© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Chapter 9 Inventory: Additional Issues.

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Chapter 9

Inventory:

Additional Issues


Slide9-2

Lower of Cost or Market (LCM)

GAAP requires that inventories be carried at cost or current market

value, whichever is lower.

GAAP requires that inventories be carried at cost or current market

value, whichever is lower.

LCM is a departure from historical cost and is a conservative accounting

method.

LCM is a departure from historical cost and is a conservative accounting

method.


Slide9-3

Determining Market Value

Net RealizableValue (Ceiling)

Net Realizable Value less Normal Profit

(Floor)

• Market value is NOT Market value is NOT necessarily the necessarily the amount for which amount for which inventory can be inventory can be sold.sold.

• Accounting Research Accounting Research Bulletin No. 43 Bulletin No. 43 defines “market defines “market value” in terms of value” in terms of current replacement current replacement cost.cost.

• Market value is NOT Market value is NOT necessarily the necessarily the amount for which amount for which inventory can be inventory can be sold.sold.

• Accounting Research Accounting Research Bulletin No. 43 Bulletin No. 43 defines “market defines “market value” in terms of value” in terms of current replacement current replacement cost.cost.


Slide9-4




(Floor)

Net Realizable Value (NRV) is the estimated selling price less cost of completion and

disposal.

Net Realizable Value (NRV) is the estimated selling price less cost of completion and

disposal.

ReplacementCost

ReplacementCost

The definition of The definition of market market valuevalue varies varies

internationally. In the UK, internationally. In the UK, Denmark, Finland, and Denmark, Finland, and New Zealand, market New Zealand, market

value is defined as NRV.value is defined as NRV.

The definition of The definition of market market valuevalue varies varies

internationally. In the UK, internationally. In the UK, Denmark, Finland, and Denmark, Finland, and New Zealand, market New Zealand, market

value is defined as NRV.value is defined as NRV.


Slide9-5



(Floor)


If replacement cost > Ceiling, then

Ceiling = Market Value

ReplacementCost

ReplacementCost

If replacement cost < Floor, then

Floor = Market Value


Slide9-6

LCM - Example

An item in inventory is currently carried at historical cost of $20 per unit. At year-end we gather the following per unit information: current replacement cost = $21.50; selling price = $30; cost to complete and dispose = $4; and normal profit margin of = $5.

How would we value this item on the Balance Sheet?


Slide9-7

LCM - Example


Net Realizable Value less Normal

Profit (Floor)

ReplacementCost =$21.50


Which one do we use?


Slide9-8

Market value = $21.50Market value = $21.50Cost = $20.00Cost = $20.00

Should the inventory be Should the inventory be recorded at cost or market?recorded at cost or market?


Should the inventory be Should the inventory be recorded at cost or market?recorded at cost or market?


Since Cost < Market, the LCM Since Cost < Market, the LCM rule would dictate that inventory rule would dictate that inventory

be recorded at Cost.be recorded at Cost.


Since Cost < Market, the LCM Since Cost < Market, the LCM rule would dictate that inventory rule would dictate that inventory

be recorded at Cost.be recorded at Cost.

LCM - Example


Net Realizable Value less Normal

Profit (Floor)



In this case, market value will be In this case, market value will be $21.50, because the $21.50, because the

replacement cost is between the replacement cost is between the ceiling and the floor.ceiling and the floor.

In this case, market value will be In this case, market value will be $21.50, because the $21.50, because the

replacement cost is between the replacement cost is between the ceiling and the floor.ceiling and the floor.


Slide9-9

LCM - Another Example

An inventory item is currently carried at An inventory item is currently carried at historical cost of $95.00 per unit. At the historical cost of $95.00 per unit. At the

Balance Sheet date we gather the Balance Sheet date we gather the following per unit information: current following per unit information: current

replacement cost = $80.00; NRV = replacement cost = $80.00; NRV = $100.00; and NRV reduced by normal $100.00; and NRV reduced by normal

profit = $85.00.profit = $85.00.How would we value the item on our How would we value the item on our

Balance Sheet?Balance Sheet?

An inventory item is currently carried at An inventory item is currently carried at historical cost of $95.00 per unit. At the historical cost of $95.00 per unit. At the

Balance Sheet date we gather the Balance Sheet date we gather the following per unit information: current following per unit information: current

replacement cost = $80.00; NRV = replacement cost = $80.00; NRV = $100.00; and NRV reduced by normal $100.00; and NRV reduced by normal

profit = $85.00.profit = $85.00.How would we value the item on our How would we value the item on our

Balance Sheet?Balance Sheet?


Slide9-10 Lower of Cost or Market

Another Example


(Floor) = $85

Net Realizable Value (Ceiling) = $100

ReplacementCost =$80


?

?

?

Which one do we use as

market value?

