Conducted by: Mr. Koy Chumnith

Inventories:Additional Issues

9

McGraw-Hill/Irwin 2011, Royal University of Law and Economics

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Reporting -- Lower of Cost or Market

Inventories are valued at the lower-of-cost-or market.

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.

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.

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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 GAAP defines “market value” in “market value” in terms of current terms of current replacement cost.replacement cost.

Market should not be Market should not be greater than the greater than the “ceiling” or less than “ceiling” or less than the “floor.”the “floor.”

GAAP defines GAAP defines “market value” in “market value” in terms of current terms of current replacement cost.replacement cost.

Market should not be Market should not be greater than the greater than the “ceiling” or less than “ceiling” or less than the “floor.”the “floor.”

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Determining Market Value

CeilingCeilingNRVNRV

CeilingCeilingNRVNRV

ReplacementReplacementCostCost

ReplacementReplacementCostCost

NRV – NPNRV – NPFloorFloor

NRV – NPNRV – NPFloorFloor

DesignatedDesignatedMarketMarket

DesignatedDesignatedMarketMarket

CostCostCostCostNot More Than

Not Less Than

Or

Step 1Determine Designated Market

Step 2Compare Designated Market with Cost

Lower of CostLower of CostOr MarketOr Market

Lower of CostLower of CostOr MarketOr Market

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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 of = $5

• How would we value this item in the Balance Sheet?

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Lower of Cost or Market

ReplacementCost =$21.50

ReplacementCost =$21.50

$21.50DesignatedMarket?

Historical cost of $20.00 is Historical cost of $20.00 is less than designated less than designated

market of $21.50, so this market of $21.50, so this inventory item will be inventory item will be

valued at cost of $20.00.valued at cost of $20.00.

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1. Apply LCM to 1. Apply LCM to each individual itemeach individual item in in inventory. inventory.

1. Apply LCM to 1. Apply LCM to each individual itemeach individual item in in inventory. inventory.

2. Apply LCM to logical inventorycategories.

2. Apply LCM to logical inventorycategories.

3. Apply LCM to the entire inventory as a group.

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.

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Adjusting Cost to Market1. 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

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U. S. GAAP vs. IFRS

• LCM requires selecting market from replacement cost, net realizable value or NRV reduced by the normal profit margin.

• Designated market is compared to historical cost to determine LCM.

International standards require inventory to be valued at the lower of cost or market, but the process is slightly

different for the U.S. method of applying LCM.

• IAS No. 2, states that the designated market will always be net realizable value.

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U. S. GAAP vs. IFRS

• Under U.S. GAAP, the LCM rule can be applied to individual items, logical inventory categories, or the entire inventory.

• Reversals are not permitted under GAAP.

International standards require inventory to be valued at the lower of cost or market, but the process is slightly

different for the U.S. method of applying LCM.

• The LCM assessment usually is applied to individual items, although using logical inventory categories is allowed under certain circumstances.

• If an inventory write-down is not longer appropriate, it must be reversed.

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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

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Gross Profit Method

Useful when . . .Useful

when . . .

Estimating inventory and 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.

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Gross Profit Method

This method assumes that the historical gross margin ratio is reasonably constant in the short-run.

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 Historical Gross Profit Ratio

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Gross Profit Method

Matrix, Inc. uses the gross profit method to estimate Matrix, Inc. uses the gross profit method to estimate end of month inventory. At the end of May, the end of month inventory. At the end of May, the

controller has the following data:controller has the following data:

1.1. Net sales for May = $1,213,000Net sales for May = $1,213,0002.2. Net purchases for May = $728,300Net purchases for May = $728,3003.3. Inventory at May 1 = $237,400 Inventory at May 1 = $237,400 4.4. EstimatedEstimated gross profit ratio = 43% of sales gross profit ratio = 43% of sales

Estimate Inventory at May 31.Estimate Inventory at May 31.

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Gross Profit Method

NOTE: The key to successfully applying this method is a reliable Gross Profit Ratio.

NOTE: The key to successfully applying this method is a reliable Gross Profit Ratio.

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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 Objective: Convert ending inventory at retail to ending inventory at cost.retail to ending inventory at cost.

Objective: Convert ending inventory at Objective: Convert ending inventory at retail to ending inventory at cost.retail to ending inventory at cost.

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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 TerminologyRetail Terminology

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The Retail Inventory Method

We need to know . . .

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.

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Retail Terminology

An Example of the Terminology

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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.

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The Retail Inventory Method

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The Retail Inventory Method

x×

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Retail Inventory MethodMarkups 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,• And 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,• And net sales for July $300,000.

Estimate inventory at July 31.

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Retail Inventory MethodWith Markups and Markdowns

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Retail Inventory MethodWith Markups and Markdowns

x

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The Retail Inventory Method

Net Markdowns areNet Markdowns are excludedexcluded in the computation of in the computation of the cost-to-retail percentage. This is referred to as thethe cost-to-retail percentage. This is referred to as the

Conventional Retail MethodConventional Retail Method

We can estimate ending inventory at We can estimate ending inventory at average LCM average LCM using the cost-to-retail using the cost-to-retail

percentage shown below:percentage shown below:

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The Retail Inventory 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.

The LIFO Retail MethodThe LIFO Retail Method

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The Retail Inventory Method

Beginning inventory has its ownBeginning inventory has its owncost-to-retail percentage.cost-to-retail percentage.

