Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Inventories: Additional Issues 9.

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Inventories: Additional

Issues

9

9-2

Learning Objective

Understand and apply the lower-of-cost-or-market rule used to value inventories.

9-3

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

method.method.

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

method.method.

9-4

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 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.

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 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.

9-5




(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 many internationally. In many countries, for example countries, for example

New Zealand market value New Zealand market value is defined as NRV.is defined as NRV.

The definition of The definition of market market valuevalue varies varies

internationally. In many internationally. In many countries, for example countries, for example

New Zealand market value New Zealand market value is defined as NRV.is defined as NRV.

9-6



(Floor)


If replacement cost > Ceiling, then

Ceiling = Market Value

ReplacementCost

ReplacementCost

If replacement cost < Floor, then

Floor = Market Value

9-7

Lower of Cost or Market 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 = $21.50current replacement cost = $21.50selling price = $30selling price = $30cost 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?

9-8

Lower of Cost or Market


Net Realizable Value less Normal

Profit (Floor)

ReplacementCost =$21.50


Which one do we use?

9-9

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.



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 replacement $21.50 because the replacement cost is between the ceiling and cost is between the ceiling and

the floor.the floor.

In this case, market value will be In this case, market value will be $21.50 because the replacement $21.50 because the replacement cost is between the ceiling and cost is between the ceiling and

the floor.the floor.

9-10


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: following per unit information:

current replacement cost = $80.00current replacement cost = $80.00NRV = $100.00NRV = $100.00

NRV reduced by normal profit = $85.00NRV reduced by normal profit = $85.00How 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: following per unit information:

current replacement cost = $80.00current replacement cost = $80.00NRV = $100.00NRV = $100.00

NRV reduced by normal profit = $85.00NRV reduced by normal profit = $85.00How would we value the item on our How would we value the item on our

Balance Sheet?Balance Sheet?

9-11



(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?

9-12


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



9-13

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 Market

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

9-14

Adjusting Cost to Market - Options

Record the Loss as a Separate Item in the Income Statement

Adjust inventory directly or by using an allowance account.

Record the Loss as part of Cost of Good Sold

Adjust inventory directly or by using an allowance account.

9-15

Learning Objective

Estimate ending inventory and cost ofgoods sold using the gross profit method.

9-16

Inventory Estimation Techniques

Estimate instead of taking physical inventory Less costly

Less time consumingTwo popular methods are . . .

Gross Profit MethodGross Profit Method

Retail Inventory MethodRetail Inventory Method

9-17

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 acceptable for use in annual financial statements.

NOTE: The Gross Profit Method is not acceptable for use in annual financial statements.

9-18

Gross Profit Method

This method assumes that the historical gross margin rate is reasonably

constant in the short run.

This method 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 We need to know . . .know . . .

We need to We need to know . . .know . . .

9-19

Steps to the Gross Profit Method

1.1. Estimate Historical Gross Margin %.Estimate Historical Gross Margin %.

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

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

4.4. COGAS - Estimated COGS = Estimated COGAS - Estimated COGS = Estimated Cost of Ending InventoryCost of Ending Inventory

1.1. Estimate Historical Gross Margin %.Estimate Historical Gross Margin %.

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

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

4.4. COGAS - Estimated COGS = Estimated COGAS - Estimated COGS = Estimated Cost of Ending InventoryCost of Ending Inventory

9-20

Gross Profit Method

Matrix, 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.

Matrix, 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.

9-21

Gross Profit Method

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

method is a reliable Gross Margin Percentage.

9-22

Learning Objective

Estimate ending inventory and cost ofgoods sold using the retail inventory method,

9-23

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.

9-24


We need to know . . .

We need to know . . .

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.

9-25

Steps to the Retail Inventory Method

1.1. Determine cost and retail value of goods Determine cost and retail value of goods sold.sold.

2.2. Calculate the cost-to-retail %. Calculate the cost-to-retail %.

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

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

9-26


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

month of May the controller gathers the following month of May the controller gathers the following information: 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 $310,000.Net 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 Matrix, Inc. uses the retail method to estimate inventory at the end of each month. For the inventory at the end of each month. For the

month of May the controller gathers the following month of May the controller gathers the following information: information:

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


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

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

9-27


9-28


x

9-29

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 %.

9-30

Retail Inventory Method - Average Cost

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


Net markups $8,000Net markups $8,000Net markdowns $4,000Net markdowns $4,000

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

Estimate inventory at June 30.






Estimate inventory at June 30.

9-31


9-32


x

9-33

Learning Objective

Explain how the retail inventory methodcan be made to approximate the

lower-of-cost-or-market rule.

