CHAPTER 9 Inventories: Additional Valuation Issues

LOWER-OF-COST-OR-MARKET

Inventories are recorded at their cost. However, if inventory declines in value below its original cost, a major departure from the historical cost principle occurs. Whatever the reason for a decline—obsolescence, price-level changes, or damaged goods—a company should write down the inventory to market to report this loss. A company abandons the historical cost principle when the future utility (revenue-producing ability) of the asset drops below its original cost. Companies therefore report inventories at the lower-of-cost-or-market at each reporting period.

Illustration 9-1 shows how Target and Best Buy reported this information.

Recall that cost is the acquisition price of inventory computed using one of the historical cost-based methods—specific identification, average-cost, FIFO, or LIFO. The term market in the phrase “the lower-of-cost-or-market” (LCM) generally means the cost to replace the item by purchase or reproduction. For a retailer like Nordstrom, the term “market” refers to the market in which it purchases goods, not the market in which it sells them. For a manufacturer like William Wrigley Jr., the term “market” refers to the cost to reproduce. Thus the rule really means that companies value goods at cost or cost to replace, whichever is lower.

For example, say Target purchased a Timex wristwatch for $30 for resale. Target can sell the wristwatch for $48.95 and replace it for $25. It should therefore value the wristwatch at $25 for inventory purposes under the lower-of-cost-or-market rule. Target can use the lower-of-cost-or-market rule of valuation after applying any of the cost flow methods discussed above to determine the inventory cost.

A departure from cost is justified because a company should charge a loss of utility against revenues in the period in which the loss occurs, not in the period of sale. Note also that the lower-of-cost-or-market method is a conservative approach to inventory valuation. That is, when doubt exists about the value of an asset, a company should use the lower value for the asset, which also reduces net income.

Ceiling and Floor

Why use replacement cost to represent market value? Because a decline in the replacement cost of an item usually reflects or predicts a decline in selling price. Using replacement cost allows a company to maintain a consistent rate of gross profit on sales (normal profit margin). Sometimes, however, a reduction in the replacement cost of an item fails to indicate a corresponding reduction in its utility. This requires using two additional valuation limitations to value ending inventory—net realizable value and net realizable value less a normal profit margin.

Net realizable value (NRV) is the estimated selling price in the ordinary course of business, less reasonably predictable costs of completion and disposal (often referred to as net selling price). A normal profit margin is subtracted from that amount to arrive at net realizable value less a normal profit margin.

To illustrate, assume that Jerry Mander 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. Jerry Mander determines the following net realizable value.

The 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 not more than net realizable value or less than net realizable value less a normal profit margin. [1]

The upper limit (ceiling) is the net realizable value of inventory. The lower limit (floor) is the net realizable value less a normal profit margin. What is the rationale for these two limitations? Establishing these limits for the value of the inventory prevents companies from over- or understating inventory.

The maximum limitation, not to exceed the net realizable value (ceiling), prevents overstatement of the value of obsolete, damaged, or shopworn inventories. That is, if the replacement cost of an item exceeds its net realizable value, a company should not report inventory at replacement cost. The company can receive only the selling price less cost of disposal. To report the inventory at replacement cost would result in an overstatement of inventory and understatement of the loss in the current period.

To illustrate, assume that Staples paid $1,000 for a color laser printer that it can now replace for $900. The printer's net realizable value is $700. At what amount should Staples report the laser printer in its financial statements? To report the replacement cost of $900 overstates the ending inventory and understates the loss for the period. Therefore, Staples should report the printer at $700.

The minimum limitation (floor) is not to be less than net realizable value reduced by an allowance for an approximately normal profit margin. The floor establishes a value below which a company should not price inventory, regardless of replacement cost. It makes no sense to price inventory below net realizable value less a normal margin. This minimum amount (floor) measures what the company can receive for the inventory and still earn a normal profit. Use of a floor deters understatement of inventory and overstatement of the loss in the current period.

Illustration 9-3 graphically presents the guidelines for valuing inventory at the lower-of-cost-or-market.

How Lower-of-Cost-or-Market Works

The designated market value is the amount that a company compares to cost. It is always the middle value of three amounts: replacement cost, net realizable value, and net realizable value less a normal profit margin. To illustrate how to compute designated market value, assume the information relative to the inventory of Regner Foods, Inc., as shown in Illustration 9-4.

Regner Foods then compares designated market value to cost to determine the lower-of-cost-or-market. It determines the final inventory value as shown in Illustration 9-5.

The application of the lower-of-cost-or-market rule incorporates only losses in value that occur in the normal course of business from such causes as style changes, shift in demand, or regular shop wear. A company reduces damaged or deteriorated goods to net realizable value. When material, it may carry such goods in separate inventory accounts.

Methods of Applying Lower-of-Cost-or-Market

In the Regner Foods illustration, we assumed that the company applied the lower-of-cost-or-market rule to each individual type of food. However, companies may apply the lower-of-cost-or-market rule either directly to each item, to each category, or to the total of the inventory. If a company follows a major category or total inventory approach in applying the lower-of-cost-or-market rule, increases in market prices tend to offset decreases in market prices. To illustrate, assume that Regner Foods separates its food products into two major categories, frozen and canned, as shown in Illustration 9-6.

If Regner Foods applied the lower-of-cost-or-market rule to individual items, the amount of inventory is $350,000. If applying the rule to major categories, it jumps to $370,000. If applying LCM to the total inventory, it totals $374,000. Why this difference? When a company uses a major categories or total inventory approach, market values higher than cost offset market values lower than cost. For Regner Foods, using the major categories approach partially offsets the high market value for spinach. Using the total inventory approach totally offsets the high market value for spinach.

