1. Inventories: Additional Issues
Intermediate Accounting I
Chapter 9
This presentation is under development.

2. Subsequent measurement of Inventory
GAAP requires that companies evaluate their unsold inventory at the end of each reporting period. On occasion, the value of inventory may decline below what the company paid for the inventory.
Inventory damage
Physical deterioration
Obsolescence
Changes in price levels
When the expected benefit of unsold inventory is estimated to have fallen below its cost, an inventory write-down is recorded with an adjusting entry.

3. Two approaches to inventory write-down
Lower of cost or net realizable value (LCNRV)
Lower of cost of market (LCM)
The approach chosen by a company depends on which inventory costing method it uses.
 The financial statement effects are the same
 The difference is the amount of the inventory write-down

4. LOWER OF COST and net realizable value
 Used by companies who apply inventory valuation methods other than LIFO or the retail inventory method.
 Inventories are reported at the lower of cost and net realizable value (NRV).
 NRV is the estimated selling price of the product in the ordinary course of business reduced by reasonably predictable costs of completion, disposal, and transportation.
Recognizes losses in the period when the value of inventory declines below cost.
Avoids reporting inventory at an amount greater than the cash it can provide to the company.

5. APPLYING LOWER OF COST and nrv
The Collins Company has five inventory items on hand at the end of The year-end unit costs (determined by applying the average cost method), current unit selling prices, and estimated costs to sell for each of the items are presented below:
Item
Cost
Selling Price
Est Cost To Sell
NRV A
$50
$100
$15
$ 85 B
100
120 30 90 C 80 85 10 75 D 15 E 95 24 96
Calculate NRV (selling price less reasonable costs to sell)

6. APPLYING LOWER OF COST and nrv
The Collins Company has five inventory items on hand at the end of The year-end unit costs (determined by applying the average cost method), current unit selling prices, and estimated costs to sell for each of the items are presented below:
Compare Cost to NRV and select the lower.
Item
Cost
NRV
LCNRV A
$50
$85 B
100 90 C 80 75 D 85 E 95 96
Total
$395
The lower of cost and net realizable value rule can be applied to individual items (as in this example), logical inventory categories, or the entire inventory. Different adjustment amounts will be generated based on the application of LCNRV.

7. APPLYING LOWER OF COST and nrv
The Collins Company has five inventory items on hand at the end of The year-end unit costs (determined by applying the average cost method), current unit selling prices, and estimated costs to sell for each of the items are presented below:
Cost compared to NRV based on entire inventory totals.
Item
Cost
NRV
LCNRV A
$50
$85 B
100 90 C 80 75 D 85 E 95 96
Total
$415
$431
The lower of cost and net realizable value rule can be applied to individual items (as in this example), logical inventory categories, or the entire inventory. Different adjustment amounts will be generated based on the application of LCNRV.

8. LOWER OF COST and nrv adjustment
If cost is lower than NRV, no adjusting entry is needed.
If NRV is lower than cost, an adjusting entry is required to reduce inventory from its cost to the lower NRV. NRV then becomes the new carrying value of inventory reported in the balance sheet.
Inventory write-downs are usually debited to Cost of Goods Sold because they are a natural consequence of holding inventory and therefore part of the inventory’s cost. However, when a write-down is substantial and unusual, the write-down should be recorded in a loss account instead.
The loss must be expressly disclosed in the financial statements through a disclosure note alone or by also reporting the loss in a separate line of the income statement.
Cost of Goods Sold XX
Inventory OR
Loss on Write-down of Inventory XX
Inventory

9. Important Financial Statement Relationships
Net Sales (Sales less Returns & Discounts)
Less: Cost of Goods Sold
= Gross Profit
Beg Inventory
Plus: Net Purchases (Purchases less Returns & Discounts)
Freight-in
= Goods Available for Sale
Less: End Inventory (physical count)
= Cost of Goods Sold
Gross Profit / Net Sales = Gross Profit %
Gross Profit as a % of Sales = Gross Profit as a % of Cost / (1 + Gross Profit as a % of Cost) (also known as a markup on cost)

10. Estimating Ending Inventory
For some companies or in certain situations, it becomes difficult or impossible to physically count each unit of inventory. Companies have therefore developed methods of estimating inventory.
Reasons for Estimating Inventory 
 To determine the cost of inventory that has been lost, destroyed, or stolen.
 To estimate inventory and cost of goods sold for interim reports.
 For testing the reasonableness of reported inventory amounts.
In budgeting and forecasting.
Methods for Estimating Inventory
Gross Profit Method
Retail Method

11. Gross Profit Method
►Especially useful in determining the cost of inventory that has been lost, stolen, or destroyed.
►Provides only an approximation of inventory and is not acceptable for the preparation of annual financial statements.
►Estimates cost of goods sold by multiplying the period's net sales by a historical gross profit percentage and then subtracting that amount from net sales.
►Deduct any known loss amounts from the estimate of ending inventory.
►Deduct any recoverable amounts from the estimate of inventory lost.

