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Intermediate Accounting

9-1

Prepared by Coby Harmon University of California, Santa Barbara

Inventories: Additional Valuation Issues

Intermediate Accounting 14th Edition

Kieso, Weygandt, and Warfield


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Learning Objectives
1. 2. Describe and apply the lower-of-cost-or-net realizable value rule. Explain when companies value inventories at net realizable value.

3.

Explain when companies use the relative sales value method to value inventories.
Discuss accounting issues related to purchase commitments.

4.

5.
6.

Determine ending inventory by applying the gross profit method.


Determine ending inventory by applying the retail inventory method. Explain how to report and analyze inventory.

7.

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Inventories: Additional Valuation Issues

Lower-of-Costor-Market
Ceiling and floor How LCM works Application of LCM Market Use of an allowance Multiple periods Evaluation of rule
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Valuation Bases
Net realizable value Relative sales value Purchase commitments

Gross Profit Method


Gross profit percentage Evaluation of method

Retail Inventory Method


Concepts Conventional method Special items Evaluation of method

Presentation and Analysis


Presentation Analysis

Lower-of-Cost-or-Market
A company abandons the historical cost principle when

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

Market = Replacement Cost Lower of Cost or Replacement Cost Loss should be recorded when loss occurs, not in the period of sale.

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LO 1 Describe and apply the lower-of-cost-or-market rule.

Lower-of-Cost-or-Market
Illustration 9-1

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LO 1

Lower-of-Cost-or-Market
Ceiling and Floor
Why use Replacement Cost (RC) for Market?

Decline in the RC usually = decline in selling price. RC allows a consistent rate of gross profit. If reduction in RC fails to indicate reduction in utility, then two additional valuation limitations are used:

Ceiling - net realizable value and Floor - net realizable value less a normal profit margin.

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LO 1 Describe and apply the lower-of-cost-or-market rule.

Lower-of-Cost-or-Market
Net realizable value (NRV) is the 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).
Illustration 9-2

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LO 1 Describe and apply the lower-of-cost-or-market rule.

Lower-of-Cost-or-Market
Illustration 9-3

What is the rationale for the Ceiling and Floor limitations?

Ceiling = NRV
Not >

Cost

Market

Replacement Cost
Not <

GAAP LCM
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Floor = NRV less Normal Profit Margin


LO 1 Describe and apply the lower-of-cost-or-market rule.

Lower-of-Cost-or-Market
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.

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LO 1 Describe and apply the lower-of-cost-or-market rule.

Lower-of-Cost-or-Market
How LCM Works (Individual Items)
Illustration 9-5

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LO 1 Describe and apply the lower-of-cost-or-market rule.

Lower-of-Cost-or-Market
Methods of Applying LCM
Illustration 9-6

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LO 1 Describe and apply the lower-of-cost-or-market rule.

Lower-of-Cost-or-Market
Recording Market Instead of Cost
Ending inventory (cost)
Ending inventory (market) Adjustment to LCM Loss Method

$ 82,000
70,000 $ 12,000

Loss due to decline in inventory


Allowance to reduce inventory

12,000
12,000

COGS Method
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Cost of goods sold


Inventory

12,000
12,000

LO 1 Describe and apply the lower-of-cost-or-market rule.

Lower-of-Cost-or-Market
Balance Sheet Presentation
Loss Method Current assets: Cash Accounts receivable Inventory Less: inventory allowance Prepaids Total current assets $ 100,000 350,000 770,000 (12,000) 20,000 1,175,000 20,000 1,175,000 $ 100,000 350,000 (758,000) COGS Method

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LO 1 Describe and apply the lower-of-cost-or-market rule.

Lower-of-Cost-or-Market
Income Statement Presentation
Loss Method Sales Cost of goods sold Gross profit Operating expenses: Selling General and administrative Total operating expenses Other revenue and (expense): Loss on inventory Interest income Total other Income from operations Income tax expense Net income
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COGS Method $ 300,000 132,000 168,000 45,000 20,000 65,000 5,000 5,000 108,000 32,400 $ 75,600

300,000 120,000 180,000 45,000 20,000 65,000 (12,000) 5,000 (7,000) 108,000 32,400

75,600

LO 1

Lower-of-Cost-or-Market
P9-1: Remmers Company manufactures desks. The company attempts to obtain a 20% gross margin on selling price. At December 31, 2012, the following finished desks appear in the companys inventory.

