1. Inventory: Additional Issues
Chapter 9
Inventory:
Additional Issues

2. 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.

3. Determining Market Value
Net Realizable
Value (Ceiling)
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 Realizable Value less Normal Profit (Floor)

4. Determining Market Value
Net Realizable Value (NRV) is the estimated selling price
less cost of completion and disposal.
Net Realizable
Value (Ceiling)
Replacement
Cost
The definition of market value varies internationally. In the UK, Denmark, Finland, and New Zealand, market value is defined as NRV.
Net Realizable Value less Normal Profit (Floor)

5. Determining Market Value
Net Realizable
Value (Ceiling)
If replacement cost > Ceiling, then Ceiling = Market Value
Replacement
Cost
If replacement cost < Floor, then Floor = Market Value
Net Realizable Value less Normal Profit (Floor)

6. LCM - Example
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; and
normal profit margin of = $5.
How would we value this item on the Balance Sheet?

7. Net Realizable Value less Normal Profit (Floor)
LCM - Example
Net Realizable
Value (Ceiling)
Replacement
Cost =$21.50
Which one do we use?
Net Realizable Value less Normal Profit (Floor)

8. LCM - Example Net Realizable Value (Ceiling) Replacement Cost =$21.50
In this case, market value will be $21.50, because the replacement cost is between the ceiling and the floor.
Net Realizable
Value (Ceiling)
Replacement
Cost =$21.50
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.
Net Realizable Value less Normal Profit (Floor)

9. How would we value the item on our Balance Sheet?
LCM - Another Example
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; and NRV reduced by normal profit = $85.00.
How would we value the item on our Balance Sheet?

10. Lower of Cost or Market Another Example
Net Realizable Value (Ceiling) = $100 ?
Which one do we use as market value?
Replacement
Cost =$80 ? ?
Net Realizable Value less Normal Profit (Floor) = $85

11. Lower of Cost or Market Another Example
Net Realizable Value (Ceiling) = $100
Should the inventory be carried at Market Value or Cost?
Replacement
Cost =$80
Market = $85 < Cost = $95
Our inventory item will be written down to the Market Value $85.
Net Realizable Value less Normal Profit (Floor) = $85

12. Applying LCM LCM can be applied 3 different ways.
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.

13. Adjusting Cost to Market - Options
Record the Loss as a Separate Item in the Income Statement
Adjust inventory directly or using an allowance account.
Record the Loss as part of COGS

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

15. Gross Profit Method
Estimating 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.
NOTE: The Gross Profit Method is not accepted by GAAP.

16. Gross Profit 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 . . .
Historical gross margin rate.
Net purchases for the period.

17. Steps to the Gross Profit Method
Estimate historical Gross Margin %.
Sales x (1 - Estimated Gross Margin %) = Estimated COGS
Beg. Inventory + Net Purchases = Cost of Goods Available for Sale (COGAS)
Estimated COGS - COGAS = Estimated Cost of Ending Inventory

18. Gross Profit Method Example
NoteCo, 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.

19. Gross Profit Method Example
NOTE: The key to successfully applying this method is a reliable Gross Margin %.

20. 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.

21. Retail Inventory Method
Sales for the period.
Beginning inventory at retail and cost.
We need to know . . .
Net purchases at retail and cost.
Adjustments to the original retail price.

22. Steps 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.

23. Retail Inventory Method Example
Webb Clothiers, 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.

24. Retail Inventory Method Example

25. Retail Inventory Method Example

26. 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 %.

27. Retail Inventory Method Average Cost Example
Webb, 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, and net sales for June $300,000.
Estimate inventory at June 30.

28. Retail Inventory Method Average Cost Example

29. Retail Inventory Method Average Cost Example

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

31. Retail Inventory Method Average LCM Example
Webb, 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, and net sales for June $300,000.
Let’s estimate inventory at June 30.

32. Retail Inventory Method Average LCM Example

33. Retail Inventory Method Average LCM Example

34. 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.

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

36. The LIFO Retail Method Example
Use the data from Webb 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.

37. The LIFO Retail Method Example

38. Others Issues of Retail Method
Purchase returns and purchase discounts.
Freight-in.
Employee discounts.
Spoilage, breakage, and theft.

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

40. Dollar-Value LIFO Retail Example
Use the data from Webb 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.

41. Dollar-Value LIFO Retail Example

42. Changes in Inventory Method
Changes not involving LIFO
Report the cumulative effect of the change, net of tax, on the current income statement.
Changes to LIFO from other methods
Usually impossible to determine the cumulative effect.
Changes from LIFO to other methods
Retroactively restate financial statements for each year reported.

43. 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.

44. 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.

45. 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.

46. End of Chapter 9