Which one do we use as

market value?


Slide9-11 Lower of Cost or Market

Another Example

Should the inventory be carried at Market Value or Cost?

Should the inventory be carried at Market Value or Cost?

Market = $85 < Cost = $95

Our inventory item will be written down to the Market Value $85.

Market = $85 < Cost = $95

Our inventory item will be written down to the Market Value $85.


(Floor) = $85

Net Realizable Value (Ceiling) = $100




Slide9-12

1. Apply LCM to 1. Apply LCM to each individual itemeach individual item in in inventory. inventory.

1. Apply LCM to 1. Apply LCM to each individual itemeach individual item in in inventory. inventory. 2. Apply LCM to each 2. Apply LCM to each classclass of inventory. of inventory. 2. Apply LCM to each 2. Apply LCM to each classclass of inventory. of inventory. 3. Apply LCM to the 3. Apply LCM to the entireentire inventory as a inventory as a

group. group. 3. Apply LCM to the 3. Apply LCM to the entireentire inventory as a inventory as a

group. group.

Applying LCMLCM can be applied 3 different ways.


Slide9-13 Adjusting Cost to Market -

Options

Record the Loss as a Separate Item in the Income Statement

Adjust inventory directly or using an allowance account.

Record the Loss as part of COGS Adjust inventory directly or using an

allowance account.


Slide9-14

Inventory Estimation Techniques

Estimate instead of taking physical inventory Less costly Less time consuming

Two popular methods are . . . Gross Profit Method Retail Inventory Method


Slide9-15

Gross Profit Method

Useful when . . .

Useful when . . .

Estimating inventory & COGS for interim

reports.

Estimating inventory & COGS for interim

reports.

Determining the cost of inventory

lost, destroyed, or stolen.

Determining the cost of inventory

lost, destroyed, or stolen.

Auditors are testing the overall

reasonableness of client inventories.

Auditors are testing the overall

reasonableness of client inventories.

Preparing budgets and forecasts.

Preparing budgets and forecasts.

NOTE: The Gross Profit Method is not accepted by GAAP.NOTE: The Gross Profit Method is not accepted by GAAP.


Slide9-16

Gross Profit MethodAssumes that the historical gross margin

rate is reasonably constant in the short run.

Assumes that the historical gross margin rate is reasonably constant in the short run.

Cost of beginning inventory.

Cost of beginning inventory.

Net purchases for the period.

Net purchases for the period.

Historical gross margin rate.

Historical gross margin rate.

Net sales for the period.

Net sales for the period.

We need to know . . .



Slide9-17

Steps to the Gross Profit Method

1. Estimate historical Gross Margin %.

2. Sales x (1 - Estimated Gross Margin %) = Estimated COGS

3. Beg. Inventory + Net Purchases = Cost of Goods Available for Sale (COGAS)

4. Estimated COGS - COGAS = Estimated Cost of Ending Inventory


Slide9-18 Gross Profit Method

Example

NoteCo, Inc. uses the gross profit method to estimate end of month inventory. At the end of May, the controller has the following data:

•Net sales for May = $1,213,000;

•Net purchases for May = $728,300;•Inventory at May 1 = $237,400; •Gross margin = 43% of sales.

Estimate Inventory at May 31.Estimate Inventory at May 31.

NoteCo, Inc. uses the gross profit method to estimate end of month inventory. At the end of May, the controller has the following data:

•Net sales for May = $1,213,000;

•Net purchases for May = $728,300;•Inventory at May 1 = $237,400; •Gross margin = 43% of sales.

Estimate Inventory at May 31.Estimate Inventory at May 31.


Slide9-19 Gross Profit Method

Example

NOTE: The key to successfully applying this method is a reliable Gross Margin %.

NOTE: The key to successfully applying this method is a reliable Gross Margin %.


Slide9-20

Retail Inventory Method

This method was developed for retail operations like department stores.

Uses both the retail value and cost of items for sale to calculate a cost to retail ratio.

Objective: Convert ending Objective: Convert ending inventory at retail to ending inventory at retail to ending

inventory at cost.inventory at cost.

Objective: Convert ending Objective: Convert ending inventory at retail to ending inventory at retail to ending

inventory at cost.inventory at cost.


Slide9-21

Retail Inventory Method



Sales for the period.

Sales for the period.

Beginning inventory at retail

and cost.

Beginning inventory at retail

and cost.

Adjustments to the original retail price.

Adjustments to the original retail price.

Net purchases at retail and cost.

Net purchases at retail and cost.