Companies usually price inventory on an item-by-item basis. In fact, tax rules require that companies use an individual-item basis barring practical difficulties. In addition, the individual-item approach gives the most conservative valuation for balance sheet purposes.¹ Often, a company prices inventory on a total-inventory basis when it offers only one end product (comprised of many different raw materials). If it produces several end products, a company might use a category approach instead. The method selected should be the one that most clearly reflects income. Whichever method a company selects, it should apply the method consistently from one period to another.²

Recording “Market” Instead of Cost

One of two methods may be used to record the income effect of valuing inventory at market. One method, referred to as the cost-of-goods-sold method, debits cost of goods sold for the write-down of the inventory to market. As a result, the company does not report a loss in the income statement because the cost of goods sold already includes the amount of the loss. The second method, referred to as the loss method, debits a loss account for the write-down of the inventory to market. We use the following inventory data for Ricardo Company to illustrate entries under both methods.

Illustration 9-7 shows the entries for both the cost-of-goods-sold and loss methods, assuming the use of a perpetual inventory system.

The cost-of-goods-sold method buries the loss in the Cost of Goods Sold account. The loss method, by identifying the loss due to the write-down, shows the loss separate from Cost of Goods Sold in the income statement.

Illustration 9-8 contrasts the differing amounts reported in the income statement under the two approaches, using data from the Ricardo example.

GAAP does not specify a particular account to debit for the write-down. We believe the loss method presentation is preferable because it clearly discloses the loss resulting from a decline in inventory to market.

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 Market. For example, using an allowance account under the loss method, Ricardo Company makes the following entry to record the inventory write-down to market.

Use of the allowance account results in reporting both the cost and the market of the inventory. Ricardo reports inventory in the balance sheet as follows.

The use of the allowance under the cost-of-goods-sold or loss method permits the balance sheet to reflect inventory measured at $82,000, although the balance sheet shows a net amount of $70,000. It also keeps subsidiary inventory ledgers and records in correspondence with the control account without changing prices. For homework purposes, use an allowance account to record market adjustments, unless instructed otherwise.

With respect to accounting for the allowance in the subsequent period, if the company still has on hand the merchandise in question, it should retain the allowance account. If it does not keep that account, the company will overstate beginning inventory and cost of goods. However, if the company has sold the goods, then it should close the account. It then establishes a “new allowance account” for any decline in inventory value that takes place in the current year.³

Use of an Allowance—Multiple Periods

In general, accountants leave the allowance account on the books. They merely adjust the balance at the next year-end to agree with the discrepancy between cost and the lower-of-cost-or-market at that balance sheet date. Thus, if prices are falling, the company records an additional write-down. If prices are rising, the company records an increase in income, as shown in Illustration 9-10.

We can think of the net increase in income as the excess of the credit effect of closing the beginning allowance balance over the debit effect of setting up the current year-end allowance account. Recognizing the increases and decreases has the same effect on net income as closing the allowance balance to beginning inventory or to cost of goods sold.

Evaluation of the Lower-of-Cost-or-Market Rule

The lower-of-cost-or-market rule suffers some conceptual deficiencies:

1. A company recognizes decreases in the value of the asset and the charge to expense in the period in which the loss in utility occurs—not in the period of sale. On the other hand, it recognizes increases in the value of the asset only at the point of sale. This inconsistent treatment can distort income data.
2. Application of the rule results in inconsistency because a company may value the inventory at cost in one year and at market in the next year.
3. Lower-of-cost-or-market values the inventory in the balance sheet conservatively, but its effect on the income statement may or may not be conservative. Net income for the year in which a company takes the loss is definitely lower. Net income of the subsequent period may be higher than normal if the expected reductions in sales price do not materialize.
4. Application of the lower-of-cost-or-market rule uses a “normal profit” in determining inventory values. Since companies estimate “normal profit” based on past experience (which they may not attain in the future), this subjective measure presents an opportunity for income manipulation.

Many financial statement users appreciate the lower-of-cost-or-market rule because they at least know that it prevents overstatement of inventory. In addition, recognizing all losses but anticipating no gains generally avoids overstating income.

VALUATION BASES

Valuation at Net Realizable Value

For the most part, companies record inventory at cost or at the lower-of-cost-or-market.⁴ However, many believe that for purposes of applying the lower-of-cost-or-market rule, companies should define “market” as net realizable value (selling price less estimated costs to complete and sell) rather than as replacement cost. This argument is based on the fact that the amount that companies will collect from this inventory in the future is the net realizable value.⁵

Under limited circumstances, support exists for recording inventory at net realizable value, even if that amount is above cost. GAAP permits this exception to the normal recognition rule under the following conditions: (1) when there is a controlled market with a quoted price applicable to all quantities, and (2) when no significant costs of disposal are involved. For example, mining companies ordinarily report inventories of certain minerals (rare metals, especially) at selling prices because there is often a controlled market without significant costs of disposal. Similar treatment is given agricultural products that are immediately marketable at quoted prices.

