Inventory

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Unit 7
8-1
Inventories
Recording and Measuring Inventory
Types (Sources) of Inventories
Merchandise
Inventory
Goods acquired for
resale
Manufacturing
Inventory
•Raw Materials
•Work-in-Process
•Finished Goods
8-2
Manufacturing Inventories
Raw
Materials Control


Direct
Labor Control


Work-inProcess Control
$XX

Finished
Goods
$XX

Cost of Goods Sold
$XX
Manufacturing
Overhead Control


Raw materials purchased
Direct labor incurred
Manufacturing overhead incurred
Raw materials used
Direct labor applied
Manufacturing overhead applied
Work-in-process transferred to finished goods
Finished goods sold
8-3
Inventory Systems
Two accounting systems are used to record
transactions involving inventory:
Perpetual
Inventory System
Periodic Inventory
System
The inventory
account is
continuously
updated as
purchases and
sales are made.
The inventory
account is
adjusted at the end
of a reporting
period.
8-4
Perpetual Inventory System
During 2013, LWBC purchased merchandise on account at
a cost of $600,000. It sold, on account, inventory with a retail
price of $820,000 and a cost basis of $540,000 (sold 90%), to
customers.
2013
Inventory
Accounts payable
600,000
600,000
To record the purchase of merchandise inventory.
2013
Accounts receivable
Sales revenue
820,000
820,000
To record sales on account.
Cost of goods sold
Inventory
To record cost of goods sold.
Note:
540,000
540,000
8-5
Periodic Inventory System
The periodic inventory system is not designed to track
either the quantity or cost of merchandise inventory. Cost
of goods sold is calculated, using the schedule below, after
the physical inventory count at the end of the period.
Beginning Inventory
+ Net Purchases
Cost of Goods Available for Sale
- Ending Inventory
= Cost of Goods Sold
8-6
Periodic Inventory System - Example
During 2013, LWBC sold, on account, inventory with a retail
price of $820,000 to customers, and a cost basis of $540,000.
2013
Accounts receivable
Sales revenue
820,000
820,000
To record sales on account.
No entry is made to record cost of goods sold. A physical count
of ending inventory shows a balance of $180,000.
We will calculate cost of goods sold at the end of 2013, next.
8-7
Periodic Inventory System
Calculation of Cost of Goods Sold
Beginning inventory (given info)
Plus: Purchases
Cost of goods available for sale
Less: Ending inventory (by counting)
Cost of goods sold
$
$
120,000
600,000
720,000
(180,000)
540,000
We need the following adjusting entry to record cost of good sold.
December 31, 2013
Cost of goods sold
Inventory (ending)
Inventory (beginning)
Purchases
1. adjust inventory,
2. close the purchases account,
3. and record cost of goods sold.
540,000
180,000
120,000
600,000
8-8
Comparison of Inventory Systems
Transaction or
Event
Periodic Inventory Perpetual Inventory
Routine purchases of
various inventory items
Costs debited to
purchases account
Costs debited to
inventory account
Sale of inventory
No accounting entries
made to inventory
Debit cost of goods
sold and credit
inventory
End-of-period
accounting entries and
related activities
Physical count to
No separate
determine ending
determination of cost of
inventory and cost of
goods sold necessary
goods sold
8-9
What is Included in Inventory?
The Problem
In some situations the identification of items that should
be included in inventory can be difficult. Consider, for
example the following:
Goods in Transit
Depends on f.o.b.
shipping terms.
f.o.b. shipping point or f.o.b. destination
Goods on
Consignment
8-10
Expenditures Included in Inventory
Purchase
Returns and
Allowances
Invoice Price
+
Freight-in on
Purchases
Inventory
Purchase
Discounts
8-11
Purchase Returns - Example
On November 8, 2013, LWBC returns merchandise that had a cost
to LWBC of $2,000.
Periodic Inventory Method
11/8/13
Accounts payable
Purchase returns
Perpetual Inventory Method
2,000
2,000
Accounts payable
Inventory
2,000
periodic inventory method: Returns of inventory are
credited to the Purchase Returns account.
perpetual inventory method: The returns are credited to
Inventory.
2,000
8-12
Purchase Discounts
Gross Method
October 5, 2013
Purchases
Accounts payable
20,000
20,000
October 14, 2013
Accounts payable
14,000
Purchase discounts
Cash
November 4, 2013
Accounts payable
Cash
Discount terms are
2/10, n/30.
$14,000
x 0.02
$ 280
Net Method
280
13,720
6,000
6,000
Purchases
Accounts payable
19,600
Accounts payable
Cash
13,720
Accounts payable
Interest expense
Cash
5,880
120
Partial payment not
made within the
discount period
19,600
13,720
6,000
$20,000
x 0.02
$ 400
̵120
$ 280
8-13
Inventory Cost Flow Assumptions

