UNIT 2: INVENTORIES: SPECIAL VALUATION METHODS

2.0 AIMS AND OBJECTIVES

The aim of this unit is to discuss the development and use of various estimation
techniques used to value ending inventory without a physical count. In addition, this
chapter aims at discussing accounting for construction-type contracts.

After you have studied this unit, you will:

 understand under what conditions the gross profit method of estimating
inventories is used and how it is applied;
 be able to use the retail inventory method to value inventory;
 be familiar with several special inventory valuation methods;
 Understand accounting for construction-type contracts.
2.1 INTRODUCTION

In the previous unit, different methods for computing the unit cost for inventories were
explained by examining the various flow assumptions used in accounting. Other
possibilities will be explored in this chapter. For example, what happens if these is a fire
and a physical count cannot be made? How does the accountant determine the ending
inventory for insurance purposes? Or, what happens in large department stores where
monthly inventory figures are needed, but monthly physical counts are not feasible.

These techniques involve the development and use of estimation techniques to value the
ending inventory without a physical count.

2.2 GROSS PROFIT METHOD

The gross profit method is useful for several purposes:

1. to control and verify the validity of inventory cost
2. to estimate interim inventory valuations between physical counts.
3. to estimate the inventory cost when necessary information normally used in cost
or unavailable.

39
When both merchandise and inventory records are destroyed by fire, the inventory cost
may be estimated by the use of the gross profit method as follows. The gross profit and
costs of goods sold percentage are obtained from prior years’ financial statements, which
presumably are available. The beginning inventory amount for the current year is the
ending inventories amount of the preceding year. Net purchases are estimated from
copies of the paid checks returned by the bank and through correspondence with
suppliers. Sales are computed by reference to cash deposits and by an estimate of the
outstanding accounts receivable through correspondence with customers.

Estimating the ending inventory by the gross profit method requires three steps:
1. Estimate the gross profit rate on the bases of prior years’ sales: (Sales  cost of
goods sold)  sales = gross profit rate.
2. Compute the cost of goods sold ratio: 1 – gross profit rate = cost of goods sold
ratio.
3. Solve the following equation for ending inventory using this period’s data.

Beginning inventory + Net purchases = Ending inventory + Net sales x Cost of goods
sold ratio

To illustrate assume the following data for comp company:

Beginning inventories, at cost -------------------------------- Br. 40,000
Net purchases ------------------------------------------------------200,000
Net sales ------------------------------------------------------------225,000
Gross profit rate for past three years ---------------------- -------20%

Solution: The ending inventory for Comp Company is estimated using the gross profit
method as follows:

Beginning inventories, at cost ----------------------------------- Br. 40,000

Add: Net purchases -------------------------------------------------- 200,000
Cost of goods available for sale -------------------------------- Br. 240,000
Less: Estimated cost of goods sold:
Net Sales x Cost of goods sold ratio ------------------- 180,000
(Br. 225,000 x 0.80)

40
Estimated ending inventories, at cost ----------------------------Br. 60,000
Cost of goods sold ratio = 1 – gross profit rate
= 1 – 0.2
= 0.8
The cost of ending inventories estimated by the gross profit method is reasonably
consistent with the usual method of valuing inventories. This follows from the fact that
the gross profit percentage is based on historical records that reflects the particular
method of valuing the inventories. If the inventories are valued at LIFO, the estimated
inventories will approximate LIFO cost; therefore, if the gross profit method is used as a
basis for recovering an insured fire loss, the inventories should be restated for insurance
purpose to current fair value at the time of the fire.

Sometimes the gross profit percentage is stated as a percentage of cost. In such situations
the gross profit percentage must be restated as a percentage of net sales to compute the
cost percentage (based on net sales) for the period. For example, if the gross profit is
stated as 30% of cost, the gross profit percentage may be restated to 23% of net sales as
follows:
(1) 30% = 3/10 gross profit based on cost
(2) Add numerator of fraction to denominator to make 3/13
(3) 3/13 = gross profit based on sales.
The gross profit method has two significant limitations:
1. The past gross profit rate may not approximately reflecting mark up changes relating to
the current or future periods.

