2Learning Objective LO1 Understand and apply the lower-of-cost- or-market rule used to value inventories.LO1Our first learning objective in Chapter 9 is to understand and apply the lower-of-cost-or- market rule used to value inventories.
3Lower 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.Generally accepted accounting principles, known as GAAP, require that inventories be carried on the balance sheet at lower-of-cost-or-market. Lower-of-cost-or-market represents a departure from the historical cost concept, but is considered a conservative accounting measure. We will refer to lower-of-cost- or-market by using the term LCM.
4Determining Market Value 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.Net RealizableValue (Ceiling)The first step in applying LCM is to determine market value. Market value is considered replacement cost, as long as replacement cost falls between the ceiling and the floor. The ceiling is a shorthand way of referring to the net realizable value of the inventory item. The floor is shorthand for net realizable value reduced by the normal profit.Net Realizable Value less Normal Profit (Floor)
5Determining Market Value Net Realizable Value (NRV) is the estimated selling priceless cost of completion and disposal.Net RealizableValue (Ceiling)ReplacementCostThe definition of market value varies internationally. In many countries, for example New Zealand market value is defined as NRV.Net realizable value is the estimated selling price per unit of the item, less the cost to complete and dispose of that item. The floor is merely the net realizable value less the normal profit on a particular item.The International Accounting Standards Board’s International Accounting Standard 2 defines market as net realizable value, the policy used in New Zealand.Net Realizable Value less Normal Profit (Floor)
6Determining Market Value Net RealizableValue (Ceiling)If replacement cost > Ceiling, then Ceiling = Market ValueReplacementCostIf replacement cost < Floor, then Floor = Market ValueIf replacement cost is greater than the ceiling, then market becomes ceiling. If replacement cost is less than the floor, then floor becomes market value. As long as replacement cost falls between the ceiling and the floor, it will be considered market value.Net Realizable Value less Normal Profit (Floor)
7Lower of Cost or MarketAn 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 = $21.50selling price = $30cost to complete and dispose = $4normal profit margin of = $5How would we value this item in the Balance Sheet?Let’s look at an example to demonstrate application of the lower of cost or market concept.Here we have an inventory item that has the historical cost of $20. Its replacement cost is $ The normal selling price of the inventory item is $30, and it will cost four dollars to complete and dispose of the item in its current condition. The normal profit margin on this item is five dollars. Let’s begin by determining market value.
8Net Realizable Value less Normal Profit (Floor) Lower of Cost or MarketNet RealizableValue (Ceiling)ReplacementCost =$21.50Which one do we use?We assume the market value will be replacement cost, as long as it falls between the floor and the ceiling. The ceiling is the selling price, $30, less the cost to complete and sell, four dollars, or $26. The floor is the ceiling of $26, less normal profit of five dollars, or $21.Net Realizable Value less Normal Profit (Floor)
9Lower of Cost or Market Net Realizable Value (Ceiling) Replacement In this case, market value will be $21.50 because the replacement cost is between the ceiling and the floor.Net RealizableValue (Ceiling)ReplacementCost =$21.50Market value = $21.50Cost = $20.00Since Cost < Market, the LCM rule would dictate that inventory be recorded at Cost.Market value = $21.50Cost = $20.00Should the inventory be recorded at cost or market?In this case, the replacement cost of $21.50 falls between the floor and the ceiling, so replacement cost becomes market. We compare market of $21.50 to cost of $20, and we see that cost is below market. So we will value this item in inventory at its historical cost of $20. Remember, we always value the item at lower-of-cost-or-market.Net Realizable Value less Normal Profit (Floor)
10Lower of Cost or MarketAn 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 = $80.00NRV = $100.00NRV reduced by normal profit = $85.00How would we value the item on our Balance Sheet?Read through this example and jot down the values, then we’ll see how this item will be valued on the balance sheet.