A third reason for allowing valuation at net realizable value is that sometimes it is too difficult to obtain the cost figures. Cost figures are not difficult to determine in, say, a manufacturing plant, where the company combines various raw materials and purchased parts to create a finished product. The manufacturer can use the cost basis to account for various items in inventory because it knows the cost of each individual component part. The situation is different in a meat-packing plant, however. The “raw material” consists of, say, cattle, each unit of which the company purchases as a whole and then divides into parts that are the products. Instead of one product out of many raw materials or parts, the meat-packing company makes many products from one “unit” of raw material. To allocate the cost of the animal “on the hoof” into the cost of, say, ribs, chuck, and shoulders, is a practical impossibility. It is much easier and more useful for the company to determine the market price of the various products and value them in the inventory at selling price less the various costs necessary to get them to market (costs such as shipping and handling). Hence, because of a peculiarity of the industry, meat-packing companies sometimes carry inventories at sales price less distribution costs.

Valuation Using Relative Sales Value

A special problem arises when a company buys a group of varying units in a single lump-sum purchase, also called a basket purchase. To illustrate, assume that 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.

You might wonder why Woodland would not simply divide the total cost of $1 million by 400 lots, to get a cost of $2,500 for each lot. This approach would not recognize that the lots vary in size, shape, and attractiveness. Therefore, to accurately value each unit, the common and most logical practice is to allocate the total among the various units on the basis of their relative sales value.

Illustration 9-11 shows the allocation of relative sales value for the Woodland Developers example.

Woodland determines the cost of lots sold and the gross profit, using the amounts given in the “Cost per Lot” column, as follows.

The ending inventory is therefore $320,000 ($1,000,000 − $680,000).

Woodland also can compute this inventory amount another way. The ratio of cost to selling price for all the lots is $1 million divided by $2,500,000, or 40 percent. Accordingly, if the total sales price of lots sold is, say $1,700,000, then the cost of the lots sold is 40 percent of $1,700,000, or $680,000. The inventory of lots on hand is then $1 million less $680,000, or $320,000.

The petroleum industry widely uses the relative sales value method to value (at cost) the many products and by-products obtained from a barrel of crude oil.

Purchase Commitments—A Special Problem

In many lines of business, a company's survival and continued profitability depends on its having a sufficient stock of merchandise to meet customer demand. Consequently, it is quite common for a company to make purchase commitments, which are agreements to buy inventory weeks, months, or even years in advance. Generally, the seller retains title to the merchandise or materials covered in the purchase commitments. Indeed, the goods may exist only as natural resources as unplanted seed (in the case of agricultural commodities), or as work in process (in the case of a product).⁶

Usually, it is not necessary for the buyer to make any entries to reflect commitments for purchases of goods that the seller has not shipped. Ordinary orders, for which the buyer and seller will determine prices at the time of shipment and which are subject to cancellation, do not represent either an asset or a liability to the buyer. Therefore, the buyer need not record such purchase commitments or report them in the financial statements.

What happens, though, if a buyer enters into a formal, noncancelable 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 part of the contract. However, if material, the buyer should disclose such contract details in a note to its financial statements. Illustration 9-13 shows an example of a purchase commitment disclosure.

In the disclosure in Illustration 9-13, the contract price was less than the market price at the balance sheet date. 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. [4]⁷

As an example, at one time many Northwest forest-product companies such as Boise Cascade, Georgia-Pacific, and Weyerhaeuser signed long-term timber-cutting contracts with the U.S. Forest Service. These contracts required that the companies pay $310 per thousand board feet for timber-cutting rights. Unfortunately, the market price for timber-cutting rights in the latter part of the year dropped to $80 per thousand board feet. As a result, a number of these companies had long-term contracts that, if fulfilled, would result in substantial future losses.

To illustrate the accounting problem, assume that St. Regis Paper Co. signed timber-cutting contracts to be executed in 2015 at a price of $10,000,000. Assume further that the market price of the timber cutting rights on December 31, 2014, dropped to $7,000,000. St. Regis would make the following entry on December 31, 2014.

St. Regis would report this unrealized holding loss in the income statement under “Other expenses and losses.” And because the contract is to be executed within the next fiscal year, St. Regis would report the Estimated Liability on Purchase Commitments in the current liabilities section on the balance sheet. When St. Regis cuts the timber at a cost of $10 million, it would make the following entry.

The result of the purchase commitment was that St. Regis paid $10 million for a contract worth only $7 million. It recorded the loss in the previous period—when the price actually declined.

If St. Regis can partially or fully recover the contract price before it cuts the timber, it reduces the Estimated Liability on Purchase Commitments. In that case, it then reports in the period of the price increase a resulting gain for the amount of the partial or full recovery. For example, Congress permitted some of the forest-products companies to buy out of their contracts at reduced prices in order to avoid potential bankruptcies. To illustrate, assume that Congress permitted St. Regis to reduce its contract price and therefore its commitment by $1,000,000. The entry to record this transaction is as follows.

If the market price at the time St. Regis cuts the timber is more than $2,000,000 below the contract price, St. Regis will have to recognize an additional loss in the period of cutting and record the purchase at the lower-of-cost-or-market.

Are purchasers at the mercy of market price declines? Not totally. Purchasers 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 a contract in which it agrees to sell in the future the same quantity of the same (or similar) goods at a fixed price. Thus the company holds a buy position in a purchase commitment and a sell position in a futures contract in the same commodity. The purpose of the hedge is to offset the price risk of the buy and sell positions. The company will be better off under one contract by approximately (maybe exactly) the same amount by which it is worse off under the other contract.

