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17/11/2020 10:46:16 AM

Inventories: additional valuation issues in U.S accounting

INVENTORIES: ADDITIONAL VALUATION ISSUES IN U.S ACCOUNTING

Nguyễn Thị Kim Hương

1. Lower- Of- Cost- Or- Net Realizable Value (LCNRV)

1.1 Net Realizable Value

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-net realizable value” (LCNRV) generally means the cost to replace the item by purchase or reproduction. For a retailer like Nordstrom, the term “market” refers to the market in which it purchases goods, not the market in which it sells them. For a manufacturer like William Wrigley Jr., the term “market” refers to the cost to reproduce. Thus the rule really means that companies value goods at cost or cost to replace, whichever is lower.

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

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

1.2 Methods of Applying LCNRV

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

1.3 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.

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.

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.

1.4 Use of Allowance

Using the indirect method, the company would report the Allowance to Reduce Inventory to Market on the balance sheet as a deduction from the inventory. This deduction permits both the income statement and the balance sheet to show the ending inventory, although the balance sheet shows a net amount. It also keeps subsidiary inventory ledgers and records in correspondence with the control account without changing unit prices.

1.5 Recovery of Inventory Loss

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.3

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,”. Note that this “gain” is not really a gain, but a recovery of a previously recognized loss.

1.6 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 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.

2. The Gross Profit Method of Estimate 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

2.1 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.

2.2 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.