11Lower of Cost or Market Net Realizable Value (Ceiling) = $100 ? Which one do we use as market value?ReplacementCost =$80??The ceiling is $100, replacement cost is $80, and the floor is $85. Which of these three values would you select as market value?Net Realizable Value less Normal Profit (Floor) = $85
12Lower of Cost or Market Net Realizable Value (Ceiling) = $100 Should the inventory be carried at Market Value or Cost?ReplacementCost =$80Replacement cost of $80 is less than the floor. So we will select the floor of $85 as market value. The cost of the item in inventory is $95 and market is $85, so we will write down this item of inventory to $85. The inventory item will be carried at market on the balance sheet.Market = $85 < Cost = $95Our inventory item will be written down to the Market Value $85.Net Realizable Value less Normal Profit (Floor) = $85
13Applying Lower of Cost or Market Lower of cost or market can be applied 3 different ways.Part I We can apply lower-of-cost-or-market in one of three different ways. First, we can apply it to individual items of inventory,Part II.or we can apply it to groups of similar items in inventory,Part IIIor finally, we can apply it to the entire inventory.3. Apply LCM to the entire inventory as a group.2. Apply LCM to each class of inventory.1. Apply LCM to each individual item in inventory.
14Adjusting Cost to Market - Options Record the Loss as a Separate Item in the Income StatementAdjust inventory directly or by using an allowance account.Record the Loss as part of Cost of Good SoldWe can adjust the cost of an inventory item to market in one of two ways.When market is lower than cost, we can recognize a separate loss for the decline in value and make the adjustment to inventory directly or by using an allowance account. As an alternative, we can record the loss as part of cost of goods sold, and either adjust inventory directly or use an allowance account.
15Learning ObjectiveEstimate ending inventory and cost of goods sold using the gross profit method.LO2Our second learning objective in Chapter 9 is to estimate ending inventory and cost of goods sold, using the gross profit method.
16Inventory Estimation Techniques Estimate instead of taking physical inventoryLess costlyLess time consumingTwo popular methods are . . .Gross Profit MethodRetail Inventory MethodMost companies estimate their inventories at interim periods. Inventory estimation is less costly than a physical count and less time consuming. The two most popular methods are known as the gross profit method and the retail inventory method.
17Gross Profit MethodEstimating inventory & COGS for interim reports.Auditors are testing the overall reasonableness of client inventories.Useful when . . .Determining the cost of inventory lost, destroyed, or stolen.Preparing budgets and forecasts.The gross profit method is perhaps the most popular method for estimating ending inventory. Companies use it when they develop interim reports, and auditors often use the gross profit method to determine the reasonableness of ending inventory. The gross profit method can be used by insurance companies to estimate lost, destroyed, or stolen inventory. We can use the gross profit method in the budgeting process.It is important to remember that the gross profit method is not acceptable for use in the annual report distributed to external users.NOTE: The Gross Profit Method is not acceptable for use in annual financial statements.
18Gross Profit MethodThis method assumes that the historical gross margin rate is reasonably constant in the short run.Net sales for the period.Cost of beginning inventory.We need to know . . .Before we can use the gross profit method, there is some information we need to know. First, we need an estimate of the historical gross margin rate. Then we need to know the net sales and net purchases for the period. Finally, we need to know the cost of beginning inventory.Historical gross margin rate.Net purchases for the period.
19Steps to the Gross Profit Method Estimate Historical Gross Margin %.Sales x (1 - Estimated Gross Margin %) = Estimated COGSBeg. Inventory + Net Purchases = Cost of Goods Available for Sale (COGAS)COGAS - Estimated COGS = Estimated Cost of Ending InventoryPresented on this screen are the four steps that we need to follow if we want to accurately estimate ending inventory under the gross profit method.First, we must estimate the historic gross profit percentage. In the last chapter, we showed you the equation for determining the gross profit percentage.Next, we multiply the net sales times one minus the gross profit percentage to determine the estimated cost of goods sold.The third step is to add beginning inventory and net purchases to arrive at cost of goods available for sale.The final step in estimating ending inventory is to subtract cost of goods sold from cost of goods available for sale. Now let’s take this four-step process and apply it to an example.
20Estimate Inventory at May 31. Gross Profit MethodMatrix, 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 purchases for May = $728,300Inventory at May 1 = $237,400Gross margin = 43% of salesEstimate Inventory at May 31.Matrix is interested in estimating its ending inventory at May 31 using the gross profit method. The controller has provided us with certain information. Review this information and make sure it’s adequate for us to apply the gross profit method.
