Ch. 9 Flashcards
When inventory declines whatever the reason (damage, physical deterioration, obsolescence, changes in price levels and other causes) a company should write down
The inventory to net realizable value to report loss
When does the company abandon the historical cost principle?
When the future utility (revenue producing ability) of the asset drops below its original cost
Cost is
Acquisition price of inventory computed using one of the historical cost based methods - specific identification, average cost, LIFO or FIFO
NRV
Is the net amount that a company expects to realize from the sale of inventory
NRV is the estimated selling price
In the ordinary course of business less reasonably predictable costs of completion disposal and transportation
LCRNV
Companies estimate NRV based on
Most predictable evidence of inventories realizable amounts (expected selling price, expected costs of completeion, disposal and transportation)
Companies usually value inventory on
Item by item basis
Individual item approach gives the most
Conservative valuation for balance sheet purposes
Company values inventory on total inventory basis when
It offers only one end product (comprised of many different raw materials)
A category approach is used when it
Produces several end products
Whatever method is used, the method should be
Consistent from one period to another
2 methods to record income effect of valuing inventory at NRV.
1
2
- COGS method
2. LOSS method
COGS method
Debits COGS sold for write down of inventory to NRV
As a result the company does not report a loss on income statement bc COGS already includes the amount of loss
Loss method
Debits loss account for write down of inventory to NRV
Loss method is more preferable bc
It clearly discloses the loss resulting from a decline in inventory to NRV
With respect to accounting for allowance in the subsequent period of the company still has merchandise on hand, it should
Retain the allowance account
If the allowance account is not kept then the company will
Overstate beginning inventory and cogs
If the company has sold the goods then it should
Close the account
A new allowance account is established for any
Decline in inventory value that takes place in the current year
Use of an allowance, multiple periods. In general accountants leave allowance account on the books. They adjust the balance at the next year end to agree with
Discrepancy between cost and LCNRV at balance sheet date
The use of the lower of cost or NRV method works well to measure?
The decline in value of a company’s inventory for most companies
LCNRV is designed to ?
Simplify and reduce the cost and complexity of inventory measurement under GAAP.
When using LIFO or retail inventory methods, the change to LCNRV would result in significant cost upon
Transitions and would not simplify their subsequent measurement of inventory
LCM
Compare a designated market value of inventory to cost
This approach begins with replacement cost and two additional limitations are applied to ending inventory NRV AND NRV less normal profit margin
General lower of cost or market rule is
A company values inventory at the lower of cost or market, with market limited to an amount that is no more than NRV or less than NRV less than normal profit margin
Upper limit (ceiling)
NRV of inventory
Lower limit (floor)
NRV less a normal profit margin
What is the rationale for upper limit and lower limit?
Prevents companies from over and understating inventory
Maximum limitation not to exceed NRV (ceiling) prevents overstatement of
Value of obsolete damanaged or shopworn inventories
If replacement cost of item exceeds its net realizable value a company should not
Report inventory at replacement cost
The company can only receive the selling price less cost of disposal
The minimum floor is to not be
Less than NRV reduced by an allowance for approximately normal profit margin
Minimum Floor measures
What the company can receiver for the inventory and still earn normal profit
Designated market value
Amount company compares to cost
Designated market value is always
Middle value of three amounts , replacement cost, NRV and NRV less a normal profit margin
Support exists for recording inventory at NRV even if
Amount is above cost
GAAP permits exception to normal recognition rule under following conditions:
- Controlled market with quoted price applicable to all quantities
- When no significant costs of disposal are involved
- Product is available for immediate delivery
Until items of inventory meet the NRV 3 conditions they are accounted for
Based on accumulated historical costs
NRV is allowed when it is too difficult to
Obtain cost figures
Lump sum purchase also called basket purchase
When a company buys a group of varying units
Company’s survival and continued profitability depend on
It’s having sufficient stock of merchandise to meet customer demand
Purchase commitments
Which are agreements to buy inventory weeks months or even years in advance
In the purchase commitments who retains title to merchandise or material?
Seller
It’s usually not necessary for buyer to make any entries reflect commitments for purchases of goods that seller has not shipped
True
Ordinary orders for which buyer and seller will determine prices at the time of shipment and which are subject to cancellation do not represent either an asset or liability to buyer so therefore the buyer does not need to record
Such ourchase commitments or report them in financial statements
What happens though if buyers enter to a formal noncanceable purchase contract ?