Specific identification

Average (Weighted) cost

First-in, first-out (FIFO)

Last-in, first-out (LIFO)
Perpetual – (Weighted) Average Cost
Method Example
8-14
Picture This, LLC, is in the process of determining the
cost of goods sold for frame number 759 for the month of
September.
The ending inventory on September 30 is 1,400 frames.
Use the perpetual average cost method to determine:
(1) Ending inventory cost
(2) Cost of goods sold
8-15
Perpetual Average Cost
Basic Data for the Example
Picture This, LLC
Inventory of frame number 759
Cost per
Units
Unit
Beg. Inventory
2,000
$ 10.00
Purchase 9/3
1,000
10.75
Purchase 9/21
1,000
10.95
Units available for sale
4,000
Units sold in September
Sale 9/7
Sale 9/29
Units sold in September
Units in ending inventory
1,800
800
2,600
1,400
Total Cost
$ 20,000.00
10,750.00
10,950.00
$ 41,700.00
8-16
Perpetual
Average Cost
Inventory System
Date
1/1/12
9/3/12
Units
Purchased
2,000
1,000
3,000
Unit
Units
Cost
Sold
10.00
10.75
10.25
9/7/12
9/21/12
9/29/12
12/31/12
Total Cost
Avg
Cost of Goods
Unit Cost
Sold
1,800
1,000
2,200
10.95
10.57
800
1,400
18,450
8,455
26,905
Ending
Balance
20,000
0
10,750
30,750 10.25=30,750/3,000
12,300 18,450=1,800x10.25
12,300=1,200 x 10.25 End Inv
10,950
23,250 10.57=23,250/2,200
14,795
41,700 ‘=26,905+14,795
Under Perpetual Average Cost Inventory System, each time inventory is purchased
or sold the inventory layer is adjusted (recalculated).
8-17
Periodic System (Weighted) Average Cost
e.g.: assume using the same information as on P. 15
to assign costs to ending inventory and cost of
goods sold.
Ending Inventory
(1,400 units)
Beginning Inventory
(2,000 units)
Available
for Sale
(4,000 units)
Goods Sold
(2,600 u)
$41,700 ÷ 4,000 = $10.425
(weighted) average cost per unit
Periodic Inventory System
Weighted Average Cost
Beginning Inventory (2,000 u @ 10)
20,000
Plus: Purchases (2,000 u @various unit cost:10750+10950)
Cost of Goods Available for Sale
Less: Ending Inventory (1,400 u x (41,700/4,000 = 10.425))
Cost of Goods Sold (2,600 u)
21,700
41,700
14,595
27,105
21,700 = (1,000 x 10.75) + (1,000 x 10.95)
8-19
First-In, First-Out (FIFO)
The FIFO
method
assumes that
items are sold
in the
chronological
order of their
acquisition.
The cost of the oldest
inventory items are
charged to COGS
when goods are sold.
 The cost of the newest
inventory items
remain in ending
inventory.