2. Gross profit rates (mark up rates) may vary widely on different types of inventory. A
change during the period in the mark up rate on one or more lines or a shift in the relative
quantities of each line sold (shifts in the sales mix) changes the average gross profit rate.
This change affects the reliability of the results.

When the gross profit method is applied in a situation that involves broad aggregations of
inventory items with significantly different markup rates, the computations should be
developed for each separate class. The estimate of the total inventory is then determined
by summing the estimates for the separate classes.

41
The gross profit method frequently is used in the preparation of interim reports. It should
be clear that the use of the gross profit results in an estimated cost of inventories. If the
reporting enterprise normally values inventories at LCM for annual reporting purposes, it
must follow the same procedure for interim reporting purposes. Thus, the estimated cost
obtained by use of the gross profit method must be compared with current replacement
costs to determine whether a write-down to a lower “market” is required. The gross profit
method may be used for interim reports even though annual inventories are determined
by the use of one of the cost flow assumption (LIFO, FIFO etc)
Enterprises that use the gross profit method for interim reports adjustment that result
from reconciliation with the annual physical inventory.

2.3 RETAIL INVENTORY METHOD

The retail inventory method often is used by retail stores, especially department stores
that sell a wide variety of items. In such situations, perpetual inventory procedures may
be impractical, and a complete physical inventory count is usually taken only annually.
The retail inventory method is appropriate when items sold within a department have
essentially the same markup rate and articles purchased for resales are priced
immediately.

The retail inventory method required that a record be kept of (1) the total cost and retail
value of goods purchased (2) the total cost and retail value of goods available for sale,
and (3) the sales for the period. The sales for the period are deducted from the retail value
of goods available for sale to produce as estimated inventory at retail. The ratio of cost to
a retail for all goods passing through a department or firm is then determined by dividing
the total goods available at retail. The inventory valued at retail is converted to
approximate cost by applying the cost to retail ratio.

Some uses of retail inventory method of estimably the cost of inventories are:
1. To verify the reasonableness of the cost of inventories at the end of the accounting
period. By using a different set of data from that used in pricing inventories
accountants may establish that the valuation of inventories is reasonable.

42
 2. To estimate the cost of inventories for interim accounting periods and for income
tax purposes
3. To permit the valuation of inventories when selling prices are the only available
data. The use of this method allows management to mark only the selling prices
on the merchandise and eliminates the need for reference to specific purchase
invoices.
To illustrate the retail method of estimating inventories (at average cost), assume the
following simple data for Ethio Company:
Cost Retail
Beginning inventories…………………………………..Br. 40, 000 Br. 50, 000
Net Purchases……………………………….………….... 150, 000 200, 000
Goods available for sale…………………………….....Br. 190, 000 Br. 250, 000
Cost percentage (Br. 190, 000  Br. 250, 000)….70%
Less: Sales and normal shrinkage…………………………………………..….220,
shrinkage…………………………………………..….220, 000
Ending Inventories, at retail Br. 30, 000
Estimated ending inventory, at cost
(Br. 30, 000 x 0.7) Br. 22, 000

Although the retail method enables estimation of the value of inventories without a
physical count of the items on hand, the accountant should insist that a physical inventory
be taken periodically. Otherwise, shrinkage due to shoplifting, breakage, and other causes
might so undetected and might result in an increasingly overstated inventories valuation.

Normal shrinkage in the inventories may be estimated on the basis of the goods that were
available for sale. The method frequently used is to develop a percentage from the
experience of past years, such as 2% of the retail value of goods available for sale. This
percentage is used to determine the estimated shrinkage, which is deducted, together with
sales, from goods available for sale at retail prices to compute the estimated inventories at
retail prices. When sales are made to employees or selected customers at a special
discount price, such discounts are added to sales to compute the estimated inventories at
retail prices. The cost of normal shrinkage is included in the cost of goods sold; the cost

43
of abnormal shrinkage (theft, unusual spoilage etc) that is material in amount is reported
separately in the income statement.

The retail method differs from the gross profit method in that it uses a computed cost
ratio based on the actual relationship between cost and retail for the current period, rather
than the historical ratio. The computed cost ratio is an average across several different
kinds of goods sold. Although the computed inventory amount is an estimate, it is
acceptable for external financial reporting.

