Chapter 9: Inventories: Additional Valuation Issues

Question 1

What is conservatism?

How does this concept relate to the valuation of inventory?

Answer 1

Never overstate assets or understate liabilities.

If value of inventory falls before it is sold, an adjustment to inventory must be made to reflect the loss.

This reduces the value of the asset to reflect reductions in market prices.

Never increase value of inventory!

Question 2

What is lower-of-cost-or-market (LCM)?

What type of companies us this method?

Answer 2

Inventory is valued at no more than the net realizable value or no less than net realizable value less a normal profit margin.

Companies using LIFO or retail methods use this method.

Question 3

What is the decision tree for valuing inventory at lower-of-cost-or-market?

Answer 3

1. Choose the middle amount between ceiling NRV, replacement cost, and NRV-NP floor. This is the designated market value.
2. Then choose the lower amount between designated market and cost.

Question 4

What can LCM be applied to?

Answer 4

• Individual items
• Logical inventory categories
• Entire inventory

For tax purposes, LCM is applied to individual items only

Question 5

What are the journal entries to record a reduction in inventory using the LCM?

Answer 5

Direct write-off, if substantial

Loss on write-down of inventory XXX

Inventory XXX

Direct write-off, common

COGS XXX

Inventory XXX

Inventory Allowance

Loss XXX

Allowance XXX

Question 6

What is the gross profit method?

Answer 6

A method to verify or determine value of ending inventory without physical count.

Not acceptable by US GAAP for annual statements.

Question 7

How is ending inventory calculated under the gross profit method?

Answer 7

Beginning inventory

+ Net Purchases

= Goods available for sale

• COGS (estimated)

= Ending inventory (estimated)

Question 8

How is COGS estimated under the gross profit method?

Answer 8

Net Sales

x

Gross Margin Percentage

Question 9

How is the gross profit percentage calculated?

Answer 9

Gross profit

divided by

Net Sales

Question 10

How is the markup on cost calculated:

as a percentage of cost

and

as a percentage of sales

Answer 10

Gross profit percentage

divided by

cost as a percentage of net sales

and

Gross profit as a percentage of cost

divided by

(1 + gross profit as % of cost)

Question 11

What is the retail inventory method?

Answer 11

Requires retailers to keep detailed records 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

Question 12

What are the advantages of the retail inventory method?

Answer 12

• Useful for retailers with large inventories
• Less bookkeeping
• Is GAAP
• Can be used for tax purposes
• Keeps track of multiple items with similar cost structures
• More accurate than gross profit method because it uses cost-to-retail % instead of historical gross profit ratio

Question 13

What are the steps to apply the retail inventory method?

Answer 13

1. Compute cost-to-retail ratio

Cost of goods available for sale at cost

divided by

Cost of goods availabe for sale at retail

2. Compute the dollar value of ending inventory at retail
3. Multiply this value by the cost-to-retail ratio

Question 14

How is estimated COGS calculated using the retail inventory method?

Answer 14

Beginning inventory

+ Purchases

= Cost of Goods available for sale

• Sales at retail

= Ending Inventory at retail

x Cost-to-retail-percentage

= Estimated COGS

Question 15

What are markups?

Answer 15

An increase in the original retail price.

Question 16

What are markups cancellation?

Answer 16

Decreases in the prices of merchandise that the retailer had marked up about the original retail price.

Question 17

What is a markdown?

Answer 17

Decrease in the original sales price.

Question 18

What are markdown cancellations?

Answer 18

Markdowns that are later offset by increases in the prices that were marked down.

Question 19

What are some issues with using the retail method?

Answer 19

• Markups and markdowns can affect the method
• To approximate an LCM rule, include markups in cost ratio but exclude markdowns (cost-to-retail ratio is more conservative)
• LIFO retail method - each layer has own cost-to-retail percentage

Question 20

What happens to these elements before calculating the cost-to-retail percentage?

Freight-in

Purchase returns

Purchase discounts taken (if gross method used)

Abnormal shortages

Answer 20

• Freight-in - added to cost
• Purchase returns - deducted in both cost and retail
• Purchase discounts taken - deducted from cost
• Abnormal shortages - deducted in both cost and retail

Question 21

What happens to these elements after calculating the cost-to-retail percentage?

Normal shortages

Employee discounts (if sales recorded net of discounts)

Answer 21

• Normal shortages - deducted from retail
• Employee discounts - added to net sales

Question 22

What is the conventional retail inventory method or lower-of-cost-or-market approach?

Answer 22

Assumes a cost ratio after net markups, but before markdowns.

Question 23

What is the cost method or average cost method?

Answer 23

Assumes cost ratio after both markups and markdowns.