INVENTORIES: ADDITIONAL ISSUES Chapter 9 © 2009 The McGraw-Hill Companies, Inc.

McGraw-Hill /Irwin Slide 2 Determining Market Value Market Should Not Exceed Net Realizable Value (Ceiling) Market Should Not Be Less Than Net Realizable Value less Normal Profit (Floor)  Accounting Research Bulletin No. 43 defines “market value” in terms of current replacement cost.  Replacement cost is constrained to fall between the “ceiling” and the “floor.”  Accounting Research Bulletin No. 43 defines “market value” in terms of current replacement cost.  Replacement cost is constrained to fall between the “ceiling” and the “floor.”

McGraw-Hill /Irwin Slide 3 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

McGraw-Hill /Irwin Slide 4 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 = $21.50current replacement cost = $21.50 selling price = $30selling price = $30 cost to complete and dispose = $4cost to complete and dispose = $4 normal profit margin of = $5normal profit margin of = $5 How would we value this item in the Balance Sheet?

McGraw-Hill /Irwin Slide 5 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.

McGraw-Hill /Irwin Slide 6 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. Applying Lower of Cost or Market Lower of cost or market can be applied 3 different ways.

McGraw-Hill /Irwin Slide 7 Adjusting Cost to Market 1. Record the Loss as a Separate Item in the Income Statement  Adjust inventory directly or by using an allowance account. 2. Record the Loss as part of Cost of Goods Sold  Adjust inventory directly or by using an allowance account.

McGraw-Hill /Irwin Slide 8 Inventory Estimation Techniques Estimate instead of taking physical inventory  Less costly  Less time consuming Two popular methods are... 1.Gross Profit Method 2.Retail Inventory Method

McGraw-Hill /Irwin Slide 9 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 acceptable for use in annual financial statements.

McGraw-Hill /Irwin Slide 10 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

McGraw-Hill /Irwin Slide 11 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 = $1,213,000Net sales for May = $1,213,000 Net purchases for May = $728,300Net purchases for May = $728,300 Inventory at May 1 = $237,400Inventory at May 1 = $237,400 Estimated gross profit ratio = 43% of salesEstimated gross profit ratio = 43% of sales Estimate Inventory at May 31.

McGraw-Hill /Irwin Slide 12 Gross Profit Method NOTE: The key to successfully applying this method is a reliable Gross Profit Ratio.

McGraw-Hill /Irwin Slide 13 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.

McGraw-Hill /Irwin Slide 14 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

McGraw-Hill /Irwin Slide 15 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.

McGraw-Hill /Irwin Slide 16 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: 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. 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: 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.

McGraw-Hill /Irwin Slide 17 The Retail Inventory Method

McGraw-Hill /Irwin Slide 18 The Retail Inventory Method x

McGraw-Hill /Irwin Slide 19 The Retail Inventory Method 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 %. Approximating Average Cost

McGraw-Hill /Irwin Slide 20 The Retail Inventory Method Net Markdowns are excluded in the computation of the Cost-to-Retail % Approximating Average LCM

McGraw-Hill /Irwin Slide 21 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

McGraw-Hill /Irwin Slide 22 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)

McGraw-Hill /Irwin Slide 23 Other Issues of Retail Method Element Treatment Before calculating the cost-to-retail percentage Freight-in Added to the cost column Purchase returns Deducted in both the cost and retail columns Purchase discounts taken Deducted in the cost column Abnormal shortage, spoilage, or theft Deducted in both the cost and retail columns After calculating the cost-to-retain percentage Normal shortage, spoilage, or theft Deducted in the retail column Employee discounts Added to net sales

McGraw-Hill /Irwin Slide 24 Dollar-Value LIFO Retail We need to eliminate the effect of any price changes before we compare the ending inventory with the beginning inventory.

McGraw-Hill /Irwin Slide 25 Dollar-Value LIFO Retail Let’s use this data from Matrix Inc. to estimate the ending inventory using dollar-value LIFO retail. 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. Let’s use this data from Matrix Inc. to estimate the ending inventory using dollar-value LIFO retail. 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.

McGraw-Hill /Irwin Slide 26 Dollar-Value LIFO Retail

McGraw-Hill /Irwin Slide 27 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.

McGraw-Hill /Irwin Slide 28 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.

McGraw-Hill /Irwin Slide 29 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.

McGraw-Hill /Irwin Slide 30 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.

McGraw-Hill /Irwin Slide 31 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.

McGraw-Hill /Irwin Appendix 9 Purchase Commitments

McGraw-Hill /Irwin Slide 33 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 2009, Matrix, Inc. signed two purchase commitments. The first requires Matrix to purchase inventory for $100,000 by December 1, The inventory is purchased on December 1 and paid for on December 31. On the purchase date, the inventory had a market value of $90,000. The second requires Matrix to purchase inventory items for $200,000 by March 1, On December 31, 2009, the market value of the inventory items was $188,000. On March 1, 2010, the market value of the inventory items was $186,000. Matrix uses the perpetual inventory system and is a calendar year-end company. Let’s make the journal entries for these commitments. In July 2009, Matrix, Inc. signed two purchase commitments. The first requires Matrix to purchase inventory for $100,000 by December 1, The inventory is purchased on December 1 and paid for on December 31. On the purchase date, the inventory had a market value of $90,000. The second requires Matrix to purchase inventory items for $200,000 by March 1, On December 31, 2009, the market value of the inventory items was $188,000. On March 1, 2010, the market value of the inventory items was $186,000. Matrix uses the perpetual inventory system and is a calendar year-end company. Let’s make the journal entries for these commitments.

McGraw-Hill /Irwin Slide 34 Purchase Commitments Single year commitment Multi-year Commitment

McGraw-Hill /Irwin End of Chapter 9 © 2008 The McGraw-Hill Companies, Inc.