The data used above for Ethio Company assumed no changes in the sales price of the
merchandise as originally set. Frequently, however, the original sales price on
merchandise is changed, particularly at the end of the selling season or when replacement
costs are changing. The retail method requires that a careful record be kept of all changes
to the original sales price because these changes affect the inventory cost computation.
To apply the retail inventory method, it is important to distinguish among the following
terms:

 Original selling price – the price at which goods originally are offered for sale.
 Markup – the original or initial margin between the selling price and cost. It also is
referred to as gross margin or mark-on.
 Additional markup – an increase in the sales price above the original sales price.
The original sales price is the base from which additional markup is
measured.
 (Additional) markup cancellation – cancellation of all or some, of an additional
markup. The reduction does not reduce the selling price below the original selling
price. Additional markup less markup cancellations is usually called net markups or
additional net markups.
 Markdown – a reduction is selling price below the original sales price.
 Markdown cancellation – an increase in the sales price (that does not exceed the
original sales price) after a reduction in the original markdown less markdown
cancellations are referred to as net markdowns.

44
The retail inventory method can be applied in different ways to estimate the cost of
ending inventory under alternative inventory cost flow assumptions.

The data below will be used to illustrate the application of retail method with different
cost flow assumptions.

December 31, 1990: At cost At retail

Inventory at beginning of period Br. 31,620 Br. 54,000
Net purchases during period 150,380 220,000
Additional markups during period 10,000
(Additional) markup cancellation during period 4,000
Markdowns during period 21,750
Markdown cancellation during period 1,750
Sales revenue for the period 180,000

2.3.1 Retail Method – Valuation at Average Cost

The average cost basis ratio is computed on total goods available for sale (i.e. the sum of
beginning inventory plus purchases) because the cost of the ending inventory is assumed
to represent the total goods available for sale during the period. Thus, this cost ratio
reflects the relationship of cost to retail values for all inventory items available for sale,
including the beginning inventory.
Average cost ratio =

cos t of (beginning inventory  net pruchases)

Re tail value of (beginning invneory  net pruchases  ne
markups  netmarkdowns )

( Br.31,620  Br.150,380)
= ( Br.54,000  220,000  Br.90,000  Br.1,750  21,750)

182,000
= 260,000 x 100%  70%

Ending inventory at retail = Br. 260,000 – Br. 180,000

= Br. 80,000
Estimated ending inventories at average cost = Br. 80,000 x 0.7
= Br. 56,000

45
The estimated cost of ending inventories is accurate only if the goods on hand consist of a
representative sample of all goods available for sale during 1990. For example, if the
ending inventories do not include any goods that were on hand on January 1, 1990, the
cost percentage should be computed with out use of the beginning inventories amount.
Similarly, if all goods on which the net markups and markdowns should be excluded
from the computation of the cost percentage. Under such circumstances, however, the net
markups and net markdowns still are used to compute the ending inventories at retail
prices
2.3.2 Retail Method- Valuation at Lower of Average Cost or Market

The retail method may be adopted to produce inventory valuations approximately the
lower of average cost or market when there have been changes in the costs and selling
prices of goods during the accounting period. The inclusion of net markups and the
exclusion of net markdowns in the computation of the cost percentage produces an
inventory valued a the lower of average cost or market. This is sometimes called the
conventional retail method.
cos tof ( Beginning invnetory  Net prucahses)
Cost ratio = Re tail price of ( Beginning inventory  net prucahses  net markups)

182,000
= 280,000  65%

The inclusion of the net markups in the computation of the cost percentage assumes that
the net markups apply proportionately to items sold and to items on hand at the end of the
accounting period; however, net markdowns are assumed to apply only to the goods sold.
Because the retail price of goods to which the markdowns apply is less than the original
retail price, the net markdowns as well as sales must be deducted from goods available
for sale at retail price to determine the inventories at retail price of these assumptions are
correct, the exclusion of net markdowns in the computation of the cost percentage values
the ending inventories at actual average cost. However, if the net markdowns apply both
to goods sold and to goods on hand, the exclusion of net markdowns from the
computation of the cost percentage results in an inventory valuation at the lower of
average cost or market.

