1. Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. 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 Chapter 9

2. 9-2 Reporting —Lower of Cost or Market Inventories are valued at the lower of cost or market (LCM). 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.

3. 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.”

4. 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

5. 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 = $5  How would we value this item in the balance sheet?

6. 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.

7. 9-7 1. Apply LCM to each individual item in inventory such as printers. Applying Lower of Cost or Market Lower of cost or market can be applied 3 different ways.

8. 9-8 1. Apply LCM to each individual item in inventory. 2. Apply LCM to logical inventory categories, such as desktop and laptop computers. Applying Lower of Cost or Market Lower of cost or market can be applied 3 different ways.

9. 9-9 1. 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.

10. 9-10 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

11. 9-11 U. S. GAAP vs. IFRS Inventory is valued at the lower of cost or market with market selected from replacement cost, net realizable value or NRV reduced by the normal profit margin. Designated market is compared to historical cost to determine LCM. The LCM rule can be applied to individual items, logical inventory categories, or the entire inventory. Reversals are not permitted. Inventory is valued at the lower or cost of market and net realizable value. The assessment usually is applied to individual items, although using logical inventory categories is allowed under certain circumstances. If an inventory write-down is no longer appropriate, it must be reversed. International and U.S. standards for valuing inventory at the lower of cost or market are slightly different.

12. 9-12 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

13. 9-13 Gross Profit Method Useful when... Estimating inventory and COGS for interim reports. Determining the cost of inventory lost, destroyed, or stolen. Auditors in 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.

14. 9-14 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 Gross Profit Ratio

15. 9-15 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.

16. 9-16 Gross Profit Method NOTE: The key to successfully applying this method is a reliable gross profit ratio.

17. 9-17 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.

18. 9-18 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

19. 9-19 Retail Terminology An Example of the Terminology

20. 9-20 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.

21. 9-21 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.

22. 9-22 The Retail Inventory Method

23. 9-23 The Retail Inventory Method x ×

24. 9-24 Retail Inventory Method Markups and Markdowns Matrix Inc. uses the retail method to estimate inventory at the end of July. 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 Net sales for July $300,000 Estimate inventory at July 31. Matrix Inc. uses the retail method to estimate inventory at the end of July. 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 Net sales for July $300,000 Estimate inventory at July 31.

25. 9-25 Conventional Retail Method: Markups and Markdowns

26. 9-26 Conventional Retail Method: Markups and Markdowns

27. 9-27 Conventional Retail Method: Markups and Markdowns

28. 9-28 Conventional Retail Method: Markups and Markdowns $43,000 × 63.69% = $27,387

29. 9-29 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.

30. 9-30 The LIFO Retail Method Beginning inventory has its own cost-to-retail percentage. Beginning inventory has its own cost-to-retail percentage. LIFO cost- = Net purchases to-retail %Retail value (Net purchases + Net markups - Net markdowns)

31. 9-31 The LIFO Retail Method

32. 9-32 The LIFO Retail Method

33. 9-33 The LIFO Retail Method

34. 9-34 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

35. 9-35 Dollar-Value LIFO Retail We need to eliminate the effect of any price changes before we compare the ending inventory with the beginning inventory.

36. 9-36 Dollar-Value LIFO Retail Return to our earlier Matrix Inc. example to estimate the ending inventory using dollar-value LIFO retail. Recall that ending inventory was estimated to be $35,000 at retail, and $21,000 at cost with a 60% base layer cost-to- retail percentage. Net purchases at cost $200,000, at retail $304,000. Net markups $8,000. Net markdowns $4,000. Net sales for July $300,000. Price index at July 1 is 100 and at July 30 the index is 102. Return to our earlier Matrix Inc. example to estimate the ending inventory using dollar-value LIFO retail. Recall that ending inventory was estimated to be $35,000 at retail, and $21,000 at cost with a 60% base layer cost-to- retail percentage. Net purchases at cost $200,000, at retail $304,000. Net markups $8,000. Net markdowns $4,000. Net sales for July $300,000. Price index at July 1 is 100 and at July 30 the index is 102.

37. 9-37 Dollar-Value LIFO Retail

38. 9-38 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.

39. 9-39 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.

40. 9-40 Inventory Errors When analyzing inventory errors, it’s helpful to visualize the way cost of goods sold, net income, and retained earnings are determined.

41. 9-41 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.

42. 9-42 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.

43. 9-43 Inventory Errors When the Inventory Error is Discovered the Following Year If an error was made in 2013, but not discovered until 2014, the 2013 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 2014 and 2013 financial statements are issued for 2014. When the Inventory Error is Discovered Subsequent to the Following Year If an error was made in 2013, but not discovered until 2015, all previous years’ financial statements that were incorrect as a result of the error also are retrospectively restated to reflect the correct inventory, cost of goods sold, retained earnings, and net income even though no correcting entry is needed in 2015. The error has self-corrected and no prior period adjustment is needed.

44. 9-44 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.

45. 9-45 Appendix 9: 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 2013, the Lassiter Company signed two purchase commitments. The first requires Lassiter to purchase inventory for $500,000 by November 15, 2013. The inventory is purchased on November 14, and paid for on December 15. On the date of acquisition, the inventory had a market value of $425,000. The second requires Lassiter to purchase inventory for $600,000 by February 15, 2014. On December 31, 2013, the market value of the inventory items was $540,000. On February 15, 2014, the market value of the inventory items was $510,000. Lassiter uses the perpetual inventory system and is a calendar year-end company. In July 2013, the Lassiter Company signed two purchase commitments. The first requires Lassiter to purchase inventory for $500,000 by November 15, 2013. The inventory is purchased on November 14, and paid for on December 15. On the date of acquisition, the inventory had a market value of $425,000. The second requires Lassiter to purchase inventory for $600,000 by February 15, 2014. On December 31, 2013, the market value of the inventory items was $540,000. On February 15, 2014, the market value of the inventory items was $510,000. Lassiter uses the perpetual inventory system and is a calendar year-end company.

46. 9-46 Appendix 9: Purchase Commitments Single-period commitment November 14, 2013 Inventory (market price)425,000 Loss on purchase commitment 75,000 Accounts payable 500,000 December 15, 2013 Accounts payable500,000 Cash 500,000 Multi-period commitment December 31, 2013 Estimated loss on commitment 60,000 Estimated liability on commitment 60,000 February 15, 2014 Inventory (market price)510,000 Loss on purchase commitment 30,000 Estimated liability on commitment 60,000 Cash 600,000

47. 9-47 End of Chapter 9