21Gross Profit MethodWe were given the historic gross profit percentage, so the first step in our process is to multiply net sales times one minus the gross margin percentage. Estimated cost of goods sold is $691,410.The next step is to sum beginning inventory and net purchases to determine cost of goods available for sale. As you can see, cost of goods available for sale is $965,700.Now subtract cost of goods sold from cost of goods available for sale to get estimated ending inventory of $274,290.NOTE: The key to successfully applying this method is a reliable Gross Margin Percentage.
22Learning ObjectiveEstimate ending inventory and cost of goods sold using the retail inventory method,LO3Our third learning objective in Chapter 9 is to estimate ending inventory and cost of goods sold using the retail inventory method.
23Retail 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.As indicated by its name, the retail method was developed for retail establishments such as department stores. There is a major difference between the gross profit and retail method. In the retail method, we need to know both cost and selling price of certain accounts. Our objective in the retail method is to calculate ending inventory at retail, and then convert it from retail to cost.Objective: Convert ending inventory at retail to ending inventory at cost.
24Retail Inventory Method Sales for the period.Beginning inventory at retail and cost.We need to know . . .Before we can successfully complete the retail inventory method, we need to know four pieces of information. We need to know sales for the period, net purchases at both retail price and cost, the value of beginning inventory at both retail and cost and, finally, whether there’s been inventory adjustment to the retail price. These adjustments might include additional markups or additional markdowns and other items that apply to retail establishments.Net purchases at retail and cost.Adjustments to the original retail price.
25Steps to the Retail Inventory Method Determine cost and retail value of goods sold.Calculate the cost-to-retail %.Retail value of goods available for sale - sales = ending inventory at retail.Cost-to-retail % x Ending inventory at retail = Estimated ending inventory at cost.We have listed a four-step process to accurately estimate ending inventory at cost. First, we have to determine the cost and retail value of goods sold. Next, we use these amounts to calculate the cost-to-retail percentage. We subtract the retail value of goods available for sale from sales to arrive at our estimate of ending inventory at retail. Finally, we use the cost-to-retail percent to adjust ending inventory at retail, to ending inventory at cost.
26Retail 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, a retail establishment, wishes to estimate its ending inventory at May 31. Information is gathered by the controller to help us accomplish this task. Read through the information carefully and we’ll begin the four-step process to solve this problem.
27Retail Inventory Method First, we add together beginning inventory and net purchases for May both at cost and retail. We divide the cost of goods available for sale by the retail price of goods available for sale to arrive at the cost-to-retail percentage of 60%. Next, we subtract our sales for May from the selling price of goods available for sale, to arrive at ending inventory at retail.
28Retail Inventory Method xFinally, we use our cost-to-retail percentage to convert our estimate of ending inventory at retail, $35,000, to our estimate of ending inventory at cost, $21,000.
29Approximating 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 %.We can use the retail method to estimate ending inventory at average cost. The cost-to-retail percentage takes the beginning inventory plus net purchases at cost and divides this total by the retail value of beginning inventory, plus the retail value of net purchases, plus any net markups, minus any net markdowns.
30Retail 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 $8,000Net markdowns $4,000Net sales for June $300,000Estimate inventory at June 30.Now Matrix wishes to use the retail method to estimate its ending inventory at June 30, at average cost. Read through the information carefully, making special note of the net markups and net markdowns provided.
31Retail Inventory Method - Average Cost Once again we begin the process by summing beginning inventory and net purchases, both cost and retail. Then we add our net markups and subtract our net markdowns from the retail column.We divide the cost of goods available for sale, $221,000, by the retail value of goods available for sale, $343,000, to arrive at our cost or retail percent of 64.43%. Next, we subtract our sales for the month of June from the retail value of goods available for sale to determine our ending inventory at retail.
32Retail Inventory Method - Average Cost Finally, we apply our cost-to-retail percent of 64.43% to our inventory at retail of $43,000, to arrive at estimated ending inventory at cost of $27,705 (rounded).x
33Learning ObjectiveExplain how the retail inventory method can be made to approximate the lower-of-cost-or-market rule.LO4Our fourth learning objective in Chapter 9 is to explain how the retail inventory method can be made to approximate the lower-of-cost-or-market rule.