46
Ending inventories, at retail = Br. 80,000 (does not change)
Estimated ending inventories at lower of average cost of market = Br. 80,000 x 0.65
= Br. 52,000
2.3.3 Retail Method – Valuation at Last-in, First-Out

If the LIFO method is used to estimate the cost of inventories, the conventional retail
method must be modified. The retail method may be adapted to approximate LIFO cost
of the ending inventories by the computation of a cost percentage for purchases of the
current accounting period only. The objective is to estimate the cost of any increase
(LIFO layer) in inventories during the accounting period.

Because LIFO is a cost method of inventory valuation, both net markups and net
markdowns are included in the computation of cost percentage for purchase of the current
period.
For purposes of this illustration, assume that selling prices have remained unchanged and
the net markups and net markdowns apply only to the goods purchased during 1990.

Net purchases, at cost = Br. 150,380

Net purchases, at retail = Br. 220,000 + Br. 10,000 – Br. 4,000
= Br. 21,000 + Br. 1,750
= Br. 206,000

Br.150,380
Cost percentage = Br.206,000  73%

Inventory increase during the period, at retail = Br. 80,000 – Br. 54,000
= Br. 26,000
Layer added during the period to beginning inventory = Br. 26,000 x 0.73
= Br. 18,980
Beginning inventory, at cost = Br. 31,620
Estimated ending inventories
at LIFO cost = Br. 50,600

47
N.B Beginning inventories are excluded from computation of cost percentage when retail
LIFO method is used.
2.3.4 Retail Method – Valuation at First-in, First-out

The cost of ending inventories on a FIFO basis may be estimated from the given data as
Ending inventory, at retail = Br. 80,000
Cost percentage (for current net purchases) = 73%
Estimated ending inventories, at FIFO = Br. 58,400 (Br. 80,000 x 0.73)

N.B. The beginning inventories are excluded from computation of cost percentage when
retail FIFO method is used.

2.3.5 Changes in price levels and the retail LIFO method

Let us now remove the simplifying assumption of the stability of selling prices. In reality,
retail prices do change from one accounting period to another, and this is particularly
significant for pricing inventories at retail LIFO. Because the procedure employed under
these circumstances is similar to that used in conjunction with money-value LIFO, it is
known as the money-value retail LIFO method. The ending inventories at retail prices
must be converted to beginning-of-year prices to ascertain the increase in the inventories
at beginning-of-year prices. An appropriate cost index must be used to convert from end-
of-year prices to beginning-of-year prices.

The procedure for estimating the cost of the ending inventories under the money-value
retail LIFO method and assuming increasing selling prices, is shown below for DOT
Company. The sales price index at the beginning of 1990, when LIFO was adopted, is
assumed to be 100, and the index at the end of 1990 is assumed to be 110, an increase of
10%. When the base-price index is other than 100, the percentage increase is determined
by dividing the index at the end of the current period by the base-period index and
subtracting 100. For example, if the base-period index is 125 and the index at the end of
the current period is 150, the increase would be 20% [(150  125) – 100 = 0.2]

48
 DOT Company
Money-value Retail LIFO method
December 31, 1990

Cost Retail
Inventories, Jan.1, 1990 (date of LIFO was adopted)………..Br. 18, 000 Br. 30, 000
Purchases during 1990 (Cost percentage is 65%) 65, 000 100, 000
Goods available for sale during 1990, at retail prices Br. 130, 000
Less: Net sales during the period 75, 000
Inventories, Dec 31, 1990, at retail prices Br. 55, 000
Computation of increase in inventories, at end-of-year
Retail prices:

Inventories, Dec. 31, 1990, at beginning-of-year

Retail prices (Br. 55, 000  1.10) Br. 50, 000
Less: Inventories, Jan. 1, 1990, at retail prices 30, 000
Increase in inventories, at end-of-year retail prices Br. 20, 000
Increase in inventories, at end-of-year retail prices
(Br. 20, 000 x 1.10) Br. 20, 000
Ending inventories, at money-value retail LIFO cost:
Beginning inventories layer Br. 18, 000
Add: Layer added in 1990 (Br. 22, 000 x 0.65)…………..14,
0.65)…………..14, 300
Estimated ending inventories, at money-value
Retail LIFO cost Br. 32, 300
2.5 ACCOUNTING FOR CONSTRUCTION-TYPE CONTRACTS

Contracts for construction of buildings, roads, bridges, dams and similar projects often
require more than one year to complete. Because of their unique features, such contracts
present special problems of asset valuation and revenue recognition.

