Intermediate accounting IFRS 3rd ch09

Determine ending inventory by applying the gross profit method.. Net Realizable ValueILLUSTRATION 9.1 Computation of Net Realizable Value Illustration: Assume that Mander AG has unfinis

Prepared by Coby Harmon

1. Describe and apply the lower-of-cost-or-net realizable

value rule

2. Identify other inventory valuation issues

3. Determine ending inventory by applying the gross profit

method.

4. Determine ending inventory by applying the retail

inventory method

5. Explain how to report and analyze inventory.

After studying this chapter, you should be able to:

Inventories:

Additional Valuation Issues

LEARNING OBJECTIVES

PREVIEW OF CHAPTER 9

Intermediate Accounting IFRS 3rd Edition

A company abandons the historical cost principle when the future utility (revenue-producing ability) of

the asset drops below its original cost

Lower-of-Cost-or-Net Realizable Value

(LCNRV)

LEARNING OBJECTIVE 1

Describe and apply the lower-of-cost-or-net realizable value rule.

Net Realizable Value

Estimated selling price in the normal course of business less

Net Realizable Value

ILLUSTRATION 9.1

Computation of Net Realizable Value

Illustration: Assume that Mander AG has unfinished inventory with a cost of €950, a sales value of €1,000,

estimated cost of completion of €50, and estimated selling costs of €200 Mander’s net realizable value is

computed as follows

 Mander reports inventory on its balance sheet at €750

 In its income statement, Mander reports a Loss on Inventory Write-Down of €200 (€950 − €750)

Net Realizable Value

ILLUSTRATION 9.1

Computation of Net Realizable Value

ILLUSTRATION 9.2

LCNRV Disclosures

Net Realizable Value

Jinn-Feng Foods computes its inventory at LCNRV (amounts in

ILLUSTRATION 9.4

Methods of Applying LCNRV

Assume that Jinn-Feng Foods separates its food products into two major groups, frozen and canned

 In most situations, companies price inventory on an item-by-item basis

 Tax rules in some countries require that companies use an individual-item basis

 Individual-item approach gives the lowest valuation for statement of financial position purposes

 Method should be applied consistently from one period to another.

Methods of Applying LCNRV

Cost of goods sold (before adj to NRV) €108,000

Loss Method

COGS Method

COGS

Method

Illustration: Data for Ricardo SpA

Recording NRV Instead of Cost

Partial Statement of Financial Position

Recording NRV Instead of Cost

Income Statement

Recording Net Realizable Value

Instead of crediting the Inventory account for NRV adjustments, companies generally use an allowance account,

often referred to as Allowance to Reduce Inventory to NRV

Using an allowance account under the loss method, Ricardo SpA makes the following entry to record the inventory write-down to NRV

Use of an Allowance

Loss Due to Decline of Inventory to NRV 12,000

Allowance to Reduce Inventory to NRV 12,000

ILLUSTRATION 9-7

Partial Statement of Financial Position

Use of an Allowance

Recovery of Inventory Loss

 Amount of write-down is reversed.

 Reversal limited to amount of original write-down

Continuing the Ricardo example, assume the net realizable value increases to €74,000 (an increase of

€4,000) Ricardo makes the following entry, using the loss method.

LCNRV

Allowance account is adjusted in subsequent periods, such that inventory is reported at the LCNRV.

Illustration shows net realizable value evaluation for Vuko Company and the effect of net realizable value adjustments

LCNRV 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

2. Application of the rule results in inconsistency because a company may value the inventory at cost in one

year and at net realizable value in the next year

3. LCNRV values the inventory in the statement of financial position 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

Evaluation of LCM Rule

P9.1: Remmers SE manufactures desks The 2019 catalog was in e ect through November 2019, and the 2020 catalog ff

is e ective as of December 1, 2019 At December 31, 2019, the following finished desks appear in the company’s ff

inventory

LCNRV

Instructions: At what amount should the four desks appear in the company’s December 31, 2019, inventory, assuming

that the company has adopted a lower-of-FIFO-cost-or-net realizable value approach for valuation of inventories on an

individual-item basis?