Perpetual Inventory System
FIFO
Date
1/1/12
Units
Purchased
2,000
9/3/12
1,000
3,000
Unit
Units
Avg
Cost
Sold Unit Cost
10.00
10.75
9/7/12
9/21/12
1,000
2,200
Ending
Balance
20,000
10,750
30,750
1,800
18,000
800
8,450
10.95
9/29/12
12/31/12
Cost of
Goods
Sold
1,400
26,450
Total Cost Availavle for Sale
12,750 = 1,000x10.75
+ 200x10
10,950
23,700 2,000 =200x10
10,750=1,000x10.75
10,950=1,000x10.95
8,450 =200x10+600x10.75
15,250 (10,950+400 x 10.75)
41,700 =26,450+15,250
Periodic Inventory System
FIFO
Beginning Inventory (2,000 u @ 10)
20,000
Plus: Purchases (2,000 u @various unit cost)
Cost of Goods Available for Sale
Less: Ending Inventory (400 u x 10.75 + (1,000 u x 10.95))
21,700
41,700
15,250
Cost of Goods Sold
26,450
Period Inventory System and the
Perpetual Inventory System are the same, only the timing of adjustments to inventory is different.
When FIFO is used, the Cost of Goods Sold and Ending Inventory under
8-21
Last-In, First-Out (LIFO)
The LIFO
method
assumes that
the newest
items are sold
first, leaving the
older units in
inventory.
The cost of the newest
inventory items are
charged to COGS
when goods are sold.
 The cost of the oldest
inventory items
remain in inventory.

8-22
Last-In, First-Out (LIFO)
Unlike FIFO, using the LIFO
method may result in COGS
and Ending Inventory Cost differ
under the periodic and
perpetual approaches because
each time inventory is
purchased or sold, the LIFO
layers are adjusted.
8-23
LIFO
Perpetual Inventory System
Date
1/1/12
Units
Purchased
2,000
9/3/12
1,000
3,000
Unit
Cost
Units
Sold
Avg
Cost of Goods
Unit Cost
Sold
10
10.75
9/7/12
Ending
Balance
20,000
10,750
30,750
1,800
18,750
12,000 18,750=1,000x10.75+800x10
12,000=1,200x10
9/21/12
1,000
2,200
9/29/12
12/31/12
10.95
10,950
22,950 12,000=1,200x10
10,950=1,000x10.95
800
1,400
Total Cost Availavle for Sale
8,760
27,510
8,760=800x10.95
14,190 14,190=200x10.95+1,200x10
41,700 41,700=27,510+14,190
LIFO
Periodic Inventory System
Beginning Inventory (2,000 u @ 10)
20,000
Plus: Purchases (2,000 u @various unit cost)
Cost of Goods Available for Sale
Less: Ending Inventory (1,400 u x 10))
Cost of Goods Sold
21,700
41,700
14,000
27,700
8-24
When Prices Are Rising . . .



FIFO
Matches low (older) costs
with current (higher)
sales.
Inventory is valued at
approximate replacement
cost.
Results: higher pre-tax
income.



LIFO
Matches high (newer) costs
with current (higher) sales.
Inventory is valued based
on low (older) cost basis.
Results: lower pre-tax
income.
8-25
U. S. GAAP vs. IFRS
LIFO is an important issue for U.S. multinational
companies. Unless the U.S. Congress repeals the LIFO
conformity rule, an inability to use LIFO under IFRS will
impose a serious impediment to convergence.



LIFO is permitted and used by U.S.
Companies.
If used for income tax reporting,
the company must use LIFO for
financial reporting (LIFO
conformity rule).
Conformity with IAS No. 2 would
cause many U.S. companies to lose
a valuable tax shelter.