The 2012 catalog was in effect through November 2012, and the 2013 catalog is effective as of December 1, 2012. Instructions: At what amount should each of the four desks appear in the companys December 31, 2012, inventory, assuming that the company has adopted a lower-of-FIFO-cost-or-market approach for valuation of inventories on an individual-item basis?
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LO 1 Describe and apply the lower-of-cost-or-market rule.

Lower-of-Cost-or-Market
Finished Desks A Inventory cost $ 470 Est. cost to manufacture 460 Commissions and disposal costs 50 Catalog selling price 500

Ceiling = 450
(500 50)
Not >

Replacement Cost = 460

Cost = 470

Market = 450

Not <

Floor = 350
(450-(500 x 20%))

LCM = 450
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LO 1 Describe and apply the lower-of-cost-or-market rule.

Lower-of-Cost-or-Market
Finished Desks B Inventory cost $ 450 Est. cost to manufacture 430 Commissions and disposal costs 60 Catalog selling price 540

Ceiling = 480
(540 60)
Not >

Replacement Cost = 430

Cost = 450

Market = 430

Not <

Floor = 372
(480-(540 x 20%))

LCM = 430
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LO 1 Describe and apply the lower-of-cost-or-market rule.

Lower-of-Cost-or-Market
Finished Desks C Inventory cost $ 830 Est. cost to manufacture 610 Commissions and disposal costs 80 Catalog selling price 900

Ceiling = 820
(900 80)
Not >

Replacement Cost = 610

Cost = 830

Market = 640

Not <

Floor = 640
(820-(900 x 20%))

LCM = 640
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LO 1 Describe and apply the lower-of-cost-or-market rule.

Lower-of-Cost-or-Market
Finished Desks D Inventory cost $ 960 Est. cost to manufacture 1,000 Commissions and disposal costs 130 Catalog selling price 1,200

Ceiling = 1,070
(1,200 130)
Not >

Replacement Cost = 1,000

Cost = 960

Market = 1,000

Not <

Floor = 830
(1,070-(1,200 x 20%))

LCM = 960
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LO 1 Describe and apply the lower-of-cost-or-market rule.

Lower-of-Cost-or-Market
Use of an AllowanceMultiple 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-ofcost-or-market at that balance sheet date.
Illustration 9-10

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LO 1 Describe and apply the lower-of-cost-or-market rule.

Lower-of-Cost-or-Market
Evaluation of LCM Rule
Some 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. LCM uses a normal profit in determining inventory values, which is a subjective measure.
LO 1 Describe and apply the lower-of-cost-or-market rule.

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Valuation Bases
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 (rare metals and agricultural products)

or
(3) too difficult to obtain cost figures (meatpacking).

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LO 2 Explain when companies value inventories at net realizable value.

Valuation Bases
Valuation Using Relative Sales Value
Used when buying varying units in a single lump-sum purchase.
E9-7: Larsen Realty Corporation purchased a tract of unimproved land for $55,000. This land was improved and subdivided into building lots at an additional cost of $30,000. These building lots were all of the same size but owing to differences in location were offered for sale at different prices as follows. Operating expenses allocated to this project total $18,200.
No. of Group 1 2 3 Lots 9 15 19 $ Price per Lot 3,000 4,000 2,000 Lots Unsold at Year-End 5 7 2

Instructions: Calculate the net income realized on this operation to date.

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LO 3 Explain when companies use the relative sales value method to value inventories.

Valuation Bases
E9-7 (Relative Sales Value Method):
No. of x Price Lots per Lot 9 15 19 $ 3,000 4,000 2,000 $

=
$

Selling Price 27,000 60,000 38,000 125,000

Relative Sales Price $27,000/125,000 60,000/125,000 38,000/125,000

x
$

Total Cost 85,000 85,000 85,000

=
$

Cost Allocated 18,360 40,800 25,840 $ 85,000

Cost Per Lot $ 2,040 2,720 1,360

Group 1 2 3

Group 1 2 3

Lots Price x Sold per Lot 4 8 17 $ 3,000 4,000 2,000

=
$

Total Sales 12,000 32,000 34,000 $ 78,000

Cost Per Lot $ 2,040 2,720 1,360

Total Cost of Goods $ 8,160 21,760 23,120 $ 53,040

Calculation of Net Income Sales $ 78,000 Cost of good sold Gross profit Expenses Net income $ 53,040 24,960 18,200 6,760

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LO 3 Explain when companies use the relative sales value method to value inventories.

