Markup cancellations 2,000
Markdowns (net) 3,600 (1) Conventional (LCM)
Normal spoilage 10,000
(2) Cost
Sales 390,000
 RETAIL INVENTORY METHOD
CONVENTIONAL Method:
Cost to
COST RETAIL Retail %
Beg. inventory $ 52,000 $ 78,000
Purchases 272,000 423,000
Freight in 16,600
Purchase returns (5,600) (8,000)
Markups, net 7,000
Current year additions 283,000 422,000
Goods available for sale 335,000 500,000 67.00%
Markdowns, net (3,600)
Normal spoilage (10,000)
Sales (390,000)
Ending inventory at retail $ 96,400

Ending inventory at Cost:

$ 96,400 x 67.00% = $ 64,588
 RETAIL INVENTORY METHOD
COST Method:
Cost to
COST RETAIL Retail %
Beg. inventory $ 52,000 $ 78,000
Purchases 272,000 423,000
Freight in 16,600
Purchase returns (5,600) (8,000)
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 (10,000)
Sales (390,000)
Ending inventory at retail $ 96,400

Ending inventory at Cost:

$ 96,400 x 67.49% = $ 65,056
RETAIL INVENTORY METHOD

Special Items Relating to Retail Method

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

Presentation of Inventories
Accounting standards require disclosure of:
1) Composition of the inventory, inventory financing
arrangements, and the inventory costing methods
employed.

2) Consistent application of costing methods from one period

to another.

3) Inventory composition either in the balance sheet or in a

separate schedule in the notes.
PRESENTATION AND ANALYSIS

Presentation of Inventories
Accounting standards require disclosure of:
4) Significant or unusual financing arrangements relating to
inventories.

5) Inventories pledged as collateral for a loan in the current

assets section rather than as an offset to the liability.

6) Basis on which it states inventory amounts (lower of-cost-

or-market) and the method used in determining cost
(LIFO, FIFO, average cost, etc.).
PRESENTATION AND ANALYSIS

Analysis of Inventories
Common ratios used in the management and evaluation of
inventory levels are inventory turnover and average days
to sell the inventory.
 PRESENTATION AND ANALYSIS

Inventory Turnover
Measures the number of times on average a company sells
the inventory during the period.

Illustration: In its 2014 annual report Kellogg Company reported

a beginning inventory of $1,248 million, an ending inventory of
$1,279 million, and cost of goods sold of $9,517 million for the year.

ILLUSTRATION 9-30
Inventory Turnover
PRESENTATION AND ANALYSIS

Average Days to Sell Inventory

Measure represents the average number of days’ sales for
which a company has inventory on hand.
ILLUSTRATION 9-30

Average Days to Sell

365 days / 7.53 times = every 48.5 days