IAS No. 2, Inventories, does not
permit the use of LIFO.
Because of this restriction, many
U.S. multinational companies use
LIFO only for domestic
inventories.
8-26
Decision Makers’ Perspective
3 Factors Influencing Method Choice:
How closely do reported
costs reflect actual flow
of inventory?
FIFO: best mirror physical flow
Average: best for liquids, e.g., chemicals
How are income
taxes affected by
inventory method
choice?
How well are costs
matched against
related revenues?
Supplemental LIFO Disclosures
IRS requires that if a co. uses LIFO for taxable income,
the co. also must use LIFO for external reporting (called
LIFO conformity rule). So, many companies use LIFO
for external reporting and income tax purposes but
maintain internal records using FIFO or average cost.
The conversion from FIFO or average cost to LIFO:
takes place at the end of the period. The conversion
may look like this:
2014
Total inventories at FIFO
$ 15,429
Less: LIFO allowance (LIFO Reserve)
(1,508)
Inventories, at LIFO cost
$ 13,921
2013
$ 15,387
(1,525)
$ 13,862
“LIFO Reserve”: a “contra inventory account”; a conversion adjustment.
JE: Dr. Cost of Goods Sold Cr. LIFO Reserve; JE is not required due to it is
internal records.
8-27
8-28
LIFO Liquidation
When prices rise . . .
LIFO inventory costs in the balance
sheet are “out of date” because they reflect
old purchase transactions, i.e., at lower cost.
If inventory quantity declines:
1. these “out of date” inventory
layers are liquidated (sold) and,
2. cost of goods sold will partially
match noncurrent costs (lower
costs) with current selling prices.
3. if costs have been increasing, it
produces higher net income. current
earnings increase.
This LIFO liquidation
results in “paper
profits”(the inventory
holding profit) that is
not really available for
distribution to owners
because it is needed
to replace inventory.
LIFO Liquidation - Example
Included in cost of goods sold are 5,000 units from beginning inventory that have now been
liquidated. If the company had purchased at least 35,000 units, no liquidation would have
occurred. Then cost of goods sold would have been $875,000 (35,000 units × $25 per unit)
instead of $850,000. The difference between these two cost of goods sold figures is $25,000
($875,000 − 850,000 or 5,000 units x $5). This is the before tax income effect of the LIFO
liquidation.
Assuming a 40% income tax rate, the net effect of the liquidation is to increase net income
by $15,000 [$25,000 × (1 − .40)]. The lower the costs of the units liquidated, the more severe
the effect on income.
A company must disclose in a note any material effect of LIFO liquidation on net income.
8-30
Inventory Management
Gross profit ratio =
Gross profit
Net sales
Inventory turnover ratio =
The higher the ratio, the higher the
markup a company is able to
achieve on its products.
Cost of goods sold
Average inventory
Designed to evaluate a company’s (Beginning inventory + Ending inventory)
2
effectiveness in managing its
investment in inventory
8-31
Quality of Earnings
Changes in the ratios we discussed above often provide information
about the quality of a company’s current period earnings.
For example:
slowing turnover ratio with higher than normal inventory levels may indicate the potential for decreased production, obsolete inventory,
or a need to decrease prices to sell inventory (which will then decrease
gross profit ratios and net income).
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 inventory-related techniques a company could use to
manipulate earnings.
8-32
Methods of Simplifying LIFO
LIFO Inventory Pools
The objectives of using LIFO inventory pools are to simplify
recordkeeping by grouping inventory units into pools based
on physical similarities of the individual units and to reduce
the risk of LIFO layer liquidation.
For example:
A glass company- might group its various grades of window
glass into a single window pool. Other pools might be auto
