Valuation Bases

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.

9-1 LO 2
 Relative Standalone Sales Value ILLUSTRATION 9.10
Allocation of Costs,
Using Relative
Standalone Sales Value

ILLUSTRATION 9.11
Determination of Gross Profit,
Using Relative Standalone Sales Value

9-2 LO 2
 Valuation Bases

Purchase Commitments—A Special Problem

 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.

9-3 LO 2
 Purchase Commitments

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.

Current liabilities on the balance sheet.

9-4 LO 2
 Purchase Commitments

Illustration: When Apres cuts the timber at a cost of €10 million,

it would make the following entry.

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

9-5 LO 2
 LEARNING OBJECTIVE 3
Gross Profit Method of Determine ending inventory by
applying the gross profit
Estimating Inventory method.

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.

9-6 LO 3
 Gross Profit Method of Estimating
Inventory
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
Application of Gross Profit Method

9-7 LO 3
 Gross Profit Method of Estimating
Inventory
Computation of Gross Profit Percentage
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.

ILLUSTRATION 9.14
Computation of Gross Profit Percentage

9-8 LO 3
 Gross Profit Method ILLUSTRATION 9.15
Formulas Relating to
Gross Profit

ILLUSTRATION 9.16
Application of Gross
Profit Formulas

9-9
 Gross Profit Method of Estimating
Inventory
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.
Inventory, May 1 € 160,000 Sales € 1,000,000
Purchases (gross) 640,000 Sales returns 70,000
Freight-in 30,000 Purchases discounts 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.

9-10 LO 3
 Gross Profit Method of Estimating
Inventory
(a) Compute the estimated inventory at May 31, assuming that the
gross profit is 25% of sales.

Inventory, May 1 (at cost) € 160,000

Purchases (gross) (at cost) 640,000
Purchase discounts (12,000)
Freight-in 30,000
Goods available (at cost) 818,000
Sales (at selling price) € 1,000,000
Sales returns (at selling price) (70,000)
Net sales (at selling price) 930,000
Less: Gross profit (25% of €930,000) 232,500
Sales (at cost) 697,500
Approximate inventory, May 31 (at cost) € 120,500

9-11 LO 3
 Gross Profit Method of Estimating
Inventory
(b) Compute the estimated inventory at May 31, assuming that the
gross profit is 25% of cost.

Inventory, May 1 (at cost) € 160,000

Purchases (gross) (at cost) 640,000
25%
Purchase discounts = 20% of sales (12,000)
100% + 25%
Freight-in 30,000
Goods available (at cost) 818,000
Sales (at selling price) € 1,000,000
Sales returns (at selling price) (70,000)
Net sales (at selling price) 930,000
Less: Gross profit (20% of €930,000) 186,000
Sales (at cost) 744,000
Approximate inventory, May 31 (at cost) € 74,000

9-12 LO 3
 Gross Profit Method of Estimating
Inventory
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

because it provides only an estimate.

IFRS requires a physical inventory as additional verification of

the inventory indicated in the records.

9-13 LO 3
 LEARNING OBJECTIVE 4
Retail Inventory Method Determine ending inventory by
applying the retail inventory
method.

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)
 Cost Method

9-14 LO 4
 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.

COST RETAIL
Beg. inventory, Oct. 1 £ 52,000 £ 78,000
Purchases 272,000 423,000
Freight in 16,600
Purchase returns 5,600 8,000
Additional markups 9,000
Markup cancellations 2,000
Markdowns (net) 3,600
Normal spoilage and breakage 10,000
Sales 390,000
9-15 LO 4
 Retail Inventory Method

CONVENTIONAL Method: Cost to

COST RETAIL Retail %
Beginning inventory £ 52,000 £ 78,000
Purchases 272,000 423,000
Purchase returns (5,600) (8,000)
Freight in 16,600
Markups, net 7,000
Current year additions 283,000 422,000
Goods available for sale 335,000 500,000 67.0%
Markdowns, net (3,600)
Normal spoilage and breakage (10,000)
Sales (390,000)
Ending inventory at retail £ 96,400

Ending inventory at Cost:

£ 96,400 x 67.0% = £ 64,588

9-16 LO 4
 Retail Inventory Method

COST Method: Cost to

COST RETAIL Retail %
Beginning inventory £ 52,000 £ 78,000
Purchases 272,000 423,000
Purchase returns (5,600) (8,000)
Freight in 16,600
Markdowns, net (3,600)
Markups, net 7,000
Current year additions 283,000 418,400
Goods available for sale 335,000 496,400 67.49%
Normal spoilage and breakage (10,000)
Sales (390,000)
Ending inventory at retail £ 96,400

Ending inventory at Cost:

£ 96,400 x 67.49% = £ 65,060

9-17 LO 4
 Retail Inventory Method

Special Items Relating to Retail Method

 Freight costs
 Purchase returns
 Purchase discounts and allowances
 Transfers-in
When sales are recorded
 Normal shortages
gross, companies do not
 Abnormal shortages recognize sales discounts.

 Employee discounts

9-18 LO 4
ILLUSTRATION 9.22
Conventional Retail
Inventory Method—
Special Items Included

9-19
 Retail Inventory Method

Evaluation of 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 profits.

9-20 LO 4
 LEARNING OBJECTIVE 5
Presentation and Analysis Explain how to report and
analyze inventory.

Presentation of Inventories
Accounting standards require disclosure of:
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.
9-21 LO 5
 Presentation and Analysis

Presentation of Inventories
Accounting standards require disclosure of:
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.

9-22 LO 5
 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.

9-23 LO 5
 Analysis of Inventories

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

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.

ILLUSTRATION 9.25

9-24 LO 5
 Analysis of Inventories

Average Days to Sell Inventory

Measure represents the average number of days’ sales for
which a company has inventory on hand.
ILLUSTRATION 9.25

Average Days to Sell

365 days / 3.59 times = every 101.7 days

9-25 LO 5