McGraw-Hill /Irwin© 2009 The McGraw-Hill Companies, Inc. INVENTORIES: ADDITIONAL ISSUES Chapter 9.

McGraw-Hill /Irwin © 2009 The McGraw-Hill Companies, Inc.

INVENTORIES:INVENTORIES:ADDITIONAL ISSUESADDITIONAL ISSUES

Chapter 9

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Reporting -- Lower of Cost or MarketReporting -- Lower of Cost or Market

GAAP requires that inventories be carried at cost or current market

value, whichever is lower.

LCM is a departure from historical cost.LCM is a departure from historical cost.LCM is a departure from historical cost.LCM is a departure from historical cost.

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Determining Market ValueDetermining Market Value

Market Should Not Exceed Net Realizable

Value (Ceiling)

Market Should Not Be Less Than Net Realizable Value less Normal Profit

(Floor)

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

Replacement cost is Replacement cost is constrained to fall constrained to fall between the “ceiling” between the “ceiling” and the “floor.”and the “floor.”

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

Replacement cost is Replacement cost is constrained to fall constrained to fall between the “ceiling” between the “ceiling” and the “floor.”and the “floor.”

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Determining Market ValueDetermining Market Value

CeilingCeilingNRVNRV

CeilingCeilingNRVNRV

ReplacementReplacementCostCost

ReplacementReplacementCostCost

NRV – NPNRV – NPFloorFloor

NRV – NPNRV – NPFloorFloor

DesignatedDesignatedMarketMarket

DesignatedDesignatedMarketMarket

CostCostCostCostNot More Than

Not Less Than

Or

Step 1Determine Designated Market

Step 2Compare Designated Market with Cost

Lower of CostLower of CostOr MarketOr Market

Lower of CostLower of CostOr MarketOr Market

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Lower of Cost or MarketLower of Cost or Market

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

How would we value this item in the Balance Sheet?

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Lower of Cost or MarketLower of Cost or Market

ReplacementCost =$21.50

ReplacementCost =$21.50

$21.50

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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 Lower of Cost or MarketApplying Lower of Cost or Market

Lower of cost or market can be applied 3 different ways.

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Adjusting Cost to MarketAdjusting Cost to Market

1. Record the Loss as a Separate Item in the Income Statement

Adjust inventory directly or by using an allowance account.

2. Record the Loss as part of Cost of Goods Sold

Adjust inventory directly or by using an allowance account.

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Inventory Estimation TechniquesInventory Estimation Techniques

Estimate instead of taking physical inventory Less costly Less time consuming

Two popular methods are . . .1.1.Gross Profit MethodGross Profit Method

2.2.Retail Inventory MethodRetail Inventory Method

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Gross Profit MethodGross Profit Method

Useful when . . .Useful

when . . .

Estimating inventory & COGS for interim

reports.

Determining the cost of inventory lost,

destroyed, or stolen.

Auditors are testing the overall reasonableness

of client inventories.

Preparing budgets and forecasts.

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Gross Profit MethodGross Profit Method

This method assumes that the historical gross margin ratio is reasonably constant in the short-run.

This method assumes that the historical gross margin ratio is reasonably constant in the short-run.

Beginning Inventory (from accounting records)

Plus: Net purchases (from accounting records)

Goods available for sale (calculated)

Less: Cost of goods sold (estimated)

Ending inventory (estimated)

Estimate the Historical Gross Profit Ratio

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Gross Profit Method Gross Profit Method

Matrix, Inc. uses the gross profit method to estimate Matrix, Inc. uses the gross profit method to estimate end of month inventory. At the end of May, the end of month inventory. At the end of May, the

controller has the following data:controller has the following data:

•Net sales for May = $1,213,000Net sales for May = $1,213,000•Net purchases for May = $728,300Net purchases for May = $728,300

•Inventory at May 1 = $237,400 Inventory at May 1 = $237,400 •Estimated gross profit ratio = 43% of sales Estimated gross profit ratio = 43% of sales

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

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Gross Profit Method Gross Profit Method

NOTE: The key to successfully applying this method is a reliable Gross Profit Ratio.

NOTE: The key to successfully applying this method is a reliable Gross Profit Ratio.

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The Retail Inventory MethodThe 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 percentage.

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

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

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Term Meaning

Initial markup Original amount of markup from cost to selling price.

Additional markup Increase in selling price subsequent to initial markup.

Markup cancellation Elimination of an additional markup.

Markdown Reduction in selling price below the original selling price.

Markdown cancellation Elimination of a markdown.

Retail TerminologyRetail Terminology

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We need to know . . .

We need to know . . .

Sales for the period. Beginning inventory at retail and cost.

Adjustments to the original retail price.

Net purchases at retail and cost.

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

controller gathers the following information: controller gathers the following information:

Beg. inventory at cost $27,000Beg. inventory at cost $27,000(at retail $45,000)(at retail $45,000)

Net purchases at cost $180,000Net purchases at cost $180,000(at retail $300,000)(at retail $300,000)

Net sales for May $310,000Net sales for May $310,000

Estimate the inventory at May 31.Estimate the inventory at May 31.

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

controller gathers the following information: controller gathers the following information:

Beg. inventory at cost $27,000Beg. inventory at cost $27,000(at retail $45,000)(at retail $45,000)


Net sales for May $310,000Net sales for May $310,000

Estimate the inventory at May 31.Estimate the inventory at May 31.