12. Gross Profit Method Illustration
Southern Wholesale Company began 2016 with inventory of $600,000, and on March 17 a warehouse fire destroyed the entire inventory. Company records indicate net purchases of $1,500,000 and net sales of $2,000,000 prior to the fire. The gross profit percentage in each of the previous three years has been very close to 40%.
Beginning inventory (from records)
$600,000
Plus: Net purchases (from records)
1,500,000
Goods available for sale
2,100,000
Less: Cost of goods sold:
Net sales
$2,000,000
Less: Estimated gross profit of 40%
800,000
Estimated cost of goods sold
1,200,000
Estimated ending inventory
$900,000

13. Brief Exercise 9–5, page 496 Beginning Inventory $220,000
Plus: Net Purchases
400,000
Cost of Goods Available for Sale
$620,000
Less: Cost of Goods Sold
Net Sales
$600,000
Less: Est Gross Profit
(180,000)
Estimated Cost of Goods Sold
(420,000)
Est Cost of Inventory Destroyed
$200,000

14. Gross Profit Method Limitations
The key to obtaining a good ending inventory estimate using the gross profit method is the reliability of the gross profit ratio.
The accuracy of the estimate can be improved by grouping inventory into pools of products that have similar gross profit relationships
The company’s cost flow assumption should be implicitly considered when estimating the gross profit ratio
Suspected theft or spoilage would require an adjustment to estimates obtained using the gross profit method.

15. Retail Inventory Method
 Relies on the relationship between cost and selling price to estimate ending inventory and cost of goods sold.
 Ideal for high-volume retailers selling many different items at low unit prices.
 A physical count of inventory is not required to estimate ending inventory and cost of goods sold.
 Provides a more accurate estimate than the gross profit method because it’s based on the current cost-to-retail percentage rather than a historical gross profit percentage.
 A company must maintain records of inventory and purchases not only at cost but also at current selling price.
 Can be used for financial reporting and income tax purposes.
Cost-to-retail percentage is calculated as Goods Available for Sale at Cost / Goods Available for Sale at Selling Price
An annual physical inventory count is recommended to detect spoilage, theft, or other irregularities.

16. Retail Inventory Method Example (Simple)
Home Improvement Store’s bank has asked for monthly financial statements as a condition attached to a loan dated May 31, To avoid a physical count of inventory, the company intends to use the retail inventory method to estimate ending inventory and cost of goods sold for the month of June.
Cost
Retail
Beginning inventory
$ 60,000
$100,000
Plus: Net purchases
287,200
460,000
Goods available for sale
347,200
560,000
Cost-to-retail percentage: $347,200 / $560,000 = 62%
Less: Net sales
(400,000)
Estimated ending inventory at retail
$160,000
Estimated ending inventory at cost (62% x $160,000)
(99,200)
Estimated cost of goods sold — goods available for sale (at cost) minus ending inventory (at cost) equals cost of goods sold
$248,000

17. Brief Exercise 9–7, page 496 Cost Retail Beginning inventory $ 300,000
Cost
Retail
Beginning inventory
$ 300,000
$ 450,000
Plus: Net purchases
861,000
1,210,000
Freight-in
22,000
Net markups
48,000
Less: Net markdowns
______
(18,000)
Goods available for sale
1,183,000
1,690,000
Cost-to-retail percentage: $1,183,000 / $1,690,000 = 70%
Less: Net sales
(1,200,000)
Estimated ending inventory at retail
$ 490,000
Estimated ending inventory at cost (70% × $490,000)
(343,000)
Estimated cost of goods sold
$ 840,000

18. Retail Inventory Method
Changes in selling prices must be included in the determination of ending inventory at retail.
Selling prices are sometimes marked up or marked down from the initial selling price at the beginning of the fiscal period.
The various cost flow methods (FIFO, LIFO, and average cost) can be explicitly incorporated into the retail inventory estimation technique by adjusting for price changes.

19. RETAIL TERMINOLOGY Cost Amount paid to acquire the inventory.
Retail Current selling price.
Cost Amount paid to acquire the inventory.
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.

20. Exercise

21. THE CONVENTIONAL RETAIL METHOD
 To approximate lower of cost and net realizable value, markdowns are not included in the calculation of the cost-to-retail percentage. They are subtracted in the retail column after the percentage is calculated.
 The logic for using this approximation is that a markdown is evidence of a reduction in the utility of inventory.

22. Conventional Retail Inventory Method Example
Home Improvement Stores, Inc. uses a periodic inventory system and the retail inventory method to estimate ending inventory and cost of goods sold. The following data are available from the company’s records for the month of July 2016: Cost Retail
Beginning inventory $ 99, $160,000
Net purchases , ,000
Net markups ,000
Net markdowns ,000
Net sales ,000
Cost
Retail
Beginning inventory
$ 99,200
$160,000
Plus: Net purchases
305,280
470,000
Net markups
10,000
640,000
Cost-to-retail percentage: $404,480/$640,000 = 63.2%
Less: Net markdowns
_____
(8,000)
Goods available for sale
404,480
632,000
Less: Net sales
(434,000)
Estimated ending inventory at retail
$198,000
Estimated ending inventory at cost (63.2% x $198,000)
(125,136)
Estimated cost of goods sold
$279,344

23. APPROXIMATING AVERAGE COST
To approximate average cost, the cost-to-retail percentage is determined for all goods available for sale.
Both markups and markdowns are included in the determination of goods available for sale at retail.
Cost
Retail
Beginning inventory
$ 99,200
$160,000
Plus: Net purchases
305,280
470,000
Net markups
10,000
Less: Net markdowns
_____
(8,000)
Goods available for sale
404,480
632,000
Cost-to-retail percentage: $404,480 / $632,000 = 64%
Less: Net sales
(434,000)
Estimated ending inventory at retail
$198,000
Estimated ending inventory at cost (64% x $198,000)
(126,720)
Estimated cost of goods sold
$277,760

24. Inventories: Additional Issues
Intermediate Accounting I – Chapter 9
End of presentation
This presentation is under development.