Inventories:
Additional Issues
Chapter 9
PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
9-2
Reporting —Lower of Cost or Market
Inventories are valued at the lower of
cost or market (LCM).
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.
9-3
Determining Market Value
 GAAP defines
“market value” in
terms of current
replacement cost.
 Market should not be
greater than the
“ceiling” or less than
the “floor.”
Market Should Not
Exceed Net Realizable
Value (Ceiling)
Market Should Not Be
Less Than Net Realizable
Value less Normal Profit
(Floor)
9-4
Determining Market Value
Step 1
Determine Designated Market
Step 2
Compare Designated Market with Cost
Ceiling
NRV
Not More Than
Replacement
Cost
Designated
Market
Or
Not Less Than
Lower of Cost
or Market
NRV – NP
Floor
Cost
9-5
Applying Lower of Cost or Market
Lower of cost or market can be applied 3
different ways.
1. Apply LCM to each individual item in
inventory such as printers.
9-6
Applying Lower of Cost or Market
Lower of cost or market can be applied 3
different ways.
2. Apply
LCM
to logical
inventory
1. Apply
LCM
to each
individual
item in
categories, such
as desktop and laptop
inventory.
computers.
9-7
Applying Lower of Cost or Market
Lower of cost or market can be applied 3
different ways.
3.1.Apply
Apply
2. Apply
LCM
LCM
LCM
to
tothe
each
to entire
logical
individual
inventory
inventory
itemasina
categories.
inventory.
group.
9-8
U. S. GAAP vs. IFRS
International and U.S. standards for valuing inventory at
the lower of cost or market are slightly different.
•
•
•
•
Inventory is valued at the lower of
cost or market with market selected
from replacement cost, net realizable
value or NRV reduced by the normal
profit margin.
Designated market is compared to
historical cost to determine LCM.
The LCM rule can be applied to
individual items, logical inventory
categories, or the entire inventory.
Reversals are not permitted.
•
•
•
Inventory is valued at the lower or
cost of market and net realizable
value.
The assessment usually is applied
to individual items, although using
logical inventory categories is
allowed under certain
circumstances.
If an inventory write-down is no
longer appropriate, it must be
reversed.
9-9
Inventory Estimation Techniques

Estimate instead of taking physical inventory
1.
2.

Less costly
Less time-consuming
Two popular methods of estimating ending inventory
are the . . .
1.
2.
Gross profit method
Retail inventory method
9-10
Gross Profit Method
Auditors in testing
the overall
reasonableness of
client inventories.
Estimating inventory
and COGS for
interim reports.
Useful
when . . .
Determining the cost
of inventory lost,
destroyed, or stolen.
Preparing budgets
and forecasts.
NOTE:The gross profit method is not acceptable
for use in annual financial statements.
9-11
Gross Profit Method
This method assumes that the historical gross margin
ratio is reasonably constant in the short-run.
Beginning Inventory
Plus: Net purchases
Goods available for sale
Less: Cost of goods sold
Ending inventory
(from accounting records)
(from accounting records)
(calculated)
(estimated)
(estimated)
Estimate the Gross Profit Ratio
9-12
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
retail to ending inventory at cost.
9-13
The Retail Inventory Method
Retail Terminology
Term
Initial markup
Additional markup
Markup cancellation
Markdown
Markdown cancellation
Meaning
Original amount of markup from cost to selling price.
Increase in selling price subsequent to initial markup.
Elimination of an additional markup.
Reduction in selling price below the original selling price.
Elimination of a markdown.
9-14
Retail Terminology
An Example of the Terminology
9-15
The Retail Inventory Method
Beginning
inventory at retail
and cost.
Sales for the
period.
We need to
know . . .
Net purchases at
retail and cost.
Adjustments to the
original retail price.
9-16
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.
9-17
The LIFO Retail Method
LIFO cost- =
to-retail %
Net purchases
Retail value (Net purchases
+ Net markups - Net markdowns)
Beginning inventory has its own
cost-to-retail percentage.
9-18
Other Issues of Retail Method
Element
Treatment
Before 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 columns
After calculating the cost-to-retain percentage
Normal shortage, spoilage, or theft
Deducted in the retail column
Employee discounts
Added to net sales
9-19
Dollar-Value LIFO Retail
We need to eliminate the effect of any price
changes before we compare the ending
inventory with the beginning inventory.
9-20
Changes 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.
Changes in inventory methods, other than a
change to LIFO, are treated retrospectively.
9-21
Change 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 retrospective
application was impracticable.
9-22
Inventory Errors
Beginning inventory
Plus: Net purchases
Less: Ending inventory
Cost of goods sold
Revenues
Less: Cost of goods sold
Less: Other expenses
Net income
Beginning retained earnings
Plus: net income
Less: Dividends
Ending retained earnings
When analyzing inventory errors, it’s helpful
to visualize the way cost of goods sold, net
income, and retained earnings are
determined.
9-23
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.
9-24
Inventory Errors
 Overstatement of beginning inventory
◦ Overstates cost of goods sold and
◦ Understates pretax income.
 Understatement of beginning
◦ Understates cost of goods sold and
◦ Overstates pretax income.
inventory
9-25
Inventory Errors
When the Inventory Error is Discovered the Following Year
If an error was made in 2013, but not discovered until 2014, the 2013
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 2014 and 2013 financial statements are issued for 2014.
When the Inventory Error is Discovered Subsequent
to the Following Year
If an error was made in 2013, but not discovered until 2015, all previous
years’ financial statements that were incorrect as a result of the error also
are retrospectively restated to reflect the correct inventory, cost of goods
sold, retained earnings, and net income even though no correcting entry
is needed in 2015. The error has self-corrected and no prior period
adjustment is needed.
9-26
End of Chapter 9