34Retail Inventory Method - Average LCM Approximating Average LCMNet Markdowns are excluded in the computation of the Cost-to-Retail %To estimate ending inventory at lower of cost or market using the retail method, the cost-to-retail percentage excludes net markdowns. Otherwise, the cost-to-retail percent is exactly the same as we calculated in the previous example.
35Retail 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 $8,000Net markdowns $4,000Net sales for June $300,000Let’s estimate inventory at June 30.Let’s use the same information to estimate the ending inventory for Matrix at June 30, using lower-of-cost-or-market and applying the retail inventory method.
36Retail Inventory Method - Average LCM In this case, our cost to retail percentage excludes net markups. Our cost-to- retail percentage is determined by dividing $221,000 by $347,000, to arrive at % (rounded). We must remember to subtract our net markdowns before we subtract our sales for the month from the retail value of goods available for sale. Ending inventory at retail is $43,000.
37Retail Inventory Method - Average LCM Once again, we convert ending inventory at retail to ending inventory of cost by multiplying the retail value times our cost to retail percentage. Our estimate of ending inventory at lower-of-cost-or-market using the retail method is $27,387 (rounded).x
38The LIFO Retail MethodAssume 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.We can also use the retail method to estimate ending inventory using LIFO. Whenever we think about LIFO, we should think about layers. There is a natural layer between beginning inventory and purchases for the period.
39Beginning inventory has its own cost-to-retail percentage. The LIFO Retail MethodBeginning inventory has its owncost-to-retail percentage.Under the LIFO retail method, the beginning inventory will have its own cost-to-retail percentage. The cost-to-retail percentage for purchases is calculated by taking net purchases at cost and dividing this amount by the retail value of net purchases plus net markups minus net markdowns.
40Estimate ending inventory. The LIFO Retail MethodUse 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.Estimate ending inventory.Let’s see how the LIFO retail method works for Matrix, Inc. in estimating its ending inventory.
41The LIFO Retail MethodPart I Here is the information from our previous example. I want to call to your attention to two items. First, beginning inventory at cost is $21,000, and $35,000 at retail. Second, our net purchases at cost are $200,000 and our net purchases, plus net markups, minus net markdowns is $308,000 at retail.Part IIOur cost-to-retail percentage for beginning inventory is 60%, and the cost-to- retail percentage for our net purchases is 64.94% (rounded). The beginning inventory layer will be converted from a retail price of $35,000 to a cost of $21,000. The remaining layer necessary to get us to $43,000 is $8,000. The $8,000 retail price current layer will be converted to cost using 64.94%, so the cost is $5,195. Adding together the beginning inventory layer and the net purchases layer, we get an estimate of ending inventory at LIFO of $26,195.
42Other Issues of Retail Method Purchase returns and purchase discounts.Freight-in.Employee discounts.Spoilage, breakage, and theft.Other items that impact the retail value of net purchases include purchase returns and allowances, purchase discounts, freight-in, employee discounts, and spoilage or theft.
43Learning ObjectiveDetermine ending inventory using the dollar-value LIFO retail inventory method.LO5Our fifth learning objective in Chapter 9 is to determine ending inventory using the dollar value LIFO retail inventory method.
44Dollar-Value LIFO Retail We need to eliminate the effect of any price changes before we compare the ending inventory with the beginning inventory.The purpose of dollar-value LIFO retail is to eliminate the effects of price changes on ending inventory and beginning inventory.
45Dollar-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 $8,000Net markdowns $4,000Net sales for June $300,000Price index at June 1 is 100 and at June 30the index is 102. Estimate ending inventory.Here is some data that we’ve used before, plus new information relating to the change in prices. At the beginning of June, the price index was 100. At the end of June, it was 102. Let’s use this new information to estimate inventory using dollar-value LIFO retail.