Valuation Bases
Purchase CommitmentsA Special Problem
Generally seller retains title to the merchandise.
Buyer recognizes no asset or liability. If material, the buyer should disclose contract details in

footnote.
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 a liability and a corresponding loss in the period during
which such declines in market prices take place.
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LO 4 Discuss accounting issues related to purchase commitments.

Valuation Bases
Illustration: St. Regis Paper Co. signed timber-cutting contracts to be executed in 2013 at a price of $10,000,000. Assume further that the market price of the timber cutting rights on December 31, 2012, dropped to $7,000,000. St. Regis would make the following entry on December 31, 2012. Unrealized Holding Gain or LossIncome 3,000,000

Purchase Commitment Liability


Other income and expense in the Income statement. Current liabilities on the statement of financial position.

3,000,000

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LO 4 Discuss accounting issues related to purchase commitments.

Valuation Bases
Illustration: When St. Regis cuts the timber at a cost of $10 million, it would make the following entry. Purchases (Inventory) Purchase Commitment Liability Cash 7,000,000 3,000,000 10,000,000

Assume the government permitted St. Regis to reduce its contract price and therefore its commitment by $1,000,000. Purchase Commitment Liability 1,000,000 1,000,000

Unrealized Holding Gain or LossIncome

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LO 4 Discuss accounting issues related to purchase commitments.

Gross Profit Method of Estimating Inventory


Substitute Measure to Approximate Inventory
Relies on Three Assumptions:
(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.

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LO 5 Determine ending inventory by applying the gross profit method.

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 9-14

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LO 5 Determine ending inventory by applying the gross profit method.

Gross Profit Method


Computation of Gross Profit Percentage
Illustration 9-17

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LO 5 Determine ending inventory by applying the gross profit method.

Gross Profit Method


E9-12: 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 Purchases (gross) Freight-in Sales Sales returns Purchase discounts $ 160,000 640,000 30,000 1,000,000 70,000 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.
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LO 5

Gross Profit Method


E9-12 (Solution):
(a) Compute the estimated inventory assuming gross profit is 25% of sales.
Inventory, May 1 (at cost) Purchases (gross) (at cost) Purchase discounts Freight-in Goods available (at cost) Sales (at selling price) Sales returns (at selling price) Net sales (at selling price) Less gross profit (25% of $930,000) Sales (at cost) Approximate inventory, May 31 (at cost)
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160,000 640,000 (12,000) 30,000 818,000

1,000,000 (70,000) 930,000 232,500 697,500 $ 120,500

LO 5 Determine ending inventory by applying the gross profit method.

Gross Profit Method


E9-12 (Solution):
(b) Compute the estimated inventory assuming gross profit is 25% of cost.
Inventory, May 1 (at cost) Purchases (gross) (at cost) Purchase discounts Freight-in Goods available (at cost) Sales (at selling price) Sales returns (at selling price) Net sales (at selling price) Less gross profit (20% of $930,000) Sales (at cost) Approximate inventory, May 31 (at cost)
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160,000 640,000

25% 100% + 25%

= 20% of sales

(12,000) 30,000 818,000

1,000,000 (70,000) 930,000 186,000 744,000 $ 74,000

LO 5 Determine ending inventory by applying the gross profit method.

Gross Profit Method


Evaluation of Gross Profit Method
Disadvantages:
(1) Provides an estimate of ending inventory. (2) Uses past percentages in calculation. (3) A blanket gross profit rate may not be representative. (4) Normally unacceptable for financial reporting purposes. GAAP requires a physical inventory as additional

verification.

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LO 5 Determine ending inventory by applying the gross profit method.

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 Conventional Method Cost Method LIFO Dollar-value LIFO

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LO 6 Determine ending inventory by applying the retail inventory method.

Retail Inventory Method


P9-8: 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 2013.
COST $ 52,000 272,000 16,600 5,600 RETAIL $ 78,000 423,000 8,000 9,000 2,000 3,600 10,000 390,000

Instructions: Prepare a schedule computing estimate retail inventory using the following methods:

Beg. inventory, Oct. 1 Purchases Freight in Purchase returns Additional markups Markup cancellations Markdowns (net) Normal spoilage Sales

(1) Conventional
(2) Cost

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LO 6 Determine ending inventory by applying the retail inventory method.

