Inventory: Additional Issues Chapter 9 Inventory: Additional Issues ACCT-3030

1. Lower of Cost or NRV Required by GAAP Theory Inventory must be reported on financial statements at lower of cost or NRV Theory should not report inventory at a value higher than benefits to be received from selling it ACCT-3030

1a. Lower of Cost or NRV Definition of NRV NRV = selling price – selling costs e.g., amount you would net when item is sold examples of selling costs: completion costs selling commissions shipping costs ACCT-3030

2. Change in Inventory Methods Change in accounting estimate account for prospectively Change in accounting principle account for retrospectively Change in reporting entity Change in inventory methods change to any method except LIFO – retrospectively change to LIFO – prospectively, because usually impossible to know old layers ACCT-3030

3. Inventory Estimation Methods Gross profit method based on relationship between sales and gross profit not acceptable for financial reporting or taxes Retail method used by large volume retailers dollar based method – not unit based method acceptable for financial reporting and taxes ACCT-3030

4. Gross Profit Method Based on assumptions that gross profit is constant from period-to-period sales mix of products is constant Used to estimate inventory value ACCT-3030

4a. Gross Profit Method Example Sales $200 Cost of goods sold $120 GP % = 80/200 = 40% CGS% = 120/200 = 60% GP% on sales = 80/200 = 40% GP% on cost = 80/120 = 66⅔% GP on Sales = GP on Costs 1 + GP on Costs ACCT-3030

4a. Gross Profit Method Example A hurricane destroyed the entire inventory stored in a warehouse. The following information is available from the company’s records. Beginning inventory $220,000 Purchases $400,000 Sales $600,000 Historical gross profit rate 30% Required: Estimate the cost of the destroyed inventory. ACCT-3030

4a. Gross Profit Method Example — Solution Beginning inventory (from records) $220,000 Plus: Net purchases (from records) 400,000 Cost of goods available for sale 620,000 Less: Cost of goods sold: Net sales $600,000 Less: Estimated gross profit of 30% (180,000) Estimated cost of goods sold (420,000) Estimated cost of inventory destroyed $200,000 ACCT-3030

5. Retail Method Method is based on the pattern between the cost and retail value of the goods Method requires: total costs of goods purchased total retail value of goods available for sale total sales Companies always keep 1 & 3 with this method also must keep 2 ACCT-3030

5a. Retail Method Basic method Cost Retail Beginning Inventory 600 1,000 Net Purchases 5,000 8,000 Goods Available for Sale 5,600 9,000 Cost Ratio: 5,600/9,000 = .62222 Sales 7,500 Ending Inventory at Retail 1,500 End Inv at Cost (1,500 x .62222) 933 ACCT-3030

5c. Retail Method Retail terminology Net markups and net markdowns Meaning Initial markup Original markup reflected in sales price Additional markup Additional increase in selling price after original markup Markup cancellation Elimination of additional markup Markdown Reduction in selling price below original selling price Markdown cancellation Elimination of markdown Net markups and net markdowns ACCT-3030

5b. Retail Method Ratios – computed as: cost of goods available for sale retail value of goods available for sale Based on how ratio computed, can be used to approximate following methods: average – include everything LCM – exclude markdowns (conventional retail method) FIFO – exclude beginning inventory LIFO – compute separate ratio for each layer ACCT-3030

5d. Retail Method Cost Retail Beginning Inventory + Purchases Purchases Returns - Purchases Discounts Freight-In Net Markups Net Markdowns Available for Sale X Sales Sales Returns and Allow. Sales Discounts Ending Inventory at Retail Ending Inventory at Cost ACCT-3030

5e. Retail Method Avg. method Cost Retail Beginning Inventory + Purchases Purchases Returns and Allow. - Purchases Discounts Freight-In Net Markups Net Markdowns Available for Sale X Sales Sales Returns and Allow. Sales Discounts Ending Inventory at Retail Ending Inventory at Cost Avg. method ACCT-3030

5f. Retail Method LCM method Cost Retail Beginning Inventory + Purchases Purchases Returns and Allow. - Purchases Discounts Freight-In Net Markups Net Markdowns Available for Sale X Sales Sales Returns and Allow. Sales Discounts Ending Inventory at Retail Ending Inventory at Cost LCM method ACCT-3030

5g. Retail Method FIFO method Cost Retail Beginning Inventory + Purchases Purchases Returns and Allow. - Purchases Discounts Freight-In Net Markups Net Markdowns Available for Sale X Sales Sales Returns and Allow. Sales Discounts Ending Inventory at Retail Ending Inventory at Cost FIFO method ACCT-3030

5h. Retail Method Example Cost Retail Beginning Inventory 195,000 400,000 Net Purchases 300,000 450,000 Net Markups 50,000 Net Markdowns <20,000> Available for Sale 495,000 880,000 Net Sales 407,000 Ending Inventory at Retail 473,000 Ending Inventory at Cost ACCT-3030

6. Inventory Errors Overstatement of ending inventory Understates cost of goods sold Overstates pretax income Understatement of ending inventory Overstates cost of goods sold Understates pretax income Overstatement of beginning inventory Understatement of beginning inventory ACCT-3030

6a. Effect of errors Self-correcting errors Permanent errors most errors correct themselves over time e.g., inventory – this year’s ending inventory is next year’s beginning inventory depreciable assets – over the life of the assets Permanent errors never will correct themselves e.g., expensing land, recording wrong amount ACCT-3030

6b. Effect of errors Determining effect of errors determine effect for all accounts involved examples ending inventory overstated interest expense not accrued on N/P this year, next year principle and interest paid in full ACCT-3030