46Dollar-Value LIFO Retail Part IRecall that earlier, we determined the retail price of ending inventory to be $43,000.Part IIThe first step is to deflate the $43,000 retail value of ending inventory to base year prices. To accomplish this, we divide the $43,000 by 1.02, the price index at the end of the period. The retail value of ending inventory in base year prices is $42,157.Part IIIOur beginning inventory at retail was $35,000 and the price index was 100, so the beginning inventory layer will be converted to $21,000 using the 60% cost-to-retail percentage. The current layer in base year prices is $7,157. We first re-inflate this amount to the value at the end of the period by multiplying $7,157 times Next, we convert the re-inflated amount from retail to cost by multiplying it times 64.94%. We have a current layer, at current prices of $4, We add the layers together to determine LIFO retail inventory at $25,
47Learning ObjectiveExplain the appropriate accounting treatment required when a change in inventory method is made.LO6Our sixth learning objective for Chapter 9 is to explain the appropriate accounting treatment required when a change in inventory method is made.
48Changes 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.Change toFIFOChanges in inventory methods, other than a change to LIFO, are treated retrospectively.RetrospectiveMost voluntary changes in accounting principles involving inventory are reported retrospectively. This means that all previous financial statements disclosed are restated as though the new principal had been used. On the next slide we will see how changes to LIFO are reported.Change fromLIFO
49Change To The LIFO Method 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 retrospectiveapplication was impracticable.It is almost impossible to calculate the LIFO impact on prior periods financial statements when a change in principle is made. As a result, when a company changes to LIFO from some other method, we report the change from the period of adoption forward.
50Learning ObjectiveExplain the appropriate accounting treatment when an inventory error is discovered.LO7Our seventh learning objective in Chapter 9 is to explain the appropriate accounting treatment when an inventory error is discovered.
51Overstatement of ending inventory Inventory ErrorsOverstatement of ending inventoryUnderstates cost of goods sold andOverstates pretax income.Understatement of ending inventoryOverstates cost of goods sold andUnderstates pretax income.This slide explains the impact of errors in ending inventory on cost of goods sold and pretax income.
52Overstatement of beginning inventory Inventory ErrorsOverstatement of beginning inventoryOverstates cost of goods sold andUnderstates pretax income.Understatement of beginning inventoryUnderstates cost of goods sold andOverstates pretax income.Here we show the impact of errors in beginning inventory on cost of goods sold in pretax income.
53Overstatement of purchases Inventory ErrorsOverstatement of purchasesOverstates cost of goods sold andUnderstates pretax income.Understatement of purchasesUnderstates cost of goods sold andOverstates pretax income.This slide shows the impact of errors in the recording of purchases on cost of goods sold and pretax income.
55In July 2006, Matrix, Inc. signed two purchase commitments. The 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. Thefirst requires Matrix to purchase raw materials for $100,000 by December 1, 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, 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. Let’s make the journal entries for these commitments.A purchase commitment is a contract between two parties, requiring one of the parties to purchase a specified amount of merchandise or raw materials at a set price, on or before a particular date. Read through the example of the two purchase commitments entered into by Matrix in July of We will look at the accounting for both of these purchase commitments. It is important to note that one of the purchase commitments requires action during 2006, while the other does not require action until 2007.
56Purchase Commitments Single year commitment Multi-year Commitment On July 1, Matrix records its purchase commitment for the year with a debit to raw materials inventory and a credit to accounts payable for $100,000. On December 1, the company is obligated to acquire the raw materials. The journal entry required is to debit accounts payable for $100,000, and credit cash for the same amount. Because the purchase price of the raw materials had dropped to $90,000 on December 1, Matrix must recognize the loss. The journal entry is to debit loss on purchase commitment for $10,000 and credit raw materials inventory for the same amount.We did not record the multi-year purchase commitments. At the end of 2006, the inventory to be purchased had dropped in value by $12,000. Matrix must recognize an estimated loss for the $12,000 and record an estimated liability. On March 1, the inventory was purchased for $200,000. The journal entry to record the transaction is to debit inventory for $186,000, debit estimated liability on commitment for $12,000, debit loss on purchase commitment for $2,000, and credit cash for $200,000. Part of the purchase commitment loss was recognized in 2006, and part was recognized in 2007.