9-34

Retail Inventory Method - Average LCM

Approximating Average LCM

Net Markdowns areNet Markdowns are excludedexcluded in the in the

computation of the computation of the Cost-to-Retail %Cost-to-Retail %

Net Markdowns areNet Markdowns are excludedexcluded in the in the

computation of the computation of the Cost-to-Retail %Cost-to-Retail %

9-35







Let’s estimate inventory at June 30.






Let’s estimate inventory at June 30.

9-36


9-37


x

9-38

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.

9-39


Beginning inventory has its owncost-to-retail percentage.

9-40

The LIFO Retail Method Use the data from Matrix Inc. to estimate

the LIFO ending inventory. 1.1. Beginning inventory at cost $21,000, at retail Beginning inventory at cost $21,000, at retail

$35,000;$35,000;2.2. Net purchases at cost $200,000, at retail Net purchases at cost $200,000, at retail

$304,000;$304,000;3.3. Net markups $8,000; Net markups $8,000; 4.4. Net markdowns $4,000; Net markdowns $4,000; 5.5. Net sales for June $300,000.Net sales for June $300,000.

Estimate ending inventory.

9-41


9-42

Other Issues of Retail Method

Purchase returns and purchase discounts.

Freight-in. Employee discounts. Spoilage, breakage, and theft.

9-43

Learning Objective

Determine ending inventory using thedollar-value LIFO retail inventory

method.

9-44

Dollar-Value LIFO Retail

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

9-45


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



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

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


Price index at June 1 is 100 and at June 30

the index is 102. Estimate ending inventory.

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



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

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


Price index at June 1 is 100 and at June 30

the index is 102. Estimate ending inventory.

9-46


9-47

Learning Objective

Explain the appropriate accountingtreatment required when a change

in inventory method is made.

9-48

Changes in Inventory Method

Recall that most voluntary changes in accounting principles are reported retrospectively. This means

reporting all previous periods’ financial statements as though the new method had been used in all prior

periods.

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

treated retrospectively.treated retrospectively.

FIFOFIFO

LIFOLIFO

Change Change toto

Change Change fromfrom

RetrospectiveRetrospective

9-49

Change 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.

9-50

Learning Objective

Explain the appropriate accountingtreatment when an inventory error is

discovered.

9-51

Inventory Errors

Overstatement of ending inventoryUnderstates cost of goods sold andUnderstates cost of goods sold and

Overstates pretax income.Overstates pretax income.

Understatement of ending inventoryOverstates cost of goods sold andOverstates cost of goods sold and

Understates pretax income.Understates pretax income.

9-52

Inventory Errors

Overstatement of beginning inventoryOverstates cost of goods sold andOverstates cost of goods sold and


Understatement of beginning inventoryUnderstates cost of goods sold andUnderstates cost of goods sold and


9-53

Inventory Errors

Overstatement of purchasesOverstates cost of goods sold andOverstates cost of goods sold and


Understatement of purchasesUnderstates cost of goods sold andUnderstates cost of goods sold and


9-54

Appendix 9

PurchaseCommitments

9-55

Purchase 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 2006, Matrix, Inc. signed two purchase commitments. The first requires Matrix to purchase raw materials for $100,000 byDecember 1, 2006. On December 1, 2006, the raw materialshad a market value of $90,000. The second requires Matrixto purchase inventory items for $200,000 by March 1, 2007.

On December 31, 2006, the market value of the inventory itemswere $188,000. On March 1, 2007, the market value of the inventory

items were $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 2006, Matrix, Inc. signed two purchase commitments. The first requires Matrix to purchase raw materials for $100,000 byDecember 1, 2006. On December 1, 2006, the raw materialshad a market value of $90,000. The second requires Matrixto purchase inventory items for $200,000 by March 1, 2007.

On December 31, 2006, the market value of the inventory itemswere $188,000. On March 1, 2007, the market value of the inventory

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

Let’s make the journal entries for these commitments.

9-56

Purchase CommitmentsDate Description Debit Credit

7/1/06 Raw materials inventory 100,000 Accounts payable 100,000

12/1/06 Accounts payable 100,000 Cash 100,000

12/1/06 Loss on purchase commitment 10,000 Raw materials inventory 10,000

12/31/06 Estimated loss on commitment 12,000 Estimated liability on commitment 12,000

3/1/07 Inventory 186,000 Estimated liability on commitment 12,000 Loss on purchase commitment 2,000 Cash 200,000

Single year commitment

Multi-year Commitment

9-57

End of Chapter 9

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Inventories: Additional Issues 9.

Documents

cost market

market lower of cost

market value slide

current market value

historical cost

replacement cost ceiling

replacement cost floor

definition of market