Retail Inventory Method


P9-8 Solution - CONVENTIONAL Method: COST $ 52,000 272,000 16,600 (5,600) 283,000 335,000 RETAIL $ 78,000 423,000 (8,000) 7,000 422,000 500,000 / (3,600) (10,000) (390,000) $ 96,400 Cost to Retail %

Beg. inventory Purchases Freight in Purchase returns Markups, net Current year additions Goods available for sale Markdowns, net Normal spoilage Sales Ending inventory at retail Ending inventory at Cost: $ 96,400 x 67.00% =
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= 67.00%

64,588

LO 6 Determine ending inventory by applying the retail inventory method.

Retail Inventory Method


P9-8 Solution - COST Method: COST $ 52,000 272,000 16,600 (5,600) RETAIL $ 78,000 423,000 (8,000) (3,600) 7,000 418,400 / 496,400 (10,000) (390,000) $ 96,400 Cost to Retail %

Beg. inventory Purchases Freight in Purchase returns Markdowns, net Markups, net Current year additions Goods available for sale Normal spoilage Sales Ending inventory at retail Ending inventory at Cost: $ 96,400 x 67.49% =
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283,000 335,000

=
67.49%

65,056

LO 6 Determine ending inventory by applying the retail inventory method.

Retail Inventory Method


Special Items Relating to Retail Method

Freight costs
Purchase returns Purchase discounts and allowances Transfers-in Normal spoilage

Abnormal shortages
Employee discounts
LO 6 Determine ending inventory by applying the retail inventory method.

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Retail Inventory Method


Special Items

Illustration 9-23

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LO 6

Retail Inventory Method


Evaluation of Retail Inventory Method
Widely 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.
LO 6 Determine ending inventory by applying the retail inventory method.

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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) Manufacturers should report the inventory composition either in the balance sheet or in a separate schedule in the notes.

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LO 7 Explain how to report and analyze inventory.

Presentation and Analysis


Presentation of Inventories
Accounting standards require disclosure of:
(4) Significant or unusual financing arrangements relating to inventories. (5) Companies should present 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-ormarket) and the method used in determining cost (LIFO, FIFO, average cost, etc.).

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LO 7 Explain how to report and analyze inventory.

Presentation and Analysis


Presentation of Inventories
Illustration 9-24 Disclosure of Inventory Methods

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LO 7 Explain how to report and analyze inventory.

Presentation and Analysis


Presentation of Inventories
Illustration 9-25 Disclosure of Trade Practice in Valuing Inventories

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LO 7

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.

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LO 7 Explain how to report and analyze inventory.

Presentation and Analysis


Inventory Turnover Ratio
Measures the number of times on average a company sells the inventory during the period.
Illustration: In its 2009 annual report Kellogg Company reported a beginning inventory of $897 million, an ending inventory of $910 million, and cost of goods sold of $7,184 million for the year.
Illustration 9-26

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LO 7 Explain how to report and analyze inventory.

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 9-26

Average Days to Sell

365 days / 7.95 times = every 45.9 days


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LO 7 Explain how to report and analyze inventory.

APPENDIX

9A

LIFO RETAIL METHODS

Primary reason to use LIFO


Tax advantages. 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.

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LO 8 Determine ending inventory by applying the LIFO retail methods.

APPENDIX

9A

LIFO RETAIL METHODS

Stable PricesLIFO Retail Method


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. Beginning inventory is excluded from the cost-to-retail

percentage.

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LO 8 Determine ending inventory by applying the LIFO retail methods.

APPENDIX

9A

LIFO RETAIL METHODS

Illustration 9A-1 LIFO Retail MethodStable Prices

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LO 8 Determine ending inventory by applying the LIFO retail methods.

APPENDIX

9A

LIFO RETAIL METHODS

Illustration 9A-2 Ending Inventory at LIFO Cost, 2012Stable Prices

Inventory is composed of two layers.

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LO 8 Determine ending inventory by applying the LIFO retail methods.

APPENDIX

9A

LIFO RETAIL METHODS

Illustration 9A-3 Ending Inventory at LIFO Cost, 2013Stable Prices

Assume that the ending inventory for 2013 at retail is $50,000. Notice that the 2012 layer is reduced from $11,000 to $5,000.

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LO 8 Determine ending inventory by applying the LIFO retail methods.

APPENDIX

9A

LIFO RETAIL METHODS

Fluctuating PricesDollar-Value LIFO Retail


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.

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LO 8 Determine ending inventory by applying the LIFO retail methods.

APPENDIX

9A

LIFO RETAIL METHODS

Illustration: 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.
Illustration 9A-4

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LO 8 Determine ending inventory by applying the LIFO retail methods.