glass and sliding door glass.
A lumber company- might pool its inventory into hardwood,
framing lumber, paneling, and so on. LIFO pools allow
companies to account for a few inventory pools rather than
every specific type of inventory separately.
Methods of Simplifying LIFO
Dollar-Value LIFO (DVL)
DVL inventory pools: viewed as layers of value
(economic similarity; goods that are likely to be subject
to the same cost change pressures), rather than layers
of similar units (physical similarity).
Example
DVL simplifies LIFO
recordkeeping.
DVL minimizes the
probability of layer
liquidation.
If the replacement inventory
differs from the old
inventory on hand, we just
create a new layer.
At the end of the period, we
determine if a new inventory
layer was added: by
comparing ending inventory
dollar amount to beginning
inventory dollar amount.
8-33
Methods of Simplifying LIFO
Dollar-Value LIFO (DVL)
Must determine if the increase in ending inventory
over beginning inventory was due to a cost increase
or inventory quantity increase.
1a. Compute a
Cost Index for the
year.
Cost index
in layer
=
year
Cost in
layer
year
Cost in
÷
base
year
8-34
Methods of Simplifying LIFO
8-35
Dollar-Value LIFO (DVL; Cont’d)
Ending
1b. Deflate the
ending inventory inventory
value using the
at base
cost index.
year cost
1c. Compare
ending inventory
at base year cost
Change in
to beginning
inventory
inventory at
base year cost.
Ending
inventory
=
÷
at yearend cost
Cost
index
Beg.
Ending Inv.
Inventory
= at base
–
at base
year cost
year cost
Methods of Simplifying LIFO
8-36
Dollar-Value LIFO (DVL; Cont’d)
Next, identify the layers in ending
inventory and the years they were created.
Convert each layer’s
base year cost to layer
year cost by
multiplying times the
cost index.
Sum all the layers to
arrive at ending
inventory at DVL cost.
8-37
Methods of Simplifying LIFO
Dollar-Value LIFO (DVL) - Example
Masterwear reports the following inventory
and cost index information. Let’s look at the
solution to this example.
12/31
2013
Ending
inventory
$ 150,000
Cost
index
100%
2014
168,000
105%
Inventory as
base-year
prices
$ 150,000
160,000
double-extension approach to calculate cost index rate:
Ending inventory at current year / Ending inventory at Base year
8-38
Methods of Simplifying LIFO
Dollar-Value LIFO (DVL)
Masterwear reports the following inventory
and general price information.
12/31
2013
2014
Ending
inventory
$ 150,000
168,000
Cost
index
100%
105%
168,000 ÷ 1.05 = 160,000
Inventory at
base-year
cost
$ 150,000
160,000
8-39
Methods of Simplifying LIFO
Dollar-Value LIFO (DVL)
First, determine the LIFO layer for the current year:
Inventory at
base-year
December 31,
costs
2013
$ 150,000
2014
160,000
2014 LIFO Layer $
10,000
Inventory
Price
index
En
I\inve
$ 1
105%
$
1
8-40
Methods of Simplifying LIFO
Dollar-Value LIFO (DVL; cont’d)
At the LIFO layer at end of period prices to the
ending LIFO inventory from last period.
December 31,
2013
2014
2014 LIFO Layer
Inventory
Inventory at
base-year
costs
$ 150,000
160,000
$
10,000
Cost
index
100%
Ending
inventory
$ 150,000
105%
10,500
160,500
$
10,000  1.05 = 10,500
Inventory is 160,500,
not $168,000
8-41
Reporting —Lower of Cost or Market
Inventories are valued at the lower of cost
or market (LCM) after cost of inventory was
determined via an inventory method, as
discussed earlier, at the end of a period.
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; not in the period that
the goods are sold.
8-42
Determining Market Value
 GAAP: “market value” =
replacement cost.
 Market must be
1. < or = “ceiling
(Net Realizable Value =
Sale Price – Disposal Cost)”
&
1. > or = the “floor
(Net Realizable Value –
Normal Profit)”
Market Should Not
Exceed Net Realizable
Value (Ceiling)
Market Should Not Be
Less Than Net Realizable
Value less Normal Profit
(Floor)
8-43
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
8-44
Lower of Cost or Market - Example