For example, St. Regis Paper Co. could have hedged its purchase commitment contract with a futures contract for timber rights of the same amount. In that case, its loss of $3,000,000 on the purchase commitment could have been offset by a $3,000,000 gain on the futures contract.⁸

As easy as this makes it sound, accounting for purchase commitments is still unsettled and controversial. Some argue that companies should report purchase commitments as assets and liabilities at the time they sign the contract. Others believe that the present recognition at the delivery date is more appropriate. FASB Concepts Statement No. 6 states, “a purchase commitment involves both an item that might be recorded as an asset and an item that might be recorded as a liability. That is, it involves both a right to receive assets and an obligation to pay…. If both the right to receive assets and the obligation to pay were recorded at the time of the purchase commitment, the nature of the loss and the valuation account that records it when the price falls would be clearly seen.” Although the discussion in Concepts Statement No. 6 does not exclude the possibility of recording assets and liabilities for purchase commitments, it contains no conclusions or implications about whether companies should record them.⁹

THE GROSS PROFIT METHOD OF ESTIMATING INVENTORY

Companies take a physical inventory to verify the accuracy of the perpetual inventory records or, if no records exist, to arrive at an inventory amount. Sometimes, however, taking a physical inventory is impractical. In such cases, companies use substitute measures to approximate inventory on hand.

One substitute method of verifying or determining the inventory amount is the gross profit method (also called the gross margin method). Auditors widely use this method in situations where they need only an estimate of the company's inventory (e.g., interim reports). Companies also use this method when fire or other catastrophe destroys either inventory or inventory records. The gross profit method relies on three assumptions:

1. The 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.

To illustrate, assume that 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 profit method as follows.

The current period's records contain all the information Cetus needs to compute inventory at cost, except for the gross profit percentage. Cetus determines the gross profit percentage by reviewing company policies or prior period records. In some cases, companies must adjust this percentage if they consider prior periods unrepresentative of the current period.¹⁰

Computation of Gross Profit Percentage

In most situations, the gross profit percentage is stated as a percentage of selling price. The previous illustration, for example, used a 30 percent gross profit on sales. Gross profit on selling price is the common method for quoting the profit for several reasons. (1) Most companies state goods on a retail basis, not a cost basis. (2) A profit quoted on selling price is lower than one based on cost. This lower rate gives a favorable impression to the consumer. (3) The gross profit based on selling price can never exceed 100 percent.¹¹

In Illustration 9-14, 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. As shown in the computations in Illustration 9-15, this markup is ¼ or 25 percent of retail, and ⅓ or, 33⅓ percent of cost.

Although companies normally compute the gross profit on the basis of selling price, you should understand the basic relationship between markup on cost and markup on selling price. For example, assume that a company marks up a given item by 25 percent. What, then, is the gross profit on selling price? To find the answer, assume that the item sells for $1. In this case, the following formula applies.

The gross profit equals $0.20 ($1.00 − $0.80). The rate of gross profit on selling price is therefore 20 percent ($0.20/$1.00).

Conversely, assume that the gross profit on selling price is 20 percent. What is the markup on cost? To find the answer, again assume that the item sells for $1. Again, the same formula holds:

As in the previous example, the markup equals $0.20 ($1.00 − $0.80). The markup on cost is 25 percent ($0.20/$0.80).

Retailers use the following formulas to express these relationships:

To understand how to use these formulas, consider their application in the following calculations.

Because selling price exceeds cost and with the gross profit amount the same for both, gross profit on selling price will always be less than the related percentage based on cost. Note that companies do not multiply sales by a cost-based markup percentage. Instead, they must convert the gross profit percentage to a percentage based on selling price.

Evaluation of Gross Profit Method

What are the major disadvantages of the gross profit method? One disadvantage is that it provides an estimate. As a result, companies must take a physical inventory once a year to verify the inventory. Second, the gross profit method uses past percentages in determining the markup. Although the past often provides answers to the future, a current rate is more appropriate. Note that whenever significant fluctuations occur, companies should adjust the percentage as appropriate. Third, companies must be careful in applying a blanket gross profit rate. Frequently, a store or department handles merchandise with widely varying rates of gross profit. In these situations, the company may need to apply the gross profit method by subsections, lines of merchandise, or a similar basis that classifies merchandise according to their respective rates of gross profit. The gross profit method is normally unacceptable for financial reporting purposes because it provides only an estimate. GAAP requires a physical inventory as additional verification of the inventory indicated in the records. Nevertheless, GAAP permits the gross profit method to determine ending inventory for interim (generally quarterly) reporting purposes, provided a company discloses the use of this method. Note that the gross profit method will follow closely the inventory method used (FIFO, LIFO, average-cost) because it relies on historical records.

RETAIL INVENTORY METHOD

Accounting for inventory in a retail operation presents several challenges. Retailers with certain types of inventory may use the specific identification method to value their inventories. Such an approach makes sense when a retailer holds significant individual inventory units, such as automobiles, pianos, or fur coats. However, imagine attempting to use such an approach at Target, Home Depot, Sears Holdings, or Bloomingdale's—high-volume retailers that have many different types of merchandise. It would be extremely difficult to determine the cost of each sale, to enter cost codes on the tickets, to change the codes to reflect declines in value of the merchandise, to allocate costs such as transportation, and so on.

An alternative is to compile the inventories at retail prices. For most retailers, an observable pattern between cost and price exists. The retailer can then use a formula to convert retail prices to cost. This method is called the retail inventory method. It requires that the retailer keep a record of (1) the total cost and retail value of goods purchased, (2) the total cost and retail value of the goods available for sale, and (3) the sales for the period. Use of the retail inventory method is very common. For example, Safeway supermarkets, Target, Wal-Mart, and Best Buy use the retail inventory method.

