Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Slide 9-1 Chapter Nine Inventory: Additional Issues

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Slide 9-2 Lower of Cost or Market (LCM) GAAP requires that inventories be carried at cost or current market value, whichever is lower. LCM is a departure from historical cost and is a conservative accounting method.

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Slide 9-3 Determining Market Value Net Realizable Value (Ceiling) Net Realizable Value less Normal Profit (Floor) Market value is NOT necessarily the amount for which inventory can be sold.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.Accounting Research Bulletin No. 43 defines “market value” in terms of current replacement cost. Market value is NOT necessarily the amount for which inventory can be sold.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.Accounting Research Bulletin No. 43 defines “market value” in terms of current replacement cost.

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Slide 9-4 Determining Market Value Net Realizable Value (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. Replacement Cost Replacement Cost The definition of market value varies internationally. In the UK, Denmark, Finland, and New Zealand, market value is defined as NRV.

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Slide 9-5 Determining Market Value Net Realizable Value less Normal Profit (Floor) Net Realizable Value (Ceiling) If replacement cost > Ceiling, then Ceiling = Market Value Replacement Cost Replacement Cost If replacement cost < Floor, then Floor = Market Value

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Slide 9-6 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?

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Slide 9-7 LCM - Example Net Realizable Value (Ceiling) Net Realizable Value less Normal Profit (Floor) Replacement Cost =$21.50 Replacement Cost =$21.50 Which one do we use?

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Slide 9-8 Market value = $21.50 Cost = $20.00 Should the inventory be recorded at cost or market? 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. Market value = $21.50 Cost = $20.00 Since Cost < Market, the LCM rule would dictate that inventory be recorded at Cost. LCM - Example Net Realizable Value (Ceiling) Net Realizable Value less Normal Profit (Floor) Replacement Cost =$21.50 Replacement Cost =$21.50 In this case, market value will be $21.50, because the replacement cost is between the ceiling and the floor.

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Slide 9-9 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 = $ How would we value the item on our Balance Sheet? 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 = $ How would we value the item on our Balance Sheet?

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Slide 9-10 Lower of Cost or Market Another Example Net Realizable Value less Normal Profit (Floor) = $85 Net Realizable Value (Ceiling) = $100 Replacement Cost =$80 Replacement Cost =$80 ? ? ? Which one do we use as market value?

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Slide 9-11 Lower of Cost or Market Another Example 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 Replacement Cost =$80 Replacement Cost =$80

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Slide 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. Applying LCM LCM can be applied 3 different ways.

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Slide 9-13 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.

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Slide 9-14 Inventory Estimation Techniques Estimate instead of taking physical inventory Less costly Less time consuming Two popular methods are... Gross Profit Method Retail Inventory Method

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Slide 9-15 Gross Profit Method 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. NOTE: The Gross Profit Method is not accepted by GAAP.

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Slide 9-16 Gross Profit Method Assumes that the historical gross margin rate is reasonably constant in the short run. Cost of beginning inventory. Net purchases for the period. Historical gross margin rate. Net sales for the period. We need to know...

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Slide 9-17 Steps to the Gross Profit Method 1. Estimate Historical Gross Margin %. 2. Sales x (1 - Estimated Gross Margin %) = Estimated COGS 3. Beg. Inventory + Net Purchases = Cost of Goods Available for Sale (COGAS) 4. COGAS - Estimated COGS = Estimated Cost of Ending Inventory

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Slide 9-18 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. 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.

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Slide 9-19 Gross Profit Method Example NOTE: The key to successfully applying this method is a reliable Gross Margin %.

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Slide 9-20 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.

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Slide 9-21 Retail Inventory Method 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.

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Slide 9-22 Steps to the Retail Inventory Method 1. Determine cost and retail value of goods sold. 2. Calculate the cost-to-retail %. 3. Retail value of goods available for sale - sales = ending inventory at retail. 4. Cost-to-retail % x Ending inventory at retail = Estimated ending inventory at cost.

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Slide 9-23 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. 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.

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Slide 9-24 Retail Inventory Method Example

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Slide 9-25 Retail Inventory Method Example x

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Slide 9-26 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 %.

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Slide 9-27 Retail Inventory Method Average 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. 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.

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Slide 9-28 Retail Inventory Method Average Cost Example

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Slide 9-29 Retail Inventory Method Average Cost Example x

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Slide 9-30 Retail Inventory Method Average LCM Approximating Average LCM Net Markdowns are excluded in the computation of the Cost-to-Retail %

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Slide 9-31 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. 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.

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Slide 9-32 Retail Inventory Method Average LCM Example

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Slide 9-33 Retail Inventory Method Average LCM Example x

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Slide 9-34 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.

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Slide 9-35 The LIFO Retail Method Beginning inventory has its own cost-to-retail percentage. Beginning inventory has its own cost-to-retail percentage.

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Slide 9-36 The LIFO Retail Method Example 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.

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Slide 9-37 The LIFO Retail Method Example

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Slide 9-38 Others Issues of Retail Method Purchase returns and purchase discounts. Freight-in. Employee discounts. Spoilage, breakage, and theft.

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Slide 9-39 Dollar-Value LIFO Retail We need to eliminate the effect of any price changes before we compare the ending inventory with the beginning inventory.

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Slide 9-40 Dollar-Value LIFO Retail Example 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. 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.

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Slide 9-41 Dollar-Value LIFO Retail Example

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Slide 9-42 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. FIFO LIFO Change to Change from Retrospective

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Slide 9-43 Change To The LIFO Method to impossible 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) the nature of the change, (b) the effect of the change on current year’s income and earnings per share, and (c) why retrospective application was impracticable. A disclosure note is needed to explain (a) the nature of the change, (b) the effect of the change on current year’s income and earnings per share, and (c) why retrospective application was impracticable.

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Slide 9-44 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.

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Slide 9-45 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.

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Slide 9-46 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.

Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Slide 9-47 End of Chapter 9