Instructions: At what amount should the four desks appear in the company’s December 31, 2019, inventory, assuming

that the company has adopted a lower-of-FIFO-cost-or-net realizable value approach for valuation of inventories on an

individual-item basis?

Net Realizable Value

Departure from LCNRV rule may be justified in situations when

 cost is difficult to determine,

 items are readily marketable at quoted market prices, and

 units of product are interchangeable.

Two common situations in which NRV is the general rule:

Agricultural Inventory

Biological asset (classified as a non-current asset) is a living animal or plant, such as sheep, cows, fruit

trees, or cotton plants

 Biological assets are measured on initial recognition and at the end of each reporting period at fair

value less costs to sell (NRV)

 Companies record gain or loss due to changes in NRV of biological assets in income when it arises.

Net Realizable Value

Agricultural Inventory

Agricultural produce is the harvested product of a biological asset, such as wool from a sheep, milk from a

dairy cow, picked fruit from a fruit tree, or cotton from a cotton plant

 Agricultural produce are measured at fair value less costs to sell (NRV) at the point of harvest

Net Realizable Value

Illustration: Bancroft Dairy produces milk for sale to local cheese-makers Bancroft began operations on January 1,

2019, by purchasing 420 milking cows for €460,000 Bancroft provides the following information related to the

milking cows

Agricultural Accounting at NRV

Bancroft makes the following entry to record the change in carrying value of the milking cows.

Unrealized Holding Gain or Loss—Income 33,800

Agricultural Assets—

Bancroft Dairy

Unrealized Holding Gain or Loss—Income

33,800

Reported on the Statement of financial position as a non-current asset at fair value less costs to sell

(net realizable value)

Reported as “Other income and expense” on the income statement

Agricultural Accounting at NRV

Inventory (milk) 36,000

Unrealized Holding Gain or Loss—Income 36,000

Illustration: Bancroft makes the following summary entry to record the milk harvested for the month of January.

Assuming the milk harvested in January was sold to a local cheese-maker for €38,500, Bancroft records the sale

as follows

Agricultural Accounting at NRV

Cash 38,500

Sales Revenue 38,500Cost of Goods Sold 36,000

Commodity Broker-Traders

Generally measure their inventories at fair value less costs to sell (NRV), with changes in NRV recognized in

income in the period of the change

 Buy or sell commodities (such as harvested corn, wheat, precious metals, heating oil)

 Primary purpose is to

► sell the commodities in the near term and

► generate a profit from fluctuations in price

Net Realizable Value

Relative Standalone Sales Value

Used when buying varying units in a single lump-sum purchase

Illustration: 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 Calculate the cost of lots sold and gross profit

Valuation Bases

ILLUSTRATION 9.10

Allocation of Costs, Using Relative Standalone Sales Value

ILLUSTRATION 9.11

Determination of Gross Profit,

Using Relative Standalone Sales Value

Relative Standalone Sales Value

 Generally seller retains title to the merchandise.

 Buyer recognizes no asset or liability

 If material, the buyer should disclose contract details in note in the financial statements.

 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 corresponding loss

in the period during which such declines in market prices take place

Purchase Commitments—A Special Problem

Valuation Bases

Illustration: Apres Paper AG signed timber-cutting contracts to be executed in 2020 at a price of €10,000,000

Assume further that the market price of the timber cutting rights on December 31, 2019, dropped to €7,000,000

Apres would make the following entry on December 31, 2019

Unrealized Holding Gain or Loss—Income 3,000,000

Purchase Commitment Liability 3,000,000

Other expenses and losses in the Income statement.

Purchase Commitments

Purchases (Inventory) 7,000,000

Purchase Commitment Liability 3,000,000

Cash 10,000,000

Assume Apres is permitted to reduce its contract price and therefore its commitment by €1,000,000

Purchase Commitment Liability 1,000,000

Unrealized Holding Gain or Loss—Income 1,000,000

Illustration: When Apres cuts the timber at a cost of €10 million, it would make the following entry.

