copyright © 2007 by the mcgraw-hill companies, inc. all rights reserved. inventories: additional...
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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
Determining Market Value
Net RealizableValue (Ceiling)
Net Realizable Value less Normal Profit
(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
Determining Market Value
Net Realizable Value less Normal Profit
(Floor)
Net RealizableValue (Ceiling)
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 RealizableValue (Ceiling)
Net Realizable Value less Normal
Profit (Floor)
ReplacementCost =$21.50
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?
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?
Market value = $21.50Market value = $21.50Cost = $20.00Cost = $20.00
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.
Market value = $21.50Market value = $21.50Cost = $20.00Cost = $20.00
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.
Lower of Cost or Market
Net RealizableValue (Ceiling)
Net Realizable Value less Normal
Profit (Floor)
ReplacementCost =$21.50
ReplacementCost =$21.50
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
Lower of Cost or Market
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
Lower of Cost or Market
Net Realizable Value less Normal Profit
(Floor) = $85
Net Realizable Value (Ceiling) = $100
ReplacementCost =$80
ReplacementCost =$80
?
?
?
Which one do we use as
market value?
Which one do we use as
market value?
9-12
Lower of Cost or Market
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.
Net Realizable Value less Normal Profit
(Floor) = $85
Net Realizable Value (Ceiling) = $100
ReplacementCost =$80
ReplacementCost =$80
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
Retail Inventory Method
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
Retail Inventory Method
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 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.
9-27
Retail Inventory Method
9-28
Retail Inventory Method
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 purchases at cost $200,000Net purchases at cost $200,000(at retail $304,000)(at retail $304,000)
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.
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 purchases at cost $200,000Net purchases at cost $200,000(at retail $304,000)(at retail $304,000)
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.
9-31
Retail Inventory Method - Average Cost
9-32
Retail Inventory Method - Average Cost
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
Retail Inventory Method - Average LCM
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 purchases at cost $200,000Net purchases at cost $200,000(at retail $304,000)(at retail $304,000)
Net markups $8,000Net markups $8,000Net markdowns $4,000Net markdowns $4,000
Net sales for June $300,000Net sales for June $300,000
Let’s estimate inventory at June 30.
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 purchases at cost $200,000Net purchases at cost $200,000(at retail $304,000)(at retail $304,000)
Net markups $8,000Net markups $8,000Net markdowns $4,000Net markdowns $4,000
Net sales for June $300,000Net sales for June $300,000
Let’s estimate inventory at June 30.
9-36
Retail Inventory Method - Average LCM
9-37
Retail Inventory Method - Average LCM
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
The LIFO Retail Method
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
The LIFO Retail Method
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
Dollar-Value LIFO Retail
Use the data from Matrix Inc. to estimate the LIFO ending inventory.
Beginning inventory at cost $21,000Beginning inventory at cost $21,000(at retail $35,000)(at retail $35,000)
Net purchases at cost $200,000Net purchases at cost $200,000(at retail $304,000)(at retail $304,000)
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. Estimate ending inventory.
Use the data from Matrix Inc. to estimate the LIFO ending inventory.
Beginning inventory at cost $21,000Beginning inventory at cost $21,000(at retail $35,000)(at retail $35,000)
Net purchases at cost $200,000Net purchases at cost $200,000(at retail $304,000)(at retail $304,000)
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. Estimate ending inventory.
9-46
Dollar-Value LIFO Retail
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
Understates pretax income.Understates pretax income.
Understatement of beginning inventoryUnderstates cost of goods sold andUnderstates cost of goods sold and
Overstates pretax income.Overstates pretax income.
9-53
Inventory Errors
Overstatement of purchasesOverstates cost of goods sold andOverstates cost of goods sold and
Understates pretax income.Understates pretax income.
Understatement of purchasesUnderstates cost of goods sold andUnderstates cost of goods sold and
Overstates pretax income.Overstates pretax income.
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