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 = $5
How would we value this item in the balance
sheet?
8-45
Lower of Cost or Market
Selling
Cost to
=
NRV
Price
Complete
$ 30.00 - $
4.00 = $ 26.00
Replacement
Cost =$21.50
Designated
$21.50
Market?
Normal
= (NRV - NP)
Profit
$ 26.00 - $
5.00 = $
21.00
Historical cost = $20.00
designated market value = $21.50,
so this inventory item will be
valued at cost of $20.00
(lower of 21.5 and 20).
NRV
-
8-46
Applying Lower of Cost or Market
Can be applied 3 different ways.
1. Apply to each individual item in inventory.
2. Apply to logical inventory categories, such as desktop
and laptop computers (product line).
3. Apply to the entire inventory as a group.
8-47
Adjusting Cost to Market
For Income statement:
1.
Record the loss as a separate item
Loss on write-down of inventory XX
Inventory (or Inventory Allowance)
XX
(only if a write-down loss is substantial and unusual;
it should be reported as a separate item in other
revenue (expense) section in operating section of
income statement, otherwise it would distort the
relationship between sales and cost of goods sold)
or, Record the loss as part of cost of goods sold
Cost of goods sold
XX
Inventory (or Inventory Allowance)
XX
8-48
Lower-of-Cost-or-Market
Income Statement Presentation - Illustration
Loss
Method
Sales
$
Cost of goods sold
300,000
COGS
Method
$
300,000
120,000
132,000
180,000
168,000
Selling
45,000
45,000
General and administrative
20,000
20,000
65,000
65,000
Gross profit
Operating expenses:
Total operating expenses
Other revenue and (expense):
Loss on inventory
(12,000)
-
Interest income
5,000
5,000
Total other
(7,000)
5,000
Income from operations
Income tax expense
Net income
$
108,000
108,000
32,400
32,400
75,600
$
75,600
8-49
Lower-of-Cost-or-Market
Balance Sheet Presentation
Loss
COGS
Method
Method
Current assets:
Cash
$
100,000
$
100,000
Accounts receivable
350,000
350,000
Inventory
770,000
758,000
Less: inventory allowance
(12,000)
Prepaids
Total current assets
20,000
20,000
1,175,000
1,175,000
8-50
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
that must stay between net realizable
value and NRV minus 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 of
cost & net realizable value (NRV =
market value, per IFRS.
Note: replacement cost usually is less
than NRV).
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.
8-51
Inventory Estimation Techniques