The LIFO Retail MethodThe LIFO Retail Method

LIFO Cost- = Net Purchases

to-Retail % Retail Value (Net Purchases + Net Markups - Net Markdowns)

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Retail Inventory MethodLIFO Retail

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Retail Inventory MethodLIFO Retail

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Retail Inventory MethodLIFO Retail

Retail CostBeginning Inventory 35,000$ x 60.00% = 21,000 Current Period's Layer 8,000 x 64.94% = 5,195 ** Total 43,000$ 26,195

** rounded

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Other Issues of Retail Method

Element TreatmentBefore 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 columnsAfter calculating the cost-to-retain percentage Normal shortage, spoilage, or theft Deducted in the retail column Employee discounts Added to net sales

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Dollar-Value LIFO Retail

We need to eliminate the effect of any price changes before we compare the ending inventory with the beginning inventory.

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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% gross profit ratio.

Net purchases at cost $200,000, at retail $304,000.Net purchases at cost $200,000, at retail $304,000.

Net markups $8,000.Net markups $8,000.

Net markdowns $4,000.Net markdowns $4,000.

Net sales for June $300,000.Net sales for June $300,000.

Price index at June 1 is 100 and at June 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% gross profit ratio.

Net purchases at cost $200,000, at retail $304,000.Net purchases at cost $200,000, at retail $304,000.

Net markups $8,000.Net markups $8,000.

Net markdowns $4,000.Net markdowns $4,000.

Net sales for June $300,000.Net sales for June $300,000.

Price index at June 1 is 100 and at June 30

the index is 102.

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Dollar-Value LIFO Retail

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Changes in Inventory Method

Recall that most voluntary changes in accounting principles are reported

retrospectivelyretrospectively. 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 Changes in inventory methods, other than a change to LIFO, are treated change to LIFO, are treated retrospectivelyretrospectively..Changes in inventory methods, other than a Changes in inventory methods, other than a change to LIFO, are treated change to LIFO, are treated retrospectivelyretrospectively..

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Change To The LIFO Method

When a company elects to change toto LIFO, it is usually impossibleimpossible 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) thenature of the change; (b) the effect of the

change on current year’s income andearnings per share, and (c) why retrospective

application was impracticable.

A disclosure note is needed to explain (a) thenature of the change; (b) the effect of the

change on current year’s income andearnings per share, and (c) why retrospective

application was impracticable.

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Analyzing Inventory Errors

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Inventory Errors

Overstatement of ending inventory◦ Understates cost of goods sold andUnderstates cost of goods sold and◦ Overstates pretax income.Overstates pretax income.

Understatement of ending inventory◦ Overstates cost of goods sold andOverstates cost of goods sold and◦ Understates pretax income.Understates pretax income.

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Inventory Errors

Overstatement of beginning inventory◦ Overstates cost of goods sold andOverstates cost of goods sold and◦ Understates pretax income.Understates pretax income.

Understatement of beginning inventory◦ Understates cost of goods sold andUnderstates cost of goods sold and◦ Overstates pretax income.Overstates pretax income.

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Inventory ErrorsWhen the Inventory Error is Discovered the Following Year

If an error was made in 2010, but not discovered until 2011, the 2010 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 2011 and 2010 financial statements are issued in 2011.

When the Inventory Error is Discovered Subsequentto the Following Year

If an error was made in 2010, but not discovered until 2012, the 2011 financial statements also are retrospectively restated to reflect the correct cost of goods sold and net income even though no correcting entry is needed. The error has self-corrected and no prior period adjustment is needed.

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Inventory Errors

Overstatement of purchases◦ Overstates cost of goods sold andOverstates cost of goods sold and◦ Understates pretax income.Understates pretax income.

Understatement of purchases◦ Understates cost of goods sold andUnderstates cost of goods sold and◦ Overstates pretax income.Overstates pretax income.

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Earnings Quality

Many believe that manipulating income reduces Many believe that manipulating income reduces earnings quality because it can mask permanent earnings quality because it can mask permanent earnings. Inventory write-downs and changes in earnings. Inventory write-downs and changes in inventory method are two additional inventory-inventory method are two additional inventory-

related techniques a company could use to related techniques a company could use to manipulate earnings.manipulate earnings.

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Appendix 9

PurchaseCommitments

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Purchase CommitmentsPurchase 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 2011, the Lassiter Company. signed two purchase commitments.The first requires Lassiter to purchase inventory for $500,000 byNovember 15, 2011. The inventory is purchased on November 14, andpaid 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, 2012. On December 31, 2011,the market value of the inventory items was $540,000. OnFebruary 15, 2012, the market value of the inventory items was$510,000. Lassiter uses the perpetual inventory system and is acalendar year-end company.

Let’s make the journal entries for these commitments.

In July 2011, the Lassiter Company. signed two purchase commitments.The first requires Lassiter to purchase inventory for $500,000 byNovember 15, 2011. The inventory is purchased on November 14, andpaid 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, 2012. On December 31, 2011,the market value of the inventory items was $540,000. OnFebruary 15, 2012, the market value of the inventory items was$510,000. Lassiter uses the perpetual inventory system and is acalendar year-end company.

Let’s make the journal entries for these commitments.

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Purchase Commitments

Single-period commitment

November 14, 2011Inventory (market price) 425,000Loss on purchase commitment 75,000

Accounts payable 500,000

December 15, 2011Accounts payable 500,000

Cash 500,000

Multi-period commitment

December 31, 2011Estimated loss on commitment 60,000

Estimated liability on commitment 60,000

February 15, 2012Inventory (market price) 510,000Loss on purchase commitment 30,000Estimated liability on commitment 60,000

Cash 600,000

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End of Chapter 9