The four basic types of construction contracts are:

1. Fixed-price (or lump-sum) contracts, which provide for a single price for all work
performed by the contractor.

49
 2. Unit-price contracts, which include a fixed price for each unit of output under the
contract.
3. Cost-type contracts, which provide for reimbursement of specified costs incurred
by the contractor plus fee for the contractor’s services.
4. Time-and-material contracts, which provide for a fixed hourly rate for the
contractor’s direct labor hours, plus payment for the cost of material and other
specified items.

Methods of accounting for construction type contracts:

contracts: As stated in chapter 5 of
financial accounting –I, the two methods of accounting for construction-type contracts
are the percentage of completion method and the completed-contract method.

Most contractors employ the percentage-of-completion method of accounting for

financial accounting. This method requires the accrual of gross profit and revenue over
the term of the contract based on the progress achieved each year. If the work performed
in a year is estimated to represent 40% of the total work required on the contract, 40% of
the total estimated gross profit and revenue is considered realized. The recognition of
gross profit and revenue is accomplished by increasing the carrying amount of the cost of
contracts in progress ledger account, which is comparable with the goods in process
inventory account of a manufacturing enterprise.

Under the completed-contract method of accounting, no gross profit is recognized for a

construction project until it is substantially completed; that is when remaining costs and
potential risks are insignificant in amount. The completed contract method is appropriate
for financial accounting only if a contractor has primarily short-term contracts that are
completed in a year or less or its estimates of input or output measures of completion are
not reasonably dependent or are subject to inherent hazards.

2.5.1 Accounting for construction-type contract: Profit anticipated

To illustrate the accounting for a construction-type contract, assume that Berta

Construction Company entered into a contract with a customer to construct an office
complex for a fixed price of Br. 1, 200, 000, on January 1, 1992, at the beginning of its

50
fiscal year. Data with respect to the contract for three years ended on December 31, 1994
were as follows:

Year Ended December 31

1992 1993 1994
Construction costs incurred…………………………………...Br. 200, 000 Br. 250, 000 Br. 400, 000
Estimated cost to complete construction at the end of year….. 600, 000 350, 000 0
Progress and other billings to the customer……………………... 300, 000 400, 000 500, 000
Collections from customer on billings…………………………....270, 000 360, 000 450, 000
Operating Expenses incurred……………………………………....50, 000 60, 000 70, 000

Using the above data we can illustrate accounting for the construction enterprise under
the two known accounting methods.

(1) The journal entries for the Company’s operations during the three years ended
December 31, 1994, under the percentage-of-completion, cost-to-cost method of
accounting, would be as follows:

Year ended December 31

1992 1993 1994
Dr. Cr. Dr. Cr. Dr. Cr.
Cost of contracts in progress……………………..200, 000 250, 000 400, 000
Operating Expenses…………………………. ……50, 000 60, 000 70, 000
Material Inventory, cash, etc………………………..250, 000 310, 000 470, 000

To record Operating Expenses and construction costs

Contract Receivable……………………………..300, 000 400, 000 500, 000

Progress Billings……………………………………..300, 000 400, 000 500, 000
To record progress billings

Cash……………………………………………..270, 000 360, 000 450, 000

Contract Receivable 270, 000 360, 000 450, 000
To record collection from customers

Cost of contract revenue……………….………200, 000 250, 000 400, 000

51
Estimated earning on contract in progress…….100, 000 125, 000 125, 000
Contract revenue……………………………………..300, 000 375, 000 525, 000
To record contract revenue estimated
on the basis of cost incurred to total
estimated cost, as follows:
Br .200,000
1992: Br. 1, 200, 000 x
Br .800,000
= Br. 300, 000
Br.450,000
1993: (Br. 1, 200, 000 x - Br. 300, 000
Br.800,000
= Br. 375, 000
1994: Br. 1, 200, 000 – Br. 675, 000
= Br. 525, 000

Progress Billings 1, 200, 000

Cost of contracts in progress 850, 000
Estimated Earnings on contracts in progress 350, 000
To record approval of project by customer

