9 Inventories: Additional Issues 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 McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved. Reporting -- Lower of Cost or Market Inventories are valued at the lowerof-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. 9-2 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.” 9-3 Market Should Not Exceed Net Realizable Value (Ceiling) Market Should Not Be Less Than Net Realizable Value less Normal Profit (Floor) 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 9-4 Cost 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? 9-5 Lower of Cost or Market Selling Cost to = Ceiling Price Complete $ 30.00 - $ 4.00 = $ 26.00 Replacement Cost =$21.50 Normal = Floor Profit $ 26.00 - $ 5.00 = $ 21.00 Ceiling 9-6 - Designated $21.50 Market? Historical cost of $20.00 is less than designated market of $21.50, so this inventory item will be valued at cost of $20.00. 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. 9-7 Adjusting Cost to Market 1. Record the Loss as a Separate Item in the Income Statement Loss on write-down of inventory Inventory XX XX 2. Record the Loss as part of Cost of Goods Sold. Cost of goods sold Inventory 9-8 XX XX U. S. GAAP vs. IFRS 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. • 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. 9-9 • IAS No. 2, states that the designated market will always be net realizable value. U. S. GAAP vs. IFRS 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. • 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. 9 - 10 • 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. 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 9 - 11 Gross Profit Method Estimating inventory and 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 acceptable for use in annual financial statements. 9 - 12 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 Historical Gross Profit Ratio 9 - 13 Gross Profit Method Matrix, Inc. uses the gross profit method to estimate end of month inventory. At the end of May, the controller has the following data: 1. 2. 3. 4. Net sales for May = $1,213,000 Net purchases for May = $728,300 Inventory at May 1 = $237,400 Estimated gross profit ratio = 43% of sales Estimate Inventory at May 31. 9 - 14 Gross Profit Method Beginning Inventory Plus: Net Purchases = Goods Available for Sale Less: Estimated COGS* = Estimated Ending Inventory $ 237,400 728,300 965,700 (691,410) $ 274,290 * COGS = Sales x (1 - GP%) = $ 1,213,000 x ( 1 - 43% ) = $ 691,410 NOTE: The key to successfully applying this method is a reliable Gross Profit Ratio. 9 - 15 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 - 16 The Retail Inventory Method Retail Terminology Term Initial markup Additional markup Markup cancellation Markdown Markdown cancellation 9 - 17 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. The Retail Inventory Method Beginning inventory at retail and cost. Sales for the period. We need to know . . . Net purchases at retail and cost. 9 - 18 Adjustments to the original retail price. Retail Terminology An Example of the Terminology 9 - 19 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. 9 - 20 The Retail Inventory Method Inventory, May 1 Net purchases for May Goods available for sale Cost-to-Retail Percentage: (207,000 ÷ 345,000) = 60% Sales for May Ending inventory at retail Ending inventory at cost 9 - 21 Cost Retail $ 27,000 $ 45,000 180,000 300,000 207,000 345,000 (310,000) $ 35,000 ? The Retail Inventory Method Cost Retail $ 27,000 $ 45,000 180,000 300,000 207,000 345,000 Inventory, May 1 Net purchases for May Goods available for sale Cost-to-Retail Percentage: (207,000 ÷ 345,000) = 60% Sales for May Ending inventory at retail Ending inventory at cost $ 9 - 22 × x 21,000 (310,000) $ 35,000 The Retail Inventory Method We can estimate ending inventory at average LCM using the cost-to-retail percentage shown below: Cost-toRetail % = Beginning Inventory + Net Purchases Retail Value (Beginning Inventory + Net Purchases + Net Markups) Net Markdowns are excluded in the computation of the cost-to-retail percentage. This is referred to as the Conventional Retail Method 9 - 23 The Retail Inventory Method 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 - 24 The Retail Inventory Method 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 - 25 Retail Inventory Method LIFO Retail Cost Inventory, July 1 ($21,000 ÷ $35,000 = 60% ) $ 21,000 Plus: Net Purchases 200,000 Net Markups Less: Net Markdowns Purchases for July 200,000 ($200,000 ÷ $308,000 = 64.94% rounded 9 - 26 Retail $ 35,000 304,000 8,000 (4,000) 308,000 Retail Inventory Method LIFO Retail Cost Inventory, July 1 ($21,000 ÷ $35,000 = 60% ) $ 21,000 Plus: Net Purchases 200,000 Net Markups Less: Net Markdowns Purchases for July 200,000 ($200,000 ÷ $308,000 = 64.94% rounded Sales for July LIFO layer for July 9 - 27 Retail $ 35,000 304,000 8,000 (4,000) 308,000 (300,000) 8,000 Retail Inventory Method LIFO Retail Inventory, July 1 ($21,000 ÷ $35,000 = 60% ) Plus: Net Purchases Net Markups Less: Net Markdowns Goods available for sale ($200,000 ÷ $308,000 = 64.94% rounded Sales for July LIFO layer for July Beginning Inventory Current Period's Layer Total ** rounded 9 - 28 Cost Retail $ 21,000 200,000 $ 35,000 304,000 8,000 (4,000) 308,000 200,000 Retail $ 35,000 x 60.00% = 8,000 x 64.94% = $ 43,000 (300,000) 8,000 Cost 21,000 5,195 ** 26,195 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 - 29 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 - 30 Analyzing Inventory Errors 9 - 31 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 - 32 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. 9 - 33 Inventory Errors When 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 Subsequent to 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. 9 - 34 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. 9 - 35 Earnings Quality Many believe that manipulating income reduces earnings quality because it can mask permanent earnings. Inventory write-downs and changes in inventory method are two additional inventoryrelated techniques a company could use to manipulate earnings. 9 - 36