Here is how it works at a company like Best Buy. Beginning with the retail value of the goods available for sale, Best Buy deducts the sales revenue for the period. This calculation determines an estimated inventory (goods on hand) at retail. It next computes the cost-to-retail ratio for all goods. The formula for this computation is to divide the total goods available for sale at cost by the total goods available at retail price. Finally, to obtain ending inventory at cost, Best Buy applies the cost-to-retail ratio to the ending inventory valued at retail. Illustration 9-18 shows the retail inventory method calculations for Best Buy (assumed data).

There are different versions of the retail inventory method. These include the conventional method (based on lower-of-average-cost-or-market), the cost method, the LIFO retail method, and the dollar-value LIFO retail method. Regardless of which version a company uses, the IRS, various retail associations, and the accounting profession all sanction use of the retail inventory method. One of its advantages is that a company like Best Buy can approximate the inventory balance without a physical count. However, to avoid a potential overstatement of the inventory, Target makes periodic inventory counts. Such counts are especially important in retail operations where loss due to shoplifting or breakage is common.

The retail inventory method is particularly useful for any type of interim report because such reports usually need a fairly quick and reliable measure of the inventory. Also, similar to use of the gross profit method, insurance adjusters often use this method to estimate losses from fire, flood, or other type of casualty. This method also acts as a control device because a company will have to explain any deviations from a physical count at the end of the year. Finally, the retail method expedites the physical inventory count at the end of the year. The crew taking the physical inventory need record only the retail price of each item. The crew does not need to look up each item's invoice cost, thereby saving time and expense.

Retail-Method Concepts

The amounts shown in the “Retail” column of Illustration 9-18 above represent the original retail prices, assuming no price changes. In practice, though, retailers frequently mark up or mark down the prices they charge buyers.

For retailers, the term markup means an additional markup of the original retail price. (In another context, such as the gross profit discussion on pages 485–488, we often think of markup on the basis of cost.) Markup cancellations are decreases in prices of merchandise that the retailer had marked up above the original retail price.

In a competitive market, retailers often need to use markdowns, which are decreases in the original sales prices. Such cuts in sales prices may be necessary because of a decrease in the general level of prices, special sales, soiled or damaged goods, overstocking, and market competition. Markdowns are common in retailing these days. Markdown cancellations occur when the markdowns are later offset by increases in the prices of goods that the retailer had marked down—such as after a one-day sale, for example. Neither a markup cancellation nor a markdown cancellation can exceed the original markup or markdown.

To illustrate these concepts, assume that Designer Clothing Store recently purchased 100 dress shirts from Marroway, Inc. The cost for these shirts was $1,500, or $15 a shirt. Designer Clothing established the selling price on these shirts at $30 a shirt. The shirts were selling quickly in anticipation of Father's Day, so the manager added a markup of $5 per shirt. This markup made the price too high for customers, and sales slowed. The manager then reduced the price to $32. At this point we would say that the shirts at Designer Clothing have had a markup of $5 and a markup cancellation of $3.

Right after Father's Day, the manager marked down the remaining shirts to a sale price of $23. At this point, an additional markup cancellation of $2 has taken place, and a $7 markdown has occurred. If the manager later increases the price of the shirts to $24, a markdown cancellation of $1 would occur.

Retail Inventory Method with Markups and Markdowns—Conventional Method

Retailers use markup and markdown concepts in developing the proper inventory valuation at the end of the accounting period. To obtain the appropriate inventory figures, companies must give proper treatment to markups, markup cancellations, markdowns, and markdown cancellations.

To illustrate the different possibilities, consider the data for In-Fusion Inc., shown in Illustration 9-19. In-Fusion can calculate its ending inventory at cost under two assumptions, A and B. (We'll explain the reasons for the two later.)

The computations for In-Fusion are:

The question becomes: Which assumption and which percentage should In-Fusion use to compute the ending inventory valuation? The answer depends on which retail inventory method In-Fusion chooses.

One approach uses only assumption A (a cost ratio using markups but not markdowns). It approximates the lower-of-average-cost-or-market. We will refer to this approach as the conventional retail inventory method or the lower-of-cost-or-market approach.

To understand why this method considers only the markups, not the markdowns, in the cost percentage, you must understand how a retail business operates. A markup normally indicates an increase in the market value of the item. On the other hand, a markdown means a decline in the utility of that item. Therefore, to approximate the lower-of-cost-or-market, we would consider markdowns a current loss and so would not include them in calculating the cost-to-retail ratio. Omitting the markdowns would make the cost-to-retail ratio lower, which leads to an approximate lower-of-cost-or-market.

An example will make the distinction between the two methods clear. In-Fusion purchased two items for $5 apiece; the original sales price was $10 each. One item was subsequently written down to $2. Assuming no sales for the period, if markdowns are considered in the cost-to-retail ratio (assumption B—the cost method), we compute the ending inventory in the following way.

This approach (the cost method) reflects an average cost of the two items of the commodity without considering the loss on the one item. It values ending inventory at $10.

If markdowns are not considered in the cost-to-retail ratio (assumption A—the conventional retail method), we compute the ending inventory as follows.