(2) The journal entries for the company’s operations during the three years ended
December 31, 1994 under the completed contract method, would be as follows:
Year ended December 31
1992 1993 1994
Dr. Cr. Dr. Cr. Dr. Cr.
Cost of contracts in progress……………………..200, 000 250, 000 400, 000
Operating Expenses…………………………. ……50, 000 60, 000 70, 000
Material Inventory, cash, etc………………………..250, 000 310, 000 470, 000

To record Operating Expenses and construction costs

Accounts Receivable……………………………..300, 000 400, 000 500, 000
Progress Billings……………………………………..300, 000 400, 000 500, 000
To record billings on contracts

Cash……………………………………………..270, 000 360, 000 450, 000

Accounts Receivable 270, 000 360, 000 450, 000
To record collection from customers

Progress Billings 1, 200, 000

52
Cost of contract Revenue 850, 000
Contract Revenue 1, 200, 000
Cost of contracts in progress 850, 000
To record approval of project by customer

Financial statement presentation

(A) presentation in income statement
(1) Percentage-of-completion method
1992 1993 1994
Contract revenue………………..Br. 300, 000 Br. 375, 000 Br. 525, 000
Less: Cost of contract revenue…… ..200,
..200, 000 250, 000 400, 000
Gross Profit Br. 100, 000 Br. 125, 000 Br. 125, 000
Operating Expenses 50, 000 60, 000 70, 000
Income before income taxes Br. 50, 000 Br. 65, 000 Br. 55, 000
(2) Completed-contract method
Contract revenue - - Br. 1, 200, 000
Cost of contract completed - - 850, 000
Gross Profit - - Br. 350, 000
Operating Expenses Br. 50, 000 Br. 60, 000 70, 000
Income before income taxes Br. (50, 000) Br. (60, 000) Br. 280, 000

B. Presentation in balance sheets

(1) Percentage of completion method.
End of 1992 End of 1993 End of 1994
Current assets:
Contract receivable Br. 30, 000 Br. 70, 000 Br. 120, 000
Current liabilities
Billings in excess of costs and
Estimated earnings on uncompleted contract Br. 25, 000

Computation: End of 1992 End of 1993

Cost incurred on uncompleted contract Br. 200, 000 Br. 450, 000
Estimated Earnings 100, 000 225, 000

53
 Br. 300, 000 Br. 675, 000
Less: Billings to date 300, 000 700, 000
Billings in excess of cost and _____ _______
Estimated earning on uncompleted contract 0 Br. 25, 000

(2) Completed contract Method

End of 1992 End of 1993 End of 1994
Current assets:
Contract receivable Br. 30, 000 Br. 70, 000 Br. 120, 000

Current liabilities:
Billings in excess of costs Br. 100, 000 Br. 250, 000
Costs incurred on uncompleted contracts Br. 200, 000 Br. 450, 000
Less: Billings to date 300, 000 700, 000
Billings in excess of costs on
Uncompleted contract Br. (100, 000) Br. (250, 000)

Note 1. The progress Billings ledger account is a contra to the cost of contracts in
progress and the estimated earnings on contracts in progress ledger accounts. In
essence, the balance of the progress Billings ledger account on any date prior to
completion of the construction project represents the customer’s equity interest
in the project.
2. The cost of contracts in progress ledger account is similar to the goods in process
inventory account of a manufacturing enterprise. In the cost of contracts in
progress account are recorded the material, direct labor, and overhead costs
incurred by the contractor, as well as costs associated with work performed by
subcontractors.
3. When the cost-to-cost method is used to estimate the percentage of completion of
a construction type contract, the cost of contract revenue for an accounting
period is identical to the total construction costs incurred in that period. Thus,
the debits to the cost of contract revenue account are the same as the debits to

54
 the cost of contracts in progress account. However, cost of goods sold of a
manufacturing enterprise, appears in the income statement of the contractor and
is closed at the end of each accounting period.
4. The estimated earnings on contracts in progress ledger account is a positive
valuation account for the cost of contracts in progress account. The use of a
separate account for the accrual of earnings on a contract under the percentage
of completion method preserves the record of actual costs incurred on the
contracts in the cost of contracts in progress account and still achieves the goal
of increasing the carrying amount of the contracts in progress account.

55