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Chapter 9

Chapter 9. Inventory: Additional Issues. 1. Lower of Cost or NRV. Required by GAAP Inventory must be reported on financial statements at lower of cost or NRV Theory should not report inventory at a value higher than benefits to be received from selling it. 1a. Lower of Cost or NRV.

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Chapter 9

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  1. Chapter 9 Inventory: Additional Issues

  2. 1. Lower of Cost or NRV • Required by GAAP • Inventory must be reported on financial statements at lower of cost or NRV • Theory • should not report inventory at a value higher than benefits to be received from selling it

  3. 1a. Lower of Cost or NRV • Definition of NRV • NRV = selling price – selling costs • e.g., amount you would net when item is sold • examples of selling costs: • completion costs • selling commissions • shipping costs

  4. 2. Change in Inventory Methods • Change in accounting estimate • account for prospectively • Change in accounting principle • account for retrospectively • Change in reporting entity • account for retrospectively • Change in inventory methods • change to any method except LIFO – retrospectively • change to LIFO – prospectively, because usually impossible to know old layers

  5. 3. Inventory Estimation Methods • Gross profit method • based on relationship between sales and gross profit • not acceptable for financial reporting or taxes • Retail method • used by large volume retailers • dollar based method – not unit based method • acceptable for financial reporting and taxes

  6. 4. Gross Profit Method • Based on assumptions that • gross profit is constant from period-to-period • sales mix of products is constant • Used to estimate inventory value

  7. 4a. Gross Profit Method • Example Sales $200 Cost of goods sold $120 Gross profit $ 80 • GP % = 80/200 = 40% • CGS% = 120/200 = 60% • GP% on sales = 80/200 = 40% • GP% on cost = 80/120 = 66⅔% GP on Sales = GP on Costs 1 + GP on Costs

  8. 4a. Gross Profit Method • ExampleA hurricane destroyed the entire inventory stored in a warehouse. The following information is available from the company’s records. Beginning inventory $220,000 Purchases $400,000 Sales $600,000 Historical gross profit rate 30% Required: Estimate the cost of the destroyed inventory.

  9. 4a. Gross Profit Method • Example — Solution Beginning inventory (from records) $220,000 Plus: Net purchases (from records) 400,000 Cost of goods available for sale 620,000 Less: Cost of goods sold: Net sales $600,000Less: Estimated gross profit of 30% (180,000) Estimated cost of goods sold (420,000) Estimated cost of inventory destroyed $200,000

  10. 5. Retail Method • Method is based on the pattern between the cost and retail value of the goods • Method requires: • total costs of goods purchased • total retail value of goods available for sale • total sales • Companies always keep 1 & 3 • with this method also must keep 2

  11. 5a. Retail Method • Basic method

  12. 5c. Retail Method • Retail terminology • Net markups and net markdowns

  13. 5b. Retail Method • Ratios – computed as: cost of goods available for sale retail value of goods available for sale • Based on how ratio computed, can be used to approximate following methods: • average – include everything • LCM – exclude markdowns (conventional retail method) • FIFO – exclude beginning inventory • LIFO – compute separate ratio for each layer

  14. 5d. Retail Method

  15. 5e. Retail Method Avg. method

  16. 5f. Retail Method LCM method

  17. 5g. Retail Method FIFO method

  18. 5h. Retail Method • Example

  19. 6. Inventory Errors • Overstatement of ending inventory • Understates cost of goods sold • Overstates pretax income • Understatement of ending inventory • Overstates cost of goods sold • Understates pretax income • Overstatement of beginning inventory • Overstates cost of goods sold • Understates pretax income • Understatement of beginning inventory • Understates cost of goods sold • Overstates pretax income

  20. 6a. Effect of errors • Self-correcting errors • most errors correct themselves over time • e.g., inventory – this year’s ending inventory is next year’s beginning inventory • depreciable assets – over the life of the assets • Permanent errors • never will correct themselves • e.g., expensing land, recording wrong amount

  21. 6b. Effect of errors • Determining effect of errors • determine effect for all accounts involved • examples • ending inventory overstated • interest expense not accrued on N/P this year, next year principle and interest paid in full

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