Under this approach (the conventional retail method, in which markdowns are not considered), ending inventory would be $6. The inventory valuation of $6 reflects two inventory items, one inventoried at $5 and the other at $1. It reflects the fact that In-Fusion reduced the sales price from $10 to $2, and reduced the cost from $5 to $1.¹²

To approximate the lower-of-cost-or-market, In-Fusion must establish the cost-to-retail ratio. It does this by dividing the cost of goods available for sale by the sum of the original retail price of these goods plus the net markups. This calculation excludes markdowns and markdown cancellations. Illustration 9-22 shows the basic format for the retail inventory method using the lower-of-cost-or-market approach along with the In-Fusion Inc. information.

Because an averaging effect occurs, an exact lower-of-cost-or-market inventory valuation is ordinarily not obtained, but an adequate approximation can be achieved. In contrast, adding net markups and deducting net markdowns yields approximate cost.

Special Items Relating to Retail Method

The retail inventory method becomes more complicated when we consider such items as freight-in, purchase returns and allowances, and purchase discounts. In the retail method, we treat such items as follows.

• Freight costs are part of the purchase cost.
• Purchase returns are ordinarily considered as a reduction of the price at both cost and retail.
• Purchase discounts and allowances usually are considered as a reduction of the cost of purchases.

In short, the treatment for the items affecting the cost column of the retail inventory approach follows the computation for cost of goods available for sale.¹³

Note also that sales returns and allowances are considered as proper adjustments to gross sales. However, when sales are recorded gross, companies do not recognize sales discounts. To adjust for the sales discount account in such a situation would provide an ending inventory figure at retail that would be overvalued.

In addition, a number of special items require careful analysis:

• Transfers-in from another department are reported in the same way as purchases from an outside company.
• Normal shortages (breakage, damage, theft, shrinkage) should reduce the retail column because these goods are no longer available for sale. Such costs are reflected in the selling price because a certain amount of shortage is considered normal in a retail enterprise. As a result, companies do not consider this amount in computing the cost-to-retail percentage. Rather, to arrive at ending inventory at retail, they show normal shortages as a deduction similar to sales.
• Abnormal shortages, on the other hand, are deducted from both the cost and retail columns and reported as a special inventory amount or as a loss. To do otherwise distorts the cost-to-retail ratio and overstates ending inventory.
• Employee discounts (given to employees to encourage loyalty, better performance, and so on) are deducted from the retail column in the same way as sales. These discounts should not be considered in the cost-to-retail percentage because they do not reflect an overall change in the selling price.¹⁴

Illustration 9-23 (page 494) shows some of these concepts. The company, Extreme Sport Apparel, determines its inventory using the conventional retail inventory method.

Evaluation of Retail Inventory Method

Companies like Gap Inc., Home Depot, or your local department store use the retail inventory method of computing inventory for the following reasons: (1) to permit the computation of net income without a physical count of inventory, (2) as a control measure in determining inventory shortages, (3) in regulating quantities of merchandise on hand, and (4) for insurance information.

One characteristic of the retail inventory method is that it has an averaging effect on varying rates of gross profit. This can be problematic when companies apply the method to an entire business, where rates of gross profit vary among departments. There is no allowance for possible distortion of results because of such differences. Companies refine the retail method under such conditions by computing inventory separately by departments or by classes of merchandise with similar gross profits. In addition, the reliability of this method assumes that the distribution of items in inventory is similar to the “mix” in the total goods available for sale.

PRESENTATION AND ANALYSIS

Presentation of Inventories

Accounting standards require financial statement disclosure of the composition of the inventory, inventory financing arrangements, and the inventory costing methods employed. The standards also require the consistent application of costing methods from one period to another.

Manufacturers should report the inventory composition either in the balance sheet or in a separate schedule in the notes. The relative mix of raw materials, work in process, and finished goods helps in assessing liquidity and in computing the stage of inventory completion.

Significant or unusual financing arrangements relating to inventories may require note disclosure. Examples include transactions with related parties, product financing arrangements, firm purchase commitments, involuntary liquidation of LIFO inventories, and pledging of inventories as collateral. Companies should present inventories pledged as collateral for a loan in the current assets section rather than as an offset to the liability.

A company should also report the basis on which it states inventory amounts (lower-of-cost-or-market) and the method used in determining cost (LIFO, FIFO, average-cost, etc.). For example, the annual report of Mumford of Wyoming contains the following disclosures.

Illustration 9-24 shows that a company can use different pricing methods for different elements of its inventory. If Mumford changes the method of pricing any of its inventory elements, it must report a change in accounting principle. For example, if Mumford changes its method of accounting for live sheep from FIFO to average-cost, it should separately report this change, along with the effect on income, in the current and prior periods. Changes in accounting principle require an explanatory paragraph in the auditor's report describing the change in method.

Fortune Brands, Inc. reported its inventories in its annual report as follows (note the “trade practice” followed in classifying inventories among the current assets).

Analysis of Inventories

As our opening story illustrates, the amount of inventory that a company carries can have significant economic consequences. As a result, companies must manage inventories. But, inventory management is a double-edged sword. It requires constant attention. On the one hand, management wants to stock a great variety and quantity of items. Doing so will provide customers with the greatest selection. However, such an inventory policy may incur excessive carrying costs (e.g., investment, storage, insurance, taxes, obsolescence, and damage). On the other hand, low inventory levels lead to stockouts, lost sales, and disgruntled customers.

Using financial ratios helps companies to chart a middle course between these two dangers. Common ratios used in the management and evaluation of inventory levels are inventory turnover and a related measure, average days to sell inventory.