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x

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Approximating Average CostApproximating Average Cost

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Approximating Average LCMApproximating Average LCM

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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.

The LIFO Retail MethodThe LIFO Retail Method

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The LIFO Retail MethodThe LIFO Retail Method

LIFO Cost- = Net Purchases

to-Retail % Retail Value (Net Purchases + Net Markups - Net Markdowns)

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Other Issues of Retail MethodOther Issues of Retail Method

Element Treatment

Before calculating the cost-to-retail percentage

Freight-in Added to the cost column

Purchase returns Deducted in both the cost and retail columns

Purchase discounts taken Deducted in the cost column

Abnormal shortage, spoilage, or theft Deducted in both the cost and retail columns

After calculating the cost-to-retain percentage

Normal shortage, spoilage, or theft Deducted in the retail column

Employee discounts Added to net sales

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Dollar-Value LIFO RetailDollar-Value LIFO Retail

We need to eliminate the effect of any price changes before we compare the ending inventory with the beginning inventory.

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Let’s use this data from Matrix Inc. to estimate the ending inventory using dollar-value LIFO retail.

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


Net markups $8,000Net markups $8,000

Net markdowns $4,000Net markdowns $4,000

Net sales for June $300,000Net sales for June $300,000

Price index at June 1 is 100 and at June 30

the index is 102.

Let’s use this data from Matrix Inc. to estimate the ending inventory using dollar-value LIFO retail.

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


Net markups $8,000Net markups $8,000

Net markdowns $4,000Net markdowns $4,000

Net sales for June $300,000Net sales for June $300,000

Price index at June 1 is 100 and at June 30

the index is 102.

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9-28

Changes in Inventory MethodChanges in Inventory Method

Recall that most voluntary changes in accounting principles are reported

retrospectivelyretrospectively. This means reporting all previous periods’ financial statements as though the new method had been used in

all prior periods.

Changes in inventory methods, other than a Changes in inventory methods, other than a change to LIFO, are treated change to LIFO, are treated retrospectivelyretrospectively..Changes in inventory methods, other than a Changes in inventory methods, other than a change to LIFO, are treated change to LIFO, are treated retrospectivelyretrospectively..

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Change To The LIFO MethodChange To The LIFO Method

When a company elects to change toto LIFO, it is usually impossibleimpossible to calculate the income effect on prior years. As a result, the company does not

report the change retrospectively. Instead, the LIFO method is used from the point of adoption forward.

A disclosure note is needed to explain (a) theA disclosure note is needed to explain (a) thenature of the change; (b) the effect of thenature of the change; (b) the effect of the

change on current year’s income andchange on current year’s income andearnings per share, and (c) why retrospective earnings per share, and (c) why retrospective

application was impracticable.application was impracticable.

A disclosure note is needed to explain (a) theA disclosure note is needed to explain (a) thenature of the change; (b) the effect of thenature of the change; (b) the effect of the

change on current year’s income andchange on current year’s income andearnings per share, and (c) why retrospective earnings per share, and (c) why retrospective

application was impracticable.application was impracticable.

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Inventory ErrorsInventory Errors

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

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

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

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

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

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

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Appendix 9

PurchaseCommitments

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Purchase CommitmentsPurchase Commitments

Purchase commitments are contracts that obligate a company to purchase a specified amount of

merchandise or raw materials at specified prices on or before specified dates.

In July 2009, Matrix, Inc. signed two purchase commitments. The first requires Matrix to purchase raw materials for $100,000 byDecember 1, 2009. On December 1, 2009, the raw materialshad a market value of $90,000. The second requires Matrixto purchase inventory items for $200,000 by March 1, 2010.

On December 31, 2009, the market value of the inventory itemswas $188,000. On March 1, 2010, the market value of the inventory

items was $186,000. Matrix uses the perpetual inventory systemand is a calendar year-end company.

Let’s make the journal entries for these commitments.

In July 2009, Matrix, Inc. signed two purchase commitments. The first requires Matrix to purchase raw materials for $100,000 byDecember 1, 2009. On December 1, 2009, the raw materialshad a market value of $90,000. The second requires Matrixto purchase inventory items for $200,000 by March 1, 2010.

On December 31, 2009, the market value of the inventory itemswas $188,000. On March 1, 2010, the market value of the inventory

items was $186,000. Matrix uses the perpetual inventory systemand is a calendar year-end company.

Let’s make the journal entries for these commitments.

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Purchase CommitmentsPurchase CommitmentsDate Description Debit Credit

7/1/09 Raw materials inventory 100,000 Accounts payable 100,000

12/1/09 Accounts payable 100,000 Cash 100,000

12/1/09 Loss on purchase commitment 10,000 Raw materials inventory 10,000

12/31/09 Estimated loss on commitment 12,000 Estimated liability on commitment 12,000

3/1/10 Inventory 186,000 Estimated liability on commitment 12,000 Loss on purchase commitment 2,000 Cash 200,000

Single year commitment

Multi-year Commitment

McGraw-Hill /Irwin© 2009 The McGraw-Hill Companies, Inc. INVENTORIES: ADDITIONAL ISSUES Chapter 9.

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Transcript of McGraw-Hill /Irwin© 2009 The McGraw-Hill Companies, Inc. INVENTORIES: ADDITIONAL ISSUES Chapter 9.