© 2004 the mcgraw-hill companies, inc. mcgraw-hill/irwin chapter 9 inventory: additional issues
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© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Slide9-2
Lower of Cost or Market (LCM)
GAAP requires that inventories be carried at cost or current market
value, whichever is lower.
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.
LCM is a departure from historical cost and is a conservative accounting
method.
© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Slide9-3
Determining Market Value
Net RealizableValue (Ceiling)
Net Realizable Value less Normal Profit
(Floor)
• Market value is NOT Market value is NOT necessarily the necessarily the amount for which amount for which inventory can be inventory can be sold.sold.
• Accounting Research Accounting Research Bulletin No. 43 Bulletin No. 43 defines “market defines “market value” in terms of value” in terms of current replacement current replacement cost.cost.
• Market value is NOT Market value is NOT necessarily the necessarily the amount for which amount for which inventory can be inventory can be sold.sold.
• Accounting Research Accounting Research Bulletin No. 43 Bulletin No. 43 defines “market defines “market value” in terms of value” in terms of current replacement current replacement cost.cost.
© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Slide9-4
Determining Market Value
Net RealizableValue (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.
ReplacementCost
ReplacementCost
The definition of The definition of market market valuevalue varies varies
internationally. In the UK, internationally. In the UK, Denmark, Finland, and Denmark, Finland, and New Zealand, market New Zealand, market
value is defined as NRV.value is defined as NRV.
The definition of The definition of market market valuevalue varies varies
internationally. In the UK, internationally. In the UK, Denmark, Finland, and Denmark, Finland, and New Zealand, market New Zealand, market
value is defined as NRV.value is defined as NRV.
© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Slide9-5
Determining Market Value
Net Realizable Value less Normal Profit
(Floor)
Net RealizableValue (Ceiling)
If replacement cost > Ceiling, then
Ceiling = Market Value
ReplacementCost
ReplacementCost
If replacement cost < Floor, then
Floor = Market Value
© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Slide9-6
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?
© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Slide9-7
LCM - Example
Net RealizableValue (Ceiling)
Net Realizable Value less Normal
Profit (Floor)
ReplacementCost =$21.50
ReplacementCost =$21.50
Which one do we use?
© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Slide9-8
Market value = $21.50Market value = $21.50Cost = $20.00Cost = $20.00
Should the inventory be Should the inventory be recorded at cost or market?recorded at cost or market?
Market value = $21.50Market value = $21.50Cost = $20.00Cost = $20.00
Should the inventory be Should the inventory be recorded at cost or market?recorded at cost or market?
Market value = $21.50Market value = $21.50Cost = $20.00Cost = $20.00
Since Cost < Market, the LCM Since Cost < Market, the LCM rule would dictate that inventory rule would dictate that inventory
be recorded at Cost.be recorded at Cost.
Market value = $21.50Market value = $21.50Cost = $20.00Cost = $20.00
Since Cost < Market, the LCM Since Cost < Market, the LCM rule would dictate that inventory rule would dictate that inventory
be recorded at Cost.be recorded at Cost.
LCM - Example
Net RealizableValue (Ceiling)
Net Realizable Value less Normal
Profit (Floor)
ReplacementCost =$21.50
ReplacementCost =$21.50
In this case, market value will be In this case, market value will be $21.50, because the $21.50, because the
replacement cost is between the replacement cost is between the ceiling and the floor.ceiling and the floor.
In this case, market value will be In this case, market value will be $21.50, because the $21.50, because the
replacement cost is between the replacement cost is between the ceiling and the floor.ceiling and the floor.
© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Slide9-9
LCM - Another Example
An inventory item is currently carried at An inventory item is currently carried at historical cost of $95.00 per unit. At the historical cost of $95.00 per unit. At the
Balance Sheet date we gather the Balance Sheet date we gather the following per unit information: current following per unit information: current
replacement cost = $80.00; NRV = replacement cost = $80.00; NRV = $100.00; and NRV reduced by normal $100.00; and NRV reduced by normal
profit = $85.00.profit = $85.00.How would we value the item on our How would we value the item on our
Balance Sheet?Balance Sheet?
An inventory item is currently carried at An inventory item is currently carried at historical cost of $95.00 per unit. At the historical cost of $95.00 per unit. At the
Balance Sheet date we gather the Balance Sheet date we gather the following per unit information: current following per unit information: current
replacement cost = $80.00; NRV = replacement cost = $80.00; NRV = $100.00; and NRV reduced by normal $100.00; and NRV reduced by normal
profit = $85.00.profit = $85.00.How would we value the item on our How would we value the item on our
Balance Sheet?Balance Sheet?
© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Slide9-10 Lower of Cost or Market
Another Example
Net Realizable Value less Normal Profit
(Floor) = $85
Net Realizable Value (Ceiling) = $100
ReplacementCost =$80
ReplacementCost =$80
?
?
?
Which one do we use as
market value?
Which one do we use as
market value?
© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Slide9-11 Lower of Cost or Market
Another Example
Should the inventory be carried at Market Value or Cost?
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
ReplacementCost =$80
ReplacementCost =$80
© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Slide9-12
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 each 2. Apply LCM to each classclass of inventory. of inventory. 2. Apply LCM to each 2. Apply LCM to each classclass of inventory. of inventory. 3. Apply LCM to the 3. Apply LCM to the entireentire inventory as a inventory as a
group. group. 3. Apply LCM to the 3. Apply LCM to the entireentire inventory as a inventory as a
group. group.
Applying LCMLCM can be applied 3 different ways.
© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Slide9-13 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 Adjust inventory directly or using an
allowance account.
© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Slide9-14
Inventory Estimation Techniques
Estimate instead of taking physical inventory Less costly Less time consuming
Two popular methods are . . . Gross Profit Method Retail Inventory Method
© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Slide9-15
Gross Profit Method
Useful when . . .
Useful when . . .
Estimating inventory & COGS for interim
reports.
Estimating inventory & COGS for interim
reports.
Determining the cost of inventory
lost, destroyed, or stolen.
Determining the cost of inventory
lost, destroyed, or stolen.
Auditors are testing the overall
reasonableness of client inventories.
Auditors are testing the overall
reasonableness of client inventories.
Preparing budgets and forecasts.
Preparing budgets and forecasts.
NOTE: The Gross Profit Method is not accepted by GAAP.NOTE: The Gross Profit Method is not accepted by GAAP.
© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Slide9-16
Gross Profit MethodAssumes that the historical gross margin
rate is reasonably constant in the short run.
Assumes that the historical gross margin rate is reasonably constant in the short run.
Cost of beginning inventory.
Cost of beginning inventory.
Net purchases for the period.
Net purchases for the period.
Historical gross margin rate.
Historical gross margin rate.
Net sales for the period.
Net sales for the period.
We need to know . . .
We need to know . . .
© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Slide9-17
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. Estimated COGS - COGAS = Estimated Cost of Ending Inventory
© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Slide9-18 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.Estimate Inventory at May 31.
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.Estimate Inventory at May 31.
© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Slide9-19 Gross Profit Method
Example
NOTE: The key to successfully applying this method is a reliable Gross Margin %.
NOTE: The key to successfully applying this method is a reliable Gross Margin %.
© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Slide9-20
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 Objective: Convert ending inventory at retail to ending inventory at retail to ending
inventory at cost.inventory at cost.
Objective: Convert ending Objective: Convert ending inventory at retail to ending inventory at retail to ending
inventory at cost.inventory at cost.
© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Slide9-21
Retail Inventory Method
We need to know . . .
We need to know . . .
Sales for the period.
Sales for the period.
Beginning inventory at retail
and cost.
Beginning inventory at retail
and cost.
Adjustments to the original retail price.
Adjustments to the original retail price.
Net purchases at retail and cost.
Net purchases at retail and cost.
© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Slide9-22 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.
© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Slide9-23 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.
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.
© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Slide9-26
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 %.
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 %.
© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Slide9-27 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.
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.
© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Slide9-28 Retail Inventory Method
Average Cost Example
© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Slide9-29 Retail Inventory Method
Average Cost Example
x
© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Slide9-30 Retail Inventory Method
Average LCM
Approximating Average LCM
Net Markdowns are excluded in the
computation of the Cost-to-Retail %
Net Markdowns are excluded in the
computation of the Cost-to-Retail %
© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Slide9-31 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.
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.
© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Slide9-32 Retail Inventory Method
Average LCM Example
© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Slide9-33 Retail Inventory Method
Average LCM Example
x
© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Slide9-34
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.
© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Slide9-35
The LIFO Retail Method
Beginning inventory has its owncost-to-retail percentage.
Beginning inventory has its owncost-to-retail percentage.
© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Slide9-36 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.
© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Slide9-38
Others Issues of Retail Method
Purchase returns and purchase discounts.
Freight-in.
Employee discounts.
Spoilage, breakage, and theft.
© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Slide9-39
Dollar-Value LIFO Retail
We need to eliminate the effect of any price changes before we compare
the ending inventory with the beginning inventory.
© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Slide9-40 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.
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.
© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Slide9-42
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.
© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Slide9-43
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.
© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Slide9-44
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.
© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin
Slide9-45
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.
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