Purchase Commitments

Substitute Measure to Approximate Inventory

Relies on three assumptions:

3. The sales, reduced to cost, deducted from the sum of the opening inventory plus purchases, equal

Illustration: Cetus SE 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 9.13

Gross Profit Method of Estimating Inventory

Illustration: In Illustration 9.13, 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.

Computation of Gross Profit Percentage

ILLUSTRATION 9.14

Computation of Gross Profit Percentage

Gross Profit Method of Estimating Inventory

ILLUSTRATION 9.15

Formulas Relating to Gross Profit

ILLUSTRATION 9.16

Application of Gross Profit Formulas

Gross Profit Method

E9.14: Astaire ASA uses the gross profit method to estimate inventory for monthly reporting purposes Presented below

is information for the month of May

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.

Gross Profit Method of Estimating Inventory

(a) Compute the estimated inventory at May 31, assuming that the gross profit is 25% of sales.

Gross Profit Method of Estimating Inventory

100% + 25%

= 20% of sales

Gross Profit Method of Estimating Inventory

(b) Compute the estimated inventory at May 31, assuming that the gross profit is 25% of cost.

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 because it provides only an estimate

IFRS requires a physical inventory as additional verification of the inventory indicated in the records.

Evaluation of Gross Profit Method

Gross Profit Method of Estimating Inventory

Method used by retailers to compile inventories at retail prices Retailer can use a formula to convert retail

prices to cost.

Requires retailers to keep a record of:

1) Total cost and retail value of goods purchased

2) Total cost and retail value of the goods available for sale

3) Sales for the period

Methods

 Conventional Method (or LCNRV)

Retail Inventory Method

LEARNING OBJECTIVE 4

Determine ending inventory by applying the retail inventory method.

Illustration: The following data pertain to a single department for the month of October for Fuque Ltd Prepare a

schedule computing retail inventory using the Conventional and Cost methods

Retail Inventory Method

Retail Inventory Method

Retail Inventory Method

Special Items Relating to Retail Method

When sales are recorded gross, companies do

not recognize sales discounts.

When sales are recorded gross, companies do

not recognize sales discounts.

Retail Inventory Method

ILLUSTRATION 9.22

Conventional Retail Inventory Method—

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

Evaluation of Retail Inventory Method

Retail Inventory Method

Accounting standards require disclosure of:

Presentation and Analysis

Presentation of Inventories

1) Accounting policies adopted in measuring inventories, including the cost formula used

(weighted-average, FIFO)

2) Total carrying amount of inventories and the carrying amount in classifications (merchandise, production

supplies, raw materials, work in progress, and finished goods)

3) Carrying amount of inventories carried at fair value less costs to sell

4) Amount of inventories recognized as an expense during the period

LEARNING OBJECTIVE 5

Explain how to report and analyze inventory.

Presentation of Inventories

5) Amount of any write-down of inventories recognized as an expense in the period and the amount of

any reversal of write-downs recognized as a reduction of expense in the period

6) Circumstances or events that led to the reversal of a write-down of inventories

7) Carrying amount of inventories pledged as security for liabilities, if any

Accounting standards require disclosure of:

Presentation and Analysis

Common ratios used in the management and evaluation of inventory levels are inventory turnover and

average days to sell the inventory.

Analysis of Inventories

Presentation and Analysis

Measures the number of times on average a company sells the inventory during the period

Inventory Turnover

Illustration: In its 2015 annual report Tate & Lyle plc (GBR) reported a beginning inventory of £372 million, an

ending inventory of £263 million, and cost of goods sold of £1,319 million for the year

Analysis of Inventories

Measure represents the average number of days’ sales for which a company has inventory on hand.

Average Days to Sell Inventory

365 days / 3.59 times = every 101.7 days

Average Days to Sell

Analysis of Inventories

ILLUSTRATION 9.25

GLOBAL ACCOUNTING INSIGHTS

Relevant Facts

Differences

• In the lower-of-cost-or-market test for inventory valuation, U.S 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 defines market as net realizable value and does not use a ceiling or a floor to determine market

• Under U.S GAAP, if inventory is written down under the lower-of-cost-or-market valuation, the new basis is now considered its cost As a result, the inventory may not be written up back 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.

GLOBAL ACCOUNTING INSIGHTS