Inventory Turnover

The inventory turnover measures the number of times on average a company sells the inventory during the period. It measures the liquidity of the inventory. To compute inventory turnover, divide the cost of goods sold by the average inventory on hand during the period.

Barring seasonal factors, analysts compute average inventory from beginning and ending inventory balances. For example, in its 2011 annual report Kellogg Company reported a beginning inventory of $1,056 million, an ending inventory of $1,132 million, and cost of goods sold of $7,750 million for the year. Illustration 9-26 shows the inventory turnover formula and Kellogg Company's 2011 ratio computation below.

Average Days to Sell Inventory

A variant of the inventory turnover is the average days to sell inventory. This measure represents the average number of days’ sales for which a company has inventory on hand. For example, the inventory turnover for Kellogg Company of 7.08 times divided into 365 is approximately 51.6 days.

There are typical levels of inventory in every industry. However, companies that keep their inventory at lower levels with higher turnovers than those of their competitors, and that still can satisfy customer needs, are the most successful.

SUMMARY OF LEARNING OBJECTIVES

Describe and apply the lower-of-cost-or-market rule. If inventory declines in value below its original cost, for whatever reason, a company should write down the inventory to reflect this loss. The general rule is to abandon the historical cost principle when the future utility (revenue-producing ability) of the asset drops below its original cost.

Explain when companies value inventories at net realizable value. Companies value inventory at net realizable value when (1) there is a controlled market with a quoted price applicable to all quantities, (2) no significant costs of disposal are involved, and (3) the cost figures are too difficult to obtain.

Explain when companies use the relative sales value method to value inventories. When a company purchases a group of varying units at a single lump-sum price—a so-called basket purchase—the company may allocate the total purchase price to the individual items on the basis of relative sales value.

Discuss accounting issues related to purchase commitments. Accounting for purchase commitments is controversial. Some argue that companies should report purchase commitment contracts as assets and liabilities at the time the contract is signed. Others believe that recognition at the delivery date is most appropriate. The FASB neither excludes nor recommends the recording of assets and liabilities for purchase commitments. However, companies record losses when market prices fall relative to the commitment price.

Determine ending inventory by applying the gross profit method. Companies follow these steps to determine ending inventory by the gross profit method. (1) Compute the gross profit percentage on selling price. (2) Compute gross profit by multiplying net sales by the gross profit percentage. (3) Compute cost of goods sold by subtracting gross profit from net sales. (4) Compute ending inventory by subtracting cost of goods sold from total goods available for sale.

Determine ending inventory by applying the retail inventory method. Companies follow these steps to determine ending inventory by the conventional retail method. (1) To estimate inventory at retail, deduct the sales for the period from the retail value of the goods available for sale. (2) To find the cost-to-retail ratio for all goods passing through a department or firm, divide the total goods available for sale at cost by the total goods available at retail. (3) Convert the inventory valued at retail to approximate cost by applying the cost-to-retail ratio.

Explain how to report and analyze inventory. Accounting standards require financial statement disclosure of (1) the composition of the inventory (in the balance sheet or a separate schedule in the notes), (2) significant or unusual inventory financing arrangements, and (3) inventory costing methods employed (which may differ for different elements of inventory). Accounting standards also require the consistent application of costing methods from one period to another. Common ratios used in the management and evaluation of inventory levels are inventory turnover and average days to sell inventory.

APPENDIX   9A LIFO RETAIL METHODS

A number of retail establishments have changed from the more conventional treatment to a LIFO retail method. For example, the world's largest retailer, Wal-Mart Stores, Inc., uses the LIFO retail method. The primary reason to do so is for the tax advantages associated with valuing inventories on a LIFO basis. In addition, adoption of LIFO results in a better matching of costs and revenues.

The use of LIFO retail is made under two assumptions: (1) stable prices and (2) fluctuating prices.

STABLE PRICES—LIFO RETAIL METHOD

It is much more complex to compute the final inventory balance using a LIFO flow than using the conventional retail method. Under the LIFO retail method, companies like Wal-Mart or Target consider both markups and markdowns in obtaining the proper cost-to-retail percentage. Furthermore, since the LIFO method is concerned only with the additional layer, or the amount that should be subtracted from the previous layer, the beginning inventory is excluded from the cost-to-retail percentage.

A major assumption of the LIFO retail method is that the markups and markdowns apply only to the goods purchased during the current period and not to the beginning inventory. This assumption is debatable and may explain why some companies do not adopt this method.

Illustration 9A-1 presents the major concepts involved in the LIFO retail method applied to the Hernandez Company. Note that, to simplify the accounting, we have assumed that the price level has remained unchanged.

Illustration 9A-2 indicates that the inventory is composed of two layers: the beginning inventory and the additional increase that occurred in the inventory this period (2014). When we start the next period (2015), the beginning inventory will be composed of those two layers. If an increase in inventory occurs again, an additional layer will be added.

However, if the final inventory figure is below the beginning inventory, Hernandez must reduce the beginning inventory starting with the most recent layer. For example, assume that the ending inventory for 2015 at retail is $50,000. Illustration 9A-3 shows the computation of the ending inventory at cost. Notice that the 2014 layer is reduced from $11,000 to $5,000.

FLUCTUATING PRICES—DOLLAR-VALUE LIFO RETAIL METHOD

The previous example simplified the LIFO retail method by ignoring changes in the selling price of the inventory. Let us now assume that a change in the price level of the inventories occurs (as is usual). If the price level does change, the company must eliminate the price change so as to measure the real increase in inventory, not the dollar increase. This approach is referred to as the dollar-value LIFO retail method.

