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
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 = $5
How would we value this item in the balance
sheet?
9-6
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 of $20.00 is
less than designated market
of $21.50, so this inventory
item will be valued at cost of
$20.00.
NRV
-
9-7
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.
9-8
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.
9-9
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.
9-10
Adjusting Cost to Market
1.
Record the loss as a separate item in the income
statement
Loss on write-down of inventory
Inventory
2.
XX
XX
Record the loss as part of cost of goods sold.
Cost of goods sold
Inventory
XX
XX
9-11
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.
9-12
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
9-13
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.
9-14
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
9-15
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.
9-16
Gross Profit Method
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: The key to successfully applying this method
is a reliable gross profit ratio.
9-17
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.
9-18
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.
9-19
Retail Terminology
An Example of the Terminology
9-20
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.
9-21
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.
9-22
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
Cost
Retail
$ 27,000 $ 45,000
180,000
300,000
207,000
345,000
(310,000)
$ 35,000
?
9-23
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
$
×
x
21,000
(310,000)
$ 35,000
Retail Inventory Method
Markups 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
• Net sales for July $300,000
Estimate inventory at July 31.
9-24
Conventional Retail Method:
Markups and Markdowns
Cost
$ 21,000
200,000
Inventory, July 1
Plus: Net purchases
Net markups
Less: Net markdowns
Cost ratio:
221,000
(221,000 ÷ 343,000) = 64.43%
Less: Sales for July
Ending inventory at retail
64.43%
Ending inventory at cost
$ 27,387
9-25
Retail
$ 35,000
304,000
8,000
(4,000)
343,000
(300,000)
#REF!
Conventional Retail Method:
Markups and Markdowns
Cost
$ 21,000
200,000
Inventory, July 1
Plus: Net purchases
Net markups
Less: Net markdowns
Cost-to-retail percentage
221,000
(221,000 ÷ 343,000) = 64.43%
Less: Sales for July
Estimated ending inventory at retail
Estimated ending inventory at cost
$ 27,705
($43,000 × 64.43% = $27,705)
9-26
Retail
$ 35,000
304,000
8,000
(4,000)
343,000
(300,000)
$ 43,000
Conventional Retail Method:
Markups and Markdowns
Cost
$ 21,000
200,000
Inventory, July 1
Plus: Net purchases
Net markups
Cost-to-retail percentage
221,000
(221,000 ÷ 347,000) = 63.69%
Less: Net Markdowns
Goods available for sale
221,000
Less: Sales for July
Ending inventory at retail
63.69%
Ending inventory at cost
$ 27,387
9-27
Retail
$ 35,000
304,000
8,000
347,000
(4,000)
343,000
(300,000)
$ 43,000
Conventional Retail Method:
Markups and Markdowns
Cost
$ 21,000
200,000
Inventory, July 1
Plus: Net purchases
Net markups
Cost ratio:
221,000
(221,000 ÷ 347,000) = 63.69%
Less: Net markdowns
Goods available for sale
221,000
Less: Sales for July
Estimated ending inventory at retail
Estimated ending inventory at cost
$ 27,387
$43,000 × 63.69% = $27,387
9-28
Retail
$ 35,000
304,000
8,000
347,000
(4,000)
343,000
(300,000)
$ 43,000
9-29
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.
9-30
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.
9-31
The LIFO Retail Method
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)
Retail
$ 35,000
304,000
8,000
(4,000)
308,000
9-32
The LIFO Retail Method
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
Retail
$ 35,000
304,000
8,000
(4,000)
308,000
(300,000)
8,000
9-33
The LIFO Retail Method
Cost
Inventory, July 1 ($21,000 ÷ $35,000 = 60%) $ 21,000
Plus: Net purchases
200,000
Net markups
Less: Net markdowns
Goods available for sale
200,000
($200,000 ÷ $308,000 = 64.94% rounded)
Sales for July
LIFO layer for July
Beginning inventory
Current period's layer
Total
** rounded
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
9-34
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
9-35
Dollar-Value LIFO Retail
We need to eliminate the effect of any price
changes before we compare the ending
inventory with the beginning inventory.
9-36
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% base layer cost-toretail 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 30
the index is 102.
9-37
Dollar-Value LIFO Retail
Ending inventory
at base-year retail
$
43,000
(Determined earlier)
Step 1
Ending inventory adjusted for
price changes
$ 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
9-38
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.
9-39
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.
9-40
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.
9-41
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.
9-42
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
9-43
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.
9-44
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.
9-45
Appendix 9: Purchase Commitments
Purchase 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 2013, the Lassiter Company signed two purchase commitments.
The first requires Lassiter to purchase inventory for $500,000 by
November 15, 2013. The inventory is purchased on November 14, and
paid 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, 2014. On December 31, 2013, the market value of the inventory
items was $540,000. On February 15, 2014, the market value of the inventory
items was $510,000.
Lassiter uses the perpetual inventory system and is a calendar year-end
company.
9-46
Appendix 9: Purchase Commitments
November 14, 2013
Inventory (market price)
Loss on purchase commitment
Accounts payable
425,000
75,000
December 15, 2013
Accounts payable
Cash
500,000
500,000
500,000
December 31, 2013
Estimated loss on commitment
60,000
Estimated liability on commitment
February 15, 2014
Inventory (market price)
Loss on purchase commitment
Estimated liability on commitment
Cash
Single-period
commitment
60,000
Multi-period
commitment
510,000
30,000
60,000
600,000
9-47
End of Chapter 9