CHAPTER TWO
INVENTORIES: ADDITIONAL VALUATION ISSUES
1.1 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. 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, the term “market” refers to the market in which it purchases goods, not the market in which it sells them. For a manufacturer, 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 company X purchased a Timex calculator wristwatch for $30 for resale. Company X 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. X can use the lower-of-cost-or-market rule of valuation after applying any of the cost flow methods discussed in chapter one 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.
The upper (ceiling) is the net realizable value of inventory. The lower (floor) is the net realizable value less a normal profit margin.
What is the rationale for these two limitations?
ü 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 below 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 (ceiling), and net realizable value less a normal profit margin (floor).
To illustrate how to compute designated market value, assume the information relative to the inventory of Regner Foods, Inc., as shown in Illustration 2-4.
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 2-5 below.
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 lowerof- 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 2-6 below.
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 it.
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. 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.
Recording “Market” Instead of Cost
One of two methods is used for recording inventory at market.
One method, referred to as the direct method, substitutes the (lower) market value figure for cost when valuing the inventory. 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 indirect method or allowance method, does not change the cost amount. Rather, it establishes a separate contra asset account and a loss account to record the write-off.
We use the following inventory data to illustrate entries under both methods.
Cost of goods sold (before adjustment to market) $108,000
Ending inventory (cost) 82,000
Ending inventory (at market) 70,000
Illustration 2-7 shows the entries for both the direct and indirect methods, assuming the use of a perpetual inventory system.
Identifying the loss due to market decline shows the loss separate from cost of goods sold in the income statement (but not as an extraordinary item). The advantage of this approach is that it does not distort the cost of goods sold.
Illustration 2-8 contrasts the differing amounts reported in the income statements under the two methods, using data from the preceding illustration.
The direct-method presentation buries the loss in the cost of goods sold. The indirect-method presentation is preferable, because it clearly discloses the loss resulting from the market decline of inventory prices.
Using the indirect method, the company would report the Allowance to Reduce Inventory to Market on the balance sheet as a $12,000 deduction from the inventory. This deduction permits both the income statement and the balance sheet to show the ending inventory of $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 unit prices.
Use of an allowance account permits balance sheet disclosure of the inventory at cost and at the lower-of-cost-or-market. However, it raises the problem of how to dispose of the balance of the allowance account in the following 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.Some 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 a loss. If prices are rising, the company recovers a loss recorded in prior years, and it records a “gain,” as shown in Illustration 2-9 below. Note that this “gain” is not really a gain, but a recovery of a previously recognized loss.
We can think of this net “gain” under the indirect method 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 a gain or loss 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 results in lower income.
1.2 VALUATION BASES
Valuation at Net Realizable Value
For the most part, companies record inventory at cost or at the lower-of-cost-or market.
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.
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 2-10 shows the allocation of relative sales value for the Woodland Developers example.
Using the amounts given in the “Cost Per Lot” column, Woodland can determine the cost of lots sold and the gross profit 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).
Usually it is neither necessary nor proper 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 2-12 below shows an example of a purchase commitment disclosure.
In the disclosure above, 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.
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 late 1984 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 2012 at a price of $10,000,000. Assume further that the market price of the timber cutting rights on December 31, 2011, dropped to $7,000,000. St. Regis would make the following entry on December 31, 2011.
Unrealized Holding Gain or Loss—Income (Purchase Commitments) 3,000,000
Estimated Liability on Purchase Commitments 3,000,000
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.
Purchases (Inventory) 7,000,000
Estimated Liability on Purchase Commitments 3,000,000
Cash 10,000,000
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.
Estimated Liability on Purchase Commitments 1,000,000
Unrealized Holding Gain or Loss—Income (Purchase Commitments) 1,000,000
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.
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.
1.3 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 margin 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.
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.
In Cetus case above, 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 2-14, this markup is 1⁄4 or 25 percent of retail, and 1⁄3 or, 33 1⁄3 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 on cost.
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.
1.4 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 in 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. Here is how it works at a company like super market: Beginning with the retail value of the goods available for sale, it deducts the sales 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 cost of total goods available for sale at cost by the total goods available at retail price. Finally, to obtain ending inventory at cost, the company applies the cost-to-retail ratio to the ending inventory valued at retail. Illustration 2-17 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 tax authorities, various retail associations, and the accounting profession all sanction use of the retail inventory method. One of it’s an advantage is that a company can approximate the inventory balance without a physical count.
However, to avoid a potential overstatement of the inventory, companies must 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, 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 2-17 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. 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 2-18. In-Fusion can calculate its ending inventory at cost under two assumptions, A and B. (We’ll explain the reasons for the two later.)
Assumption A: Computes a cost ratio after markups (and markup cancellations) but before markdowns.
Assumption B: Computes a cost ratio after both markups and markdowns (and cancellations).
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 2-21 below 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. 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:
Ø Transfers-in from another department are reported in the same way as purchases from an outside enterprise.
Ø 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.
Ø 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.
Ø 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.
Illustration 2-22 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 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.
1.5 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
The preceding illustration 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).
The following inventory disclosures by Newmont Gold Company reveal the use of different bases of valuation, including market value, for different classifications of inventory.
Analysis of Inventories
As we all expect, 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 the inventory.
Inventory Turnover Ratio
The inventory turnover ratio 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 2007 annual report Kellogg Company reported a beginning inventory of $924 million, an ending inventory of $824 million, and cost of goods sold of $6,597 million for the year. Illustration 2-26 below shows the inventory turnover formula and Kellogg Company’s 2007 ratio computation below.
Average Days to Sell Inventory
A variant of the inventory turnover ratio 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 7.5 times divided into 365 is approximately 49 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.