To illustrate, assume that the beginning inventory had a retail market value of $10,000 and the ending inventory had a retail market value of $15,000. Assume further that the price level has risen from 100 to 125. It is inappropriate to suggest that a real increase in inventory of $5,000 has occurred. Instead, the company must deflate the ending inventory at retail, as the computation in Illustration 9A-4 shows.

This approach is essentially the dollar-value LIFO method discussed in Chapter 8. In computing the LIFO inventory under a dollar-value LIFO approach, the company finds the dollar increase in inventory and deflates it to beginning-of-the-year prices. This indicates whether actual increases or decreases in quantity have occurred. If an increase in quantities occurs, the company prices this increase at the new index, in order to compute the value of the new layer. If a decrease in quantities happens, the company subtracts the increase from the most recent layers to the extent necessary.

The following computations, based on those in Illustration 9A-1 for Hernandez Company, illustrate the differences between the dollar-value LIFO retail method and the regular LIFO retail approach. Assume that the current 2014 price index is 112 (prior year = 100) and that the inventory ($56,000) has remained unchanged. In comparing Illustrations 9A-1 and 9A-5 (see below), note that the computations involved in finding the cost-to-retail percentage are exactly the same. However, the dollar-value method determines the increase that has occurred in the inventory in terms of base-year prices.

From this information, we compute the inventory amount at cost:

As Illustration 9A-6 shows, before the conversion to cost takes place, Hernandez must restate layers of a particular year to the prices in effect in the year when the layer was added.

Note the difference between the LIFO approach (stable prices) and the dollar-value LIFO method as indicated below.

The difference of $3,780 ($34,700 − $30,920) results from an increase in the price of goods, not from an increase in the quantity of goods.

SUBSEQUENT ADJUSTMENTS UNDER DOLLAR-VALUE LIFO RETAIL

The dollar-value LIFO retail method follows the same procedures in subsequent periods as the traditional dollar-value method discussed in Chapter 8. That is, when a real increase in inventory occurs, Hernandez adds a new layer.

To illustrate, using the data from the previous example, assume that the retail value of the 2015 ending inventory at current prices is $64,800, the 2015 price index is 120 percent of base-year, and the cost-to-retail percentage is 75 percent. In base-year dollars, the ending inventory is therefore $54,000 ($64,800/120%). Illustration 9A-8 shows the computation of the ending inventory at LIFO cost.

Conversely, when a real decrease in inventory develops, Hernandez “peels off” previous layers at prices in existence when the layers were added. To illustrate, assume that in 2015 the ending inventory in base-year prices is $48,000. The computation of the LIFO inventory is as follows.

The advantages and disadvantages of the lower-of-cost-or-market method (conventional retail) versus LIFO retail are the same for retail operations as for non-retail operations. As a practical matter, a company's selection of which retail inventory method to use often involves determining which method provides a lower taxable income. It might appear that retail LIFO will provide the lower taxable income in a period of rising prices. But this is not always the case. LIFO will provide an approximate current cost matching, but it states ending inventory at cost. The conventional retail method may have a large write-off because of the use of the lower-of-cost-or-market approach, which may offset the LIFO current cost matching.

CHANGING FROM CONVENTIONAL RETAIL TO LIFO

Because conventional retail is a lower-of-cost-or-market approach, the company must restate beginning inventory to a cost basis when changing from the conventional retail to the LIFO method.¹⁵ The usual approach is to compute the cost basis from the purchases of the prior year, adjusted for both markups and markdowns.¹⁶

To illustrate, assume that Hakeman Clothing Store employs the conventional retail method but wishes to change to the LIFO retail method beginning in 2015. The amounts shown on the company's books are as follows.

Illustration 9A-10 (page 502) shows computation of ending inventory under the conventional retail method for 2014.

Hakeman Clothing can then quickly approximate the ending inventory for 2014 under the LIFO retail method, as shown in Illustration 9A-11.

The difference of $500 ($11,250 − $10,750) between the LIFO retail method and the conventional retail method in the ending inventory for 2014 is the amount by which the company must adjust beginning inventory for 2015. The entry to adjust the inventory to a cost basis is as follows.

SUMMARY OF LEARNING OBJECTIVE FOR APPENDIX 9A

Determine ending inventory by applying the LIFO retail methods. The application of LIFO retail is made under two assumptions: stable prices and fluctuating prices.

Procedures under stable prices: (a) Because the LIFO method is a cost method, both markups and markdowns must be considered in obtaining the proper cost-to-retail percentage. (b) Since the LIFO method is concerned only with the additional layer, or the amount that should be subtracted from the previous layer, the beginning inventory is excluded from the cost-to-retail percentage. (c) The markups and markdowns apply only to the goods purchased during the current period and not to the beginning inventory.

Procedures under fluctuating prices: The steps are the same as for stable prices except that in computing the LIFO inventory under a dollar-value LIFO approach, the dollar increase in inventory is found and deflated to beginning-of-the-year prices. Doing so will determine whether actual increases or decreases in quantity have occurred. If quantities increase, this increase is priced at the new index to compute the new layer. If quantities decrease, the decrease is subtracted from the most recent layers to the extent necessary.

Be sure to check the book's companion website for a Review and Analysis Exercise, with solution.

Brief Exercises, Exercises, Problems, and many more learning and assessment tools and resources are available for practice in WileyPLUS.