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Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Inventories: Additional Issues 9.

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Presentation on theme: "Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Inventories: Additional Issues 9."— Presentation transcript:

1 Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Inventories: Additional Issues 9

2 9-2 Learning Objective Understand and apply the lower-of-cost- or-market rule used to value inventories.

3 9-3 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.

4 9-4 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.

5 9-5 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 many countries, for example New Zealand market value is defined as NRV.

6 9-6 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

7 9-7 Lower of Cost or Market 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 normal profit margin of = $5 How would we value this item in the Balance Sheet?

8 9-8 Lower of Cost or Market Net Realizable Value (Ceiling) Net Realizable Value less Normal Profit (Floor) Replacement Cost =$21.50 Replacement Cost =$21.50 Which one do we use?

9 9-9 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. Lower of Cost or Market 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.

10 9-10 Lower of Cost or Market 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 NRV reduced by normal profit = $85.00 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 NRV reduced by normal profit = $85.00 How would we value the item on our Balance Sheet?

11 9-11 Lower of Cost or Market 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?

12 9-12 Lower of Cost or Market 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

13 9-13 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.

14 9-14 Adjusting Cost to Market - Options Record the Loss as a Separate Item in the Income Statement Adjust inventory directly or by using an allowance account. Record the Loss as part of Cost of Good Sold Adjust inventory directly or by using an allowance account.

15 9-15 Learning Objective Estimate ending inventory and cost of goods sold using the gross profit method.

16 9-16 Inventory Estimation Techniques Estimate instead of taking physical inventory Less costly Less time consuming Two popular methods are... Gross Profit Method Retail Inventory Method

17 9-17 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.

18 9-18 Gross Profit Method This 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...

19 9-19 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 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

20 9-20 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 = $1,213,000 Net purchases for May = $728,300 Inventory at May 1 = $237,400 Gross margin = 43% of sales Estimate Inventory at May 31. 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 = $1,213,000 Net purchases for May = $728,300 Inventory at May 1 = $237,400 Gross margin = 43% of sales Estimate Inventory at May 31.

21 9-21 Gross Profit Method NOTE: The key to successfully applying this method is a reliable Gross Margin Percentage.

22 9-22 Learning Objective Estimate ending inventory and cost of goods sold using the retail inventory method,

23 9-23 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.

24 9-24 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.

25 9-25 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.

26 9-26 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.

27 9-27 Retail Inventory Method

28 9-28 Retail Inventory Method x

29 9-29 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 %.

30 9-30 Retail Inventory Method - Average Cost Matrix, 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 Net sales for June $300,000 Estimate inventory at June 30. Matrix, 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 Net sales for June $300,000 Estimate inventory at June 30.

31 9-31 Retail Inventory Method - Average Cost

32 9-32 Retail Inventory Method - Average Cost x

33 9-33 Learning Objective Explain how the retail inventory method can be made to approximate the lower-of-cost-or-market rule.

34 9-34 Retail Inventory Method - Average LCM Approximating Average LCM Net Markdowns are excluded in the computation of the Cost-to-Retail %

35 9-35 Retail Inventory Method - Average LCM Matrix, 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 Net sales for June $300,000 Lets estimate inventory at June 30. Matrix, 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 Net sales for June $300,000 Lets estimate inventory at June 30.

36 9-36 Retail Inventory Method - Average LCM

37 9-37 Retail Inventory Method - Average LCM x

38 9-38 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.

39 9-39 The LIFO Retail Method Beginning inventory has its own cost-to-retail percentage.

40 9-40 The LIFO Retail Method Use the data from Matrix Inc. to estimate the LIFO ending inventory. 1.Beginning inventory at cost $21,000, at retail $35,000; 2.Net purchases at cost $200,000, at retail $304,000; 3.Net markups $8,000; 4.Net markdowns $4,000; 5.Net sales for June $300,000. Estimate ending inventory.

41 9-41 The LIFO Retail Method

42 9-42 Other Issues of Retail Method Purchase returns and purchase discounts. Freight-in. Employee discounts. Spoilage, breakage, and theft.

43 9-43 Learning Objective Determine ending inventory using the dollar-value LIFO retail inventory method.

44 9-44 Dollar-Value LIFO Retail We need to eliminate the effect of any price changes before we compare the ending inventory with the beginning inventory.

45 9-45 Dollar-Value LIFO Retail Use the data from Matrix 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 Matrix 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.

46 9-46 Dollar-Value LIFO Retail

47 9-47 Learning Objective Explain the appropriate accounting treatment required when a change in inventory method is made.

48 9-48 Changes in Inventory Method 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. FIFO LIFO Change to Change from Retrospective

49 9-49 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 years 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 years income and earnings per share, and (c) why retrospective application was impracticable.

50 9-50 Learning Objective Explain the appropriate accounting treatment when an inventory error is discovered.

51 9-51 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.

52 9-52 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.

53 9-53 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.

54 9-54 Appendix 9 Purchase Commitments

55 9-55 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 2006, Matrix, Inc. signed two purchase commitments. The first requires Matrix to purchase raw materials for $100,000 by December 1, 2006. On December 1, 2006, the raw materials had a market value of $90,000. The second requires Matrix to purchase inventory items for $200,000 by March 1, 2007. On December 31, 2006, the market value of the inventory items were $188,000. On March 1, 2007, the market value of the inventory items were $186,000. Matrix uses the perpetual inventory system and is a calendar year-end company. Lets make the journal entries for these commitments. In July 2006, Matrix, Inc. signed two purchase commitments. The first requires Matrix to purchase raw materials for $100,000 by December 1, 2006. On December 1, 2006, the raw materials had a market value of $90,000. The second requires Matrix to purchase inventory items for $200,000 by March 1, 2007. On December 31, 2006, the market value of the inventory items were $188,000. On March 1, 2007, the market value of the inventory items were $186,000. Matrix uses the perpetual inventory system and is a calendar year-end company. Lets make the journal entries for these commitments.

56 9-56 Purchase Commitments Single year commitment Multi-year Commitment

57 9-57 End of Chapter 9


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