PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA Inventories: Additional Issues 9 McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.

9 - 2 Reporting -- Lower of Cost or Market Inventories are valued at the lower- of-cost-or market. LCM is a departure from historical cost. The method causes losses to be recognized in the period the value of inventory declines below its cost rather than in the period that the goods ultimately are sold.

9 - 3 Determining Market Value Market Should Not Exceed Net Realizable Value (Ceiling) Market Should Not Be Less Than Net Realizable Value less Normal Profit (Floor)  GAAP defines “market value” in terms of current replacement cost.  Market should not be greater than the “ceiling” or less than the “floor.”  GAAP defines “market value” in terms of current replacement cost.  Market should not be greater than the “ceiling” or less than the “floor.”

9 - 4 Determining Market Value Ceiling NRV Replacement Cost NRV – NP Floor Designated Market CostCost Not More Than Not Less Than Or Step 1 Determine Designated Market Step 2 Compare Designated Market with Cost Lower of Cost Or Market

9 - 5 Lower of Cost or Market An item in inventory has a 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 normal profit margin of = $5 How would we value this item in the Balance Sheet?

9 - 6 Lower of Cost or Market Replacement Cost =$21.50 Replacement Cost =$21.50 $21.50 Designated Market? Historical cost of $20.00 is less than designated market of $21.50, so this inventory item will be valued at cost of $20.00.

Apply LCM to each individual item in inventory. 2. Apply LCM to logical inventory categories. 3. Apply LCM to the entire inventory as a group. Applying Lower of Cost or Market Lower of cost or market can be applied 3 different ways.

9 - 8 Adjusting Cost to Market 1.Record the Loss as a Separate Item in the Income Statement Loss on write-down of inventory XX Inventory XX 2.Record the Loss as part of Cost of Goods Sold. Cost of goods sold XX Inventory XX

9 - 9 U. S. GAAP vs. IFRS LCM requires selecting market from replacement cost, net realizable value or NRV reduced by the normal profit margin. Designated market is compared to historical cost to determine LCM. IAS No. 2, states that the designated market will always be net realizable value. International standards require inventory to be valued at the lower of cost or market, but the process is slightly different for the U.S. method of applying LCM.

U. S. GAAP vs. IFRS Under U.S. GAAP, the LCM rule can be applied to individual items, logical inventory categories, or the entire inventory. Reversals are not permitted under GAAP. The LCM assessment usually is applied to individual items, although using logical inventory categories is allowed under certain circumstances. If an inventory write-down is not longer appropriate, it must be reversed. International standards require inventory to be valued at the lower of cost or market, but the process is slightly different for the U.S. method of applying LCM.

Inventory Estimation Techniques Estimate instead of taking physical inventory 1.Less costly 2.Less time consuming Two popular methods of estimating ending inventory are the... 1.Gross Profit Method 2.Retail Inventory Method

Gross Profit Method Useful when... Estimating inventory and 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 acceptable for use in annual financial statements.

Gross Profit Method This method assumes that the historical gross margin ratio is reasonably constant in the short-run. Beginning Inventory (from accounting records) Plus: Net purchases (from accounting records) Goods available for sale (calculated) Less: Cost of goods sold (estimated) Ending inventory (estimated) Estimate the Historical Gross Profit Ratio

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: 1.Net sales for May = $1,213,000 2.Net purchases for May = $728,300 3.Inventory at May 1 = $237,400 4.Estimated gross profit ratio = 43% of sales Estimate Inventory at May 31.

Gross Profit Method NOTE: The key to successfully applying this method is a reliable Gross Profit Ratio.

The 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 percentage. Objective: Convert ending inventory at retail to ending inventory at cost.

The Retail Inventory Method Term Meaning Initial markup Original amount of markup from cost to selling price. Additional markup Increase in selling price subsequent to initial markup. Markup cancellation Elimination of an additional markup. Markdown Reduction in selling price below the original selling price. Markdown cancellation Elimination of a markdown. Retail Terminology

The 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.

Retail Terminology An Example of the Terminology

The Retail Inventory Method Matrix, 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: 1)Beginning inventory at cost $27,000, at retail $45,000 2)Net purchases at cost $180,000 at retail $300,000 3)Net sales for May $310,000 Estimate the inventory at May 31.

The Retail Inventory Method

The Retail Inventory Method x ×

The Retail Inventory Method Net Markdowns are excluded in the computation of the cost-to-retail percentage. This is referred to as the Conventional Retail Method We can estimate ending inventory at average LCM using the cost-to-retail percentage shown below:

The Retail Inventory 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. The LIFO Retail Method

The Retail Inventory Method Beginning inventory has its own cost-to-retail percentage. Beginning inventory has its own cost-to-retail percentage. The LIFO Retail Method LIFO Cost- = Net Purchases to-Retail %Retail Value (Net Purchases + Net Markups - Net Markdowns)

Retail Inventory Method LIFO Retail

Retail Inventory Method LIFO Retail

Retail Inventory Method LIFO Retail

Changes in Inventory Method retrospectively 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, other than a change to LIFO, are treated retrospectively.

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.

Analyzing Inventory Errors

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.

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.

Inventory Errors When the Inventory Error is Discovered the Following Year If an error was made in 2010, but not discovered until 2011, the 2010 financial statements were incorrect as a result of the error. The error should be retrospectively restated to reflect the correct inventory amount, cost of goods sold, net income, and retained earnings when the comparative 2011 and 2010 financial statements are issued in When the Inventory Error is Discovered Subsequent to the Following Year If an error was made in 2010, but not discovered until 2012, the 2011 financial statements also are retrospectively restated to reflect the correct cost of goods sold and net income even though no correcting entry is needed. The error has self-corrected and no prior period adjustment is needed.

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.

Earnings Quality Many believe that manipulating income reduces earnings quality because it can mask permanent earnings. Inventory write-downs and changes in inventory method are two additional inventory- related techniques a company could use to manipulate earnings.