APPENDIX

9A

LIFO RETAIL METHODS

Illustration: Assume that the current 2010 price index is 112 (prior year 100) and that the inventory ($56,000) has remained unchanged.
Dollar-Value LIFO Retail Method Fluctuating Prices

Illustration 9A-5

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LO 8

APPENDIX

9A

LIFO RETAIL METHODS

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


Illustration 9A-6

Hernandez must restate layers of a particular year to the prices in effect in the year when the layer was added.

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LO 8 Determine ending inventory by applying the LIFO retail methods.

APPENDIX

9A

LIFO RETAIL METHODS

Comparison of Effect of Price Assumptions


Illustration 9A-7

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LO 8 Determine ending inventory by applying the LIFO retail methods.

APPENDIX

9A

LIFO RETAIL METHODS

Subsequent Adjustments under Dollar-Value LIFO Retail


Illustration: Using the data from the previous example, assume that the retail value of the 2013 ending inventory at current prices is $64,800, the 2013 price index is 120 percent of base-year, and the cost-to-retail percentage is 75 percent. Compute the ending inventory at LIFO cost.
Illustration 9A-8

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LO 8

APPENDIX

9A

LIFO RETAIL METHODS

Subsequent Adjustments under Dollar-Value LIFO Retail


Illustration: Conversely assume that in 2011 the ending inventory in base-year prices is $48,000. Compute the ending inventory at LIFO cost.
Illustration 9A-9

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LO 8 Determine ending inventory by applying the LIFO retail methods.

APPENDIX

9A

LIFO RETAIL METHODS

Changing from Conventional Retail to LIFO


Illustration: Hackman Clothing Store employs the conventional retail method but wishes to change to the LIFO retail method beginning in 2013. The amounts shown by the firms books are as follows.

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LO 8 Determine ending inventory by applying the LIFO retail methods.

APPENDIX

9A

LIFO RETAIL METHODS

Conventional Retail Inventory Method

Illustration 9A-10

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LO 8

APPENDIX

9A

LIFO RETAIL METHODS

Hakeman Clothing can then quickly approximate the ending inventory for 2012 under the LIFO retail method.
Illustration 9A-11

The difference of $500 ($11,250 - $10,750) between the LIFO retail method and the conventional retail method is the amount by which the company must adjust beginning inventory for 2013.
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LO 8 Determine ending inventory by applying the LIFO retail methods.

RELEVANT FACTS

Goods in transit, consigned goods, special sales agreementsas well as the costs to include in inventory are essentially accounted for the same under IFRS and GAAP. GAAP permits the use of LIFO for inventory valuation. IFRS prohibits its use. FIFO and average cost are the only two acceptable cost flow assumptions permitted under IFRS. Both sets of standards permit specific identification where appropriate. In the lower-of-cost-or-market test for inventory valuation, IFRS defines market as net realizable value. GAAP defines market as replacement cost subject to the constraints of net realizable value (the ceiling) and net realizable value less a normal markup (the floor). IFRS does not use a ceiling or a floor to determine market.

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RELEVANT FACTS

Under GAAP, if inventory is written down under the lower-of-cost-ormarket valuation, the new basis is now considered its cost. As a result, the inventory may not be written back up to its original cost in a subsequent period. Under IFRS, the write-down may be reversed in a subsequent period up to the amount of the previous write-down. Both the write-down and any subsequent reversal should be reported on the income statement. IFRS requires both biological assets and agricultural produce at the point of harvest to be reported to net realizable value. GAAP does not require companies to account for all biological assets in the same way. Furthermore, these assets generally are not reported at net realizable value. Disclosure requirements also differ between the two sets of standards.

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IFRS SELF-TEST QUESTION


All of the following are key similarities between GAAP and IFRS with respect to accounting for inventories except:
a. costs to include in inventories are similar. b. LIFO cost flow assumption where appropriate is used by both sets of standards. c. fair value valuation of inventories is prohibited by both sets of standards.

d. guidelines on ownership of goods are similar.

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IFRS SELF-TEST QUESTION


All of the following are key differences between GAAP and IFRS with respect to accounting for inventories except the:
a. definition of the lower-of-cost-or-market test for inventory valuation differs between GAAP and IFRS. b. average cost method is prohibited under IFRS. c. inventory basis determination for write-downs differs between GAAP and IFRS.

d. guidelines are more principles based under IFRS than they are under GAAP.

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