Chapter Nine Inventory: Additional Issues

1. Chapter Nine Inventory: Additional Issues

2. LCM is a departure from historical cost and is a conservative accounting method. Lower of Cost or Market (LCM) GAAP requires that inventories be carried at cost or current market value, whichever is lower.

3. Determining Market Value Net Realizable Value (Ceiling) • Market value is NOT necessarily the amount for which inventory can be sold. • Accounting Research Bulletin No. 43 defines “market value” in terms of current replacement cost. Net Realizable Value less Normal Profit (Floor)

4. Determining Market Value Net Realizable Value (NRV) is the estimated selling price less cost of completion and disposal. Net Realizable Value (Ceiling) Replacement Cost The definition of market value varies internationally. In the UK, Denmark, Finland, and New Zealand, market value is defined as NRV. Net Realizable Value less Normal Profit (Floor)

5. Determining Market Value Net Realizable Value (Ceiling) If replacement cost > Ceiling, then Ceiling = Market Value Replacement Cost If replacement cost < Floor, then Floor = Market Value Net Realizable Value less Normal Profit (Floor)

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?

7. LCM - Example Net Realizable Value (Ceiling) Which one do we use? Replacement Cost =$21.50 Net Realizable Value less Normal Profit (Floor)

8. LCM - Example Net Realizable Value (Ceiling) In this case, market value will be $21.50, because the replacement cost is between the ceiling and the floor. Replacement Cost =$21.50 Market value = $21.50 Cost = $20.00 Should the inventory be recorded at cost or market? Market value = $21.50 Cost = $20.00 Since Cost < Market, the LCM rule would dictate that inventory be recorded at Cost. Net Realizable Value less Normal Profit (Floor)

9. LCM - Another Example An inventory item is currently carried at historical cost of $95.00 per unit. At the Balance Sheet date we gather the following per unit information: current replacement cost = $80.00; NRV = $100.00; and NRV reduced by normal profit = $85.00. How would we value the item on our Balance Sheet?

10. Lower of Cost or MarketAnother Example Net Realizable Value (Ceiling) = $100 ? Which one do we use as market value? Replacement Cost =$80 ? ? Net Realizable Value less Normal Profit (Floor) = $85

11. Lower of Cost or MarketAnother Example Net Realizable Value (Ceiling) = $100 Replacement Cost =$80 Should the inventory be carried at Market Value or Cost? Market = $85 < Cost = $95 Our inventory item will bewritten downto the Market Value $85. Net Realizable Value less Normal Profit (Floor) = $85

12. Applying LCM LCM can be applied 3 different ways. 1. Apply LCM to each individual item in inventory. 2. Apply LCM to each class of inventory. 3. Apply LCM to the entire inventory as a group.

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.

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

15. Gross Profit Method Auditors are testing the overall reasonableness of client inventories. Estimating inventory & COGS for interim reports. Useful when . . . Determining the cost of inventory lost, destroyed, or stolen. Preparing budgets and forecasts. NOTE: The Gross Profit Method is not accepted by GAAP.

16. Gross Profit Method Assumes that the historical gross margin rate is reasonably constant in the short run. Net sales for the period. Cost of beginning inventory. We need to know . . . Historical gross margin rate. Net purchases for the period.

17. Steps to the Gross Profit Method • Estimate Historical Gross Margin %. • Sales x (1 - Estimated Gross Margin %) = Estimated COGS • Beg. Inventory + Net Purchases = Cost of Goods Available for Sale (COGAS) • COGAS - Estimated COGS = Estimated Cost of Ending Inventory

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.

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

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 inventory at retail to ending inventory at cost.

21. Retail Inventory Method Beginning inventory at retail and cost. Sales for the period. We need to know . . . Adjustments to the original retail price. Net purchases at retail and cost.

22. Steps to the Retail Inventory Method • Determine cost and retail value of goods sold. • Calculate the cost-to-retail %. • Retail value of goods available for sale - sales = ending inventory at retail. • Cost-to-retail % x Ending inventory at retail = Estimated ending inventory at cost.

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.

24. Retail Inventory Method Example

25. x Retail Inventory Method Example

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 %.

27. Retail Inventory MethodAverage 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.

28. Retail Inventory MethodAverage Cost Example

29. x Retail Inventory MethodAverage Cost Example

30. Retail Inventory Method Average LCM • Approximating Average LCM Net Markdowns are excluded in the computation of the Cost-to-Retail %

31. Retail Inventory Method Average LCM 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. • Let’s estimate inventory at June 30.

32. Retail Inventory Method Average LCM Example

33. x Retail Inventory Method Average LCM Example

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.

35. The LIFO Retail Method Beginning inventory has its own cost-to-retail percentage.

36. The LIFO Retail MethodExample • 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.

37. The LIFO Retail MethodExample

38. Others Issues of Retail Method • Purchase returns and purchase discounts. • Freight-in. • Employee discounts. • Spoilage, breakage, and theft.

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.

40. Dollar-Value LIFO RetailExample 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.

41. Dollar-Value LIFO RetailExample

42. Changes in Inventory Method Recall that most voluntary changes in accounting principles are reported retrospectively. This means reporting all previous periods’ financial statements as if the new method had been used in all prior period. Changes in inventory methods, other that a change to LIFO are treated retrospectively. Change to FIFO Retrospective Change from LIFO

43. Change To The LIFO Method When a company elects to change to LIFO it is usually impossible 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) thenature of the change, (b) the effect of thechange on current year’s income andearnings per share, and (c) why retrospective application was impracticable.

44. 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.

45. 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.

46. 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.

47. End of Chapter 9