Even then the buyer recognizes no asset or liability at the date of inception because the contract is “executory” in nature: neither party has fulfilled its pet of contract
If contract price > market price
Buyer expects that losses will occur when purchase is effected
Purchases can protect themselves against the possibility of market price declines of goods under contract by
Hedging
In hedging
The purchaser in the purchase commitment simultaneously enters into contract in which it agrees to sell in the future the same quantity or similar goods at fixed price
This the company holds a buy position in purchase commitment and a sell position in a futures contract in the same commodity
Gross profit method
One substitute method of verifying or determine the inventory amount
Gross profit method relies on 3 assumptions
- Beginning inventory + purchases = goods to be accounted for
- Goods not sold must be ok hand
- Sales reduced to cost - sum of opening inventory + purchases = ending inventory
Gross profit percentage
Stated as % of selling price
Gross profit on selling price is the most common method for quoting profit for several reasons
- Most companies state goods on retail basis not cost basis
2. A profit quoted on selling price is lower than one based on cost
Bc selling price exceeds cost and with gross profit amount being same for both, gross profit on
Selling price will always be less than related % based on cost
Gross profit method is normally unacceptable for financial reporting purposes bc
It provides only an estimate
GAAP permits gross profit method to determine
Ending inventory for interim reporting purposes, provided a company discloses the use of method
Gross method relies on
Historical records
Retail inventory method
Retailer uses formula to convert retail prices to cost
Retail inventory method requires the retail to keep a record of
- Total cost and retail value of goods purchased
- The total cost and retail value of goods available for sale
- Sales for the period
Different versions of retail inventory method and it includes
Convential method (lower of average cost or msrket) , cost method , LIFO retail method and dollar value LIFO
Advantages of retail method is
Inventory balance can be approximated without physical count
To avoid potential ovrrstament of inventory, what is to be taken?
Periodic inventory counts
Retail inventory method is useful for any time of
Interim report bc the reports usually need a fairly quick and realiable measure of inventory
Retail inventory is used for
Estimate losses from fire flood or type of causality
Acts as control device bc company will have to explain deviations from physical count st end of year
It expedites physical inventory count @ end of yr
Markup
Additional markup of original retail price
Markup cancellations
Decrease in price of merchandise that a retailer had marked up above the original retail price
Markdowns
Decreases in original sale prices
Markdown cancellations occur when
Markdowns are later offset by increases in the prices of goods that retailer had marked down
Neither the markup cancellation nor markdown cancellation can exceed
Original Markup or markdown
Conventional retail inventory method
Approximates lower of average cost or market
To approximate the lower of cost or market we would consider markdowns a current loss and so it will
Not be include in calculating cost to retail ratio
Special items relating to retail method
Freight costs: part of purchase cost
Purchase returns: ordinarily considered as reduction of price at both cost and retail
Purchase discounts and allowances: considered as reduction of cost of purchases
Transfer ins: from another department are reported same way as purchases from outside of company
Normal shortages: reduce retail column because no longer for sale
Abnormal shortages: deducted from both cost and retail columns and reported as special inventory amount or as a loss
Employee discounts: deducted from retail columns in same way as sales
Use retail method of computing inventory for the following reasons:
- To permit computation of net income without physical count of inventory
- Control measure in determining inventory shortages
- Regulating quantities of merchandise on hand
- Insurance information
One characteristic of retail inventory method is
That is has an averaging effect on varying rates of gross profit
Inventories must be
Managed
Inventory turnover measures
Number of times on average company sells the inventory during the period .
Measure sthe liquidity of inventory
A variant of inventory turnover is
Average days to sell inventory
LIFO results in
Better matching costs and revenues
LIFO retail is made under two assumptions
- Stable prices
2. Fluctuating prices
LIFO method is concerned only with additional layer or amount that should be subtracted from previous layer, beginning inventory should be
Excluded from cost to retail %
Major assumption of LIFO retail method
Markup and markdowns apply only to goods purchases during the current period and not beginning inventory
Dollar value LIFO retail method
If price level does change the company must eliminate price change so as to measure the teal increase in inventory not dollar increase
Changing from conventional retail to LIFO
Conventional retail is a lower of cost or market approach and the company must restate beginning inventory to a cost basis when changing from conventional retail to the LIFO method