Estimate instead of taking physical inventory
1.
2.

Less costly
Less time-consuming
Two popular methods of estimating ending inventory:
1. Gross profit method
2. Retail inventory method
2 Inventory Estimation Techniques
1. Gross Profit Method
Useful
when . . .
Estimating inventory
and COGS for
interim reports.
Auditors in testing
the overall
reasonableness of
client inventories.
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.
8-52
8-53
Gross Profit Method
This method assumes that the historical gross margin
ratio is reasonably constant in the short-run.
Sales
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
(COGS)
Gross Profit
8-54
Gross Profit Method
Computation of Gross Profit Percentage
Illustration 9-17
e.g.,
gross sales
cost of goods sold
Gross profit
100%
80%
20% = (20% / 80%=25%) / [1+ (20% / 80%)]
proof: .25 / 1.25 = .2
80 x 1.25 = 100
Gross profit as a % of cost, or
% Markup on Cost
8-55
Gross Profit Method - Example
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
We will estimate Inventory for May 31 as follows:
8-56
Gross Profit Method – example continued
Beginning inventory
Plus: Net purchases
= Goods available for sale
Sales
$
Less: estimated gross profit
Less: Estimated COGS
Estimated ending inventory
$
237,400
728,300
965,700
$
$
(691,410)
274,290
Sales
$ 1,213,000
Gross profit percentage
43%
Estimated gross profit
$ 521,590
1,213,000
(521,590)
NOTE:
$1,213,000 x 57% = 691,410
The key to successfully applying this method is a
reliable gross profit ratio.
Inventory Estimation Techniques
2. The Retail Inventory Method
 This method was developed for retail
operations like department stores.
 Converting retail prices to cost:
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.
8-57
8-58
The Retail Inventory Method (Con’d)
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.
8-59
Retail Terminology
An Example of the Terminology
Smeared part: Selling price increased to $8.
8-60
Retail Inventory Method (Con’d)
A method used by retailers, to value inventory without a
physical count, by converting retail prices to cost.
Requires retailers to keep:
(1) Total cost and retail value of goods purchased which
helps to calculate cost to retail % and goods available
for sale amount.
(2) Sales for the period.
4 Methods
A. Conventional Method
B. Cost Method
C. LIFO
D. Dollar-value LIFO
8-61
Retail Inventory Method
Must know
...
Beginning
inventory at retail
and cost.
Net purchases at
retail and cost.
Sales for the
period.
Adjustments to the
original retail price.
8-62
Retail Inventory Method - Example
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.
8-63
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
Cost
Retail
$ 27,000 $ 45,000
180,000
300,000
207,000
345,000
(310,000)
$ 35,000
?
8-64
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
$
x
×
21,000
(310,000)
$ 35,000
8-65
Retail Inventory Method
Conventional & Cost Method - Example
Fuque Inc. uses the retail inventory method to estimate ending
inventory for its monthly financial statements. The following data
pertain to a single department for the month of October 2013.
Beg. inventory, Oct. 1
Purchases
Freight in
Purchase returns
Additional markups
Markup cancellations
Markdowns (net)
Normal spoilage
Sales
COST
$
52,000
272,000
16,600
5,600
RETAIL
$ 78,000
423,000
8,000
9,000
2,000
3,600
10,000
390,000
Instructions:
Prepare a schedule
computing estimate
retail inventory using
the following
methods:
A.
Conventional
B.
Cost
8-66
Retail Inventory Method
A. Conventional Method Example
Solution - CONVENTIONAL Method:
Beg. inventory
Purchases
Freight in
Purchase returns
Markups, net
Current year additions
Goods available for sale
Markdowns, net
Normal spoilage
Sales
Ending inventory at retail
Ending inventory at Cost:
$
96,400 x 67.00% =
COST
$
52,000
272,000
16,600
(5,600)
283,000
335,000
$
RETAIL
$ 78,000
423,000
(8,000)
7,000
422,000
500,000
(3,600)
/
(10,000)
(390,000)
$ 96,400
Cost to
Retail %
= 67.00%
64,588
Note: Markdowns usually are caused by lessened utility value due to obsolescence,
spoilage, overstocking, price declines, or competition; they do not decrease (impact)
retail value, and is excluded from the cost-to-retail %.
8-67
Retail Inventory Method
B. Cost Method Example
Solution - COST Method:
Beg. inventory
Purchases
Freight in
Purchase returns
Markdowns, net
Markups, net
Current year additions
Goods available for sale
Normal spoilage
Sales
Ending inventory at retail
Ending inventory at Cost:
$
96,400 x 67.49% =
COST
$
52,000
272,000
16,600
(5,600)
283,000
335,000
$
RETAIL
$ 78,000
423,000
(8,000)
(3,600)
7,000
418,400
/
496,400
(10,000)
(390,000)
$ 96,400
Cost to
Retail %
=
67.49%
65,056
Note: Assumes markdown decrease retail value, thus increase cost to retail %.
Retail Inventory Method
8-68
A. Conventional Method with Abnormal Shortage - Example
Special Items:
1.
Purchase Returns
2.
Abnormal - Shortage, spoilage, or - theft
(decrease retail value,
increase cost to retail
%)
3.
Sales Returns
4.
Employee Discounts
(can not be deduced
from goods avail for
sale because it is not
relevant to the cost to
retail % and it was not
available for sale)
5.
Normal - Shortage, spoilage, or - theft
(relevant to the
establishment of cost to
retail %; not subtracting it
out will result a normal
Cost-to-retail %)
Abnormal spoilage: deducted in both retail and cost columns before the normal Cost to
retail % is calculated because the goods are not available for sale and the
Cost of such goods is not relevant to the normal cost to retail %, i.e., subtracting it will
result a higher and more accurate Cost-to-retail %.
8-69
Issues Relevant to 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-retail percentage
Normal shortage, spoilage, or theft
Employee discounts
added to net sales in the retail column after
the cost to retail is calculated; i.e., deducted
after Goods available for sale
added to net sales; i.e., deducted after Goods
available for sale
8-70
C. 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:
*beginning inventory
*adjusted net purchases for the period.

