CHAPTER 9 INVENTORIES ADDITIONAL VALUATION ISSUES Overview We covered most of the principal measurement and reporting issues involving the asset inventory and the corresponding expense cost of goods sold in the previous chapter In this chapter we complete our discussion of inventory measurement by explaining the lower of cost or market rule used to value inventories In addition we investigate inventory estimation techniques methods of simplifying LIFO changes in inventory method and inventory errors Learning Objectives LO9 1 Understand and apply the lower of cost or market rule used to value inventories LO9 2 Estimate ending inventory and cost of goods sold using the gross profit method LO9 3 Estimate ending inventory and cost of goods sold using the retail inventory method applying the various cost flow methods LO9 4 Explain how the retail inventory method can be made to approximate the lower of cost ormarket rule LO9 5 Determine ending inventory using the dollar value LIFO retail inventory method LO9 6 Explain the appropriate accounting treatment required when a change in inventory method is made LO9 7 Explain the appropriate accounting treatment required when an inventory error is discovered LO9 8 Discuss the primary differences between U S GAAP and IFRS with respect to the lower ofcost or market rule for valuing inventory LOWER OF COST OR MARKET Inventories are reported at the lower of cost or market LCM For LCM purposes market is defined as replacement cost except that market should Not exceed the net realizable value NRV Not be less than NRV reduced by an allowance for an approximately normal profit margin NRV NP NRV provides a ceiling and NRV NP a floor between which market must fall The Collins Company has five inventory items on hand at the end of 2013 The yearend unit costs determined by applying the average cost method current unit selling prices and estimated disposal selling costs for each of the items are presented below The gross profit ratio for each of the products is 20 of selling price Item A B C D E Replacement Cost 55 90 70 37 92 Cost 50 100 80 90 95 Selling Price 100 120 85 100 110 Estimated Disposal Costs 15 20 20 24 24 The determination of inventory value is a two step process first determine the designated market value and second compare the designated market value to cost The lower of the two is the LCM inventory value LOWER OF COST OR MARKET 1 Item A B C D E RC 55 90 70 37 92 2 NRV 85 100 65 76 86 3 4 Designated Market Value Middle value of 1 2 3 NRV NP 65 65 76 90 48 65 56 56 64 86 continued 5 Cost 50 100 80 90 95 Inventory Value Lower of 4 or 5 50 90 65 56 86 RC Current replacement cost NRV Estimated selling price less estimated disposal costs NRV NP NRV less a normal profit margin Example for item B Selling price Less Disposal costs NRV Less Normal profit NRV NP 120 20 100 24 120 selling price x 20 76 INTERNATIONAL FINANCIAL REPORTING STANDARDS Lower of cost or market You just learned that in the United States inventory is valued at the lower of cost or market with market defined as replacement cost with a ceiling of net realizable value NRV and a floor of NRV less a normal profit margin However according to IAS No 2 inventory is valued at the lower of cost and net realizable value IAS No 2 also specifies that if circumstances indicate that an inventory write down is no longer appropriate it should be reversed Reversals are not permitted under U S GAAP Under U S GAAP the LCM rule can be applied to individual items logical inventory categories or the entire inventory Using the international standard the LCM assessment usually is applied to individual items although using logical inventory categories is allowed under certain circumstances Consider the following illustration Biddle and White LTD prepares its financial statements according to IFRS Using the data in Illustrations 9 3 and 9 3A the company would determine the inventory carrying value at year end assuming the LCM rule is applied to individual items as 377 000 Item A B C D E Cost 50 000 100 000 80 000 90 000 95 000 NRV 85 000 100 000 65 000 76 000 86 000 LCM 50 000 100 000 65 000 76 000 86 000 Totals 415 000 377 000 Notice that the carrying value of 377 000 is larger than the 347 000 determined using U S GAAP This normally will be the case because replacement cost usually is less than NRV The entry to record the write down is as follows Inventory write down expense 415 000 377 000 Inventory valuation allowance 38 000 38 000 Because IFRS allows companies to reverse write downs later if NRV increases it s convenient to use an inventory valuation account in the above entry rather than reducing inventory directly Reversals then are recorded by debiting the allowance account IFRS does not require the writedown to be recorded in any specific income statement account Siemens AG a German electronics and electrical engineering company prepares its financial statements according to IFRS The following disclosure note illustrates the valuation of inventory at the lower of cost and net realizable value Inventories in part Inventory is valued at the lower of acquisition or production cost and net realizable value cost being generally determined on the basis of an average or first in first out method APPLYING THE LOWER OF COST OR MARKET The LCM rule can be applied to individual items logical inventory categories or the entire inventory Item A B Total A B Cost 50 000 100 000 150 000 Designated Market Value 65 000 90 000 155 000 C D E Total C D E 80 000 90 000 95 000 265 000 65 000 56 000 86 000 207 000 Lower of cost or market By Individual By Product By Total Items Line Inventory 50 000 90 000 150 000 65 000 56 000 86 000 207 000 Total 415 000 362 000 347 000 357 000 362 000 THE GROSS PROFIT METHOD The gross profit method is useful in situations where estimates of inventory are desirable In determining the cost of inventory that has been lost stolen or destroyed In estimating inventory and cost of goods sold for interim reports avoiding the expense of a physical inventory count In auditors testing of the overall reasonableness of inventory amounts reported by clients In budgeting and forecasting Provides only an approximation of inventory and is not acceptable for the preparation of annual financial statements Estimates cost of goods sold by multiplying the period s net sales by a historical gross profit percentage and then subtracting that amount from net sales GROSS PROFIT METHOD ILLUSTRATION Southern