Slide9-22 Steps to the Retail Inventory

Method

1. Determine cost and retail value of goods sold.

2. Calculate the cost-to-retail %.

3. Retail value of goods available for sale - sales = ending inventory at retail.

4. Cost-to-retail % x Ending inventory at retail = Estimated ending inventory at cost.


Slide9-23 Retail Inventory Method

Example

Webb Clothiers, Inc. uses the retail method to estimate inventory at the end of each month. For

the month of May the controller gathers the following information:

Beg. inventory at cost $27,000 (at retail $45,000), net purchases at cost $180,000 (at retail $300,000); net sales for May $310,000.

Estimate the inventory at May 31.

Webb Clothiers, Inc. uses the retail method to estimate inventory at the end of each month. For

the month of May the controller gathers the following information:

Beg. inventory at cost $27,000 (at retail $45,000), net purchases at cost $180,000 (at retail $300,000); net sales for May $310,000.

Estimate the inventory at May 31.



Example



Example

x


Slide9-26

Approximating Average Cost

The primary difference between this and our earlier,

simplified example, is the inclusion of markups and

markdowns in the computation of the Cost-to-Retail %.

The primary difference between this and our earlier,

simplified example, is the inclusion of markups and

markdowns in the computation of the Cost-to-Retail %.



Average Cost Example

Webb, Inc. uses the average cost retail method to estimate inventory at the end of June. The

controller gathers the following information:

Beginning inventory at cost $21,000 (at retail $35,000), net purchases at cost $200,000 (at

retail $304,000), net markups $8,000, net markdowns $4,000, and net sales for June

$300,000.

Estimate inventory at June 30.





$300,000.

Estimate inventory at June 30.




x



Average LCM

Approximating Average LCM

Net Markdowns are excluded in the

computation of the Cost-to-Retail %

Net Markdowns are excluded in the

computation of the Cost-to-Retail %



Average LCM Example





$300,000.

Let’s estimate inventory at June 30.





$300,000.

Let’s estimate inventory at June 30.



Average LCM Example



Average LCM Example

x


Slide9-34

The LIFO Retail Method

Assume that retail prices of goods remain stable during the period.Establish a LIFO base layer (beginning inventory) and add (or subtract) the layer from the current period.Calculate the cost-to-retail percentage for beginning inventory and for adjusted net purchases for the period.


Slide9-35

The LIFO Retail Method

Beginning inventory has its owncost-to-retail percentage.

Beginning inventory has its owncost-to-retail percentage.


Slide9-36 The LIFO Retail Method

Example

Use the data from Webb Inc. to estimate the LIFO ending inventory. Beginning inventory at cost $21,000, at retail

$35,000; Net purchases at cost $200,000, at retail

$304,000; Net markups $8,000; Net markdowns $4,000; Net sales for June $300,000.

Estimate ending inventory.


Slide9-37 The LIFO Retail Method

Example


Slide9-38

Others Issues of Retail Method

Purchase returns and purchase discounts.

Freight-in.

Employee discounts.

Spoilage, breakage, and theft.


Slide9-39

Dollar-Value LIFO Retail

We need to eliminate the effect of any price changes before we compare

the ending inventory with the beginning inventory.


Slide9-40 Dollar-Value LIFO Retail

Example

Use the data from Webb Inc. to estimate the LIFO ending inventory.

Beginning inventory at cost $21,000, at retail

$35,000; Net purchases at cost $200,000, at retail $304,000; Net markups $8,000; Net markdowns $4,000; Net sales for June $300,000.

Price index at June 1 is 100 and at June 30 the index is 102. Estimate ending inventory.

Use the data from Webb Inc. to estimate the LIFO ending inventory.

Beginning inventory at cost $21,000, at retail

$35,000; Net purchases at cost $200,000, at retail $304,000; Net markups $8,000; Net markdowns $4,000; Net sales for June $300,000.

Price index at June 1 is 100 and at June 30 the index is 102. Estimate ending inventory.


Slide9-41 Dollar-Value LIFO Retail

Example


Slide9-42

Changes in Inventory Method

Changes not involving LIFO Report the cumulative effect of the change, net of

tax, on the current income statement.

Changes to LIFO from other methods Usually impossible to determine the cumulative

effect.

Changes from LIFO to other methods Retroactively restate financial statements for each

year reported.


Slide9-43

Inventory Errors

Overstatement of ending inventory Understates cost of goods sold and Overstates pretax income.

Understatement of ending inventory Overstates cost of goods sold and Understates pretax income.


Slide9-44

Inventory Errors

Overstatement of beginning inventory Overstates cost of goods sold and Understates pretax income.

Understatement of beginning inventory Understates cost of goods sold and Overstates pretax income.


Slide9-45

Inventory Errors

Overstatement of purchases Overstates cost of goods sold and Understates pretax income.

Understatement of purchases Understates cost of goods sold and Overstates pretax income.


Slide9-46

End of Chapter 9

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Chapter 9 Inventory: Additional Issues.

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Transcript of © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Chapter 9 Inventory: Additional Issues.