8-71
C. 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.
8-72
The LIFO Retail Method – Matrix Inc. example
Inventory, July 1 ($21,000 ÷ $35,000 = 60%)
Plus: Net purchases
Net markups
Less: Net markdowns
Purchases for July
($200,000 ÷ $308,000 = 64.94% rounded)
Note:
Cost
Retail
$ 21,000 $ 35,000
200,000
304,000
8,000
(4,000)
200,000
308,000
Beginning Inventory layer is calculated separately from
the Purchase layer.
8-73
The LIFO Retail Method – Matrix Inc continued
Inventory, July 1 ($21,000 ÷ $35,000 = 60%)
Plus: Net purchases
Net markups
Less: Net markdowns
Purchases for July
($200,000 ÷ $308,000 = 64.94% rounded)
Sales for July
LIFO layer for July
Beginning inventory
Current period's layer
Total
** rounded
Cost
$ 21,000
200,000
200,000
Retail
$
35,000 x 60.00% =
8,000 x 64.94% =
$
43,000
Retail
$ 35,000
304,000
8,000
(4,000)
308,000
(300,000)
8,000
Cost
21,000
5,195 **
26,195
8-74
D. Dollar-Value LIFO Retail
Need to eliminate the effect of any price
changes before comparing the ending
inventory with the beginning inventory.
8-75
Dollar-Value LIFO Retail
Return to our earlier Matrix Inc. example (P. 73) 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% base
layer (beg inventory) cost-to-retail percentage.
Net purchases at cost $200,000, at retail $304,000.
Net markups $8,000.
Net markdowns $4,000.
Net sales for July $300,000.
Price index at July 1 is 100 and
at July 31 the index is 102.
8-76
Dollar-Value LIFO Retail
Ending inventory
at current-year
retail
$
43,000
(Determined earlier)
Step 1
Ending inventory adjusted for
price changes (to base year)
$ 43,000 ÷ 1.02 = $ 42,157
Step 2
Inventory Layers at Base Year
Retail Prices
$ 42,157
35,000 x 1.00 x
60.00% =
7,157 x 1.02 x
64.94% =
Total Ending Inventory at Dollar
Value LIFO Retail Cost
Step 3
Inventory Layers
Converted to LIFO
Cost
$
21,000.00
4,740.71
$
25,740.71
$43,000, 60%, and 64.94% are all determined under LIFO Retail Method (slide 73).
8-77
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.
8-78
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.
The beginning inventory in the year the LIFO
method is adopted is the base year inventory.
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.
Why: It would require assumptions as to when specific LIFO inventory layers were
created in years prior to the change.
8-79
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.
8-80
Inventory Errors
Overstatement of ending inventory

◦
◦
Understates cost of goods sold &
Overstates pretax income.
Understatement of ending inventory

◦
◦
Overstates cost of goods sold &
Understates pretax income.
8-81
Inventory Errors
 Overstatement of beginning
◦ Overstates cost of goods sold &
◦ Understates pretax income.
inventory
 Understatement of beginning
◦ Understates cost of goods sold &
◦ Overstates pretax income.
inventory
8-82
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.
Dr. Retained Earnings
Cr. Inventory
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.
8-83
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. By overstating the writedown, profits are increased in future periods when
the inventory in sold or used.
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