Chapter 9
Inventory:
Additional Issues
McGraw-Hill/Irwin
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Slide
9-2
Lower of Cost or Market (LCM)
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.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
9-3
Determining Market Value
• Market value is NOT
necessarily the
amount for which
inventory can be
sold.
• Accounting
Research Bulletin
No. 43 defines
“market value” in
terms of current
replacement cost.
McGraw-Hill/Irwin
Net Realizable
Value (Ceiling)
Net Realizable Value
less Normal Profit
(Floor)
© 2004 The McGraw-Hill Companies, Inc.
Slide
9-4
Determining Market Value
Net Realizable Value (NRV) is
the estimated selling price
less cost of completion and
disposal.
Net Realizable
Value (Ceiling)
Replacement
Cost
The definition of market
value varies
internationally. In the UK,
Denmark, Finland, and
New Zealand, market
value is defined as NRV.
McGraw-Hill/Irwin
Net Realizable Value
less Normal Profit
(Floor)
© 2004 The McGraw-Hill Companies, Inc.
Slide
9-5
Determining Market Value
If replacement cost
> Ceiling, then
Ceiling = Market
Value
Replacement
Cost
If replacement
cost < Floor, then
Floor = Market
Value
McGraw-Hill/Irwin
Net Realizable
Value (Ceiling)
Net Realizable Value
less Normal Profit
(Floor)
© 2004 The McGraw-Hill Companies, Inc.
Slide
9-6
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?
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
9-7
LCM - Example
Selling
Price
$
30
Cost to
Complete
- $
4
=
Ceiling
=
$
26
Which one do
we use?
Replacement
Cost =$21.50
Normal
Profit
26 - $
5
Ceiling
$
McGraw-Hill/Irwin
-
=
Net Realizable
Value (Ceiling)
Floor
= $
21
Net Realizable
Value less Normal
Profit (Floor)
© 2004 The McGraw-Hill Companies, Inc.
Slide
9-8
LCM - Example
In this case, market value will be
$21.50, because the
replacement cost is between the
ceiling and the floor.
Net Realizable
Value (Ceiling)
Replacement
Cost =$21.50
Market value = $21.50
Cost = $20.00
Since
Should
Costthe
< Market,
inventory
thebe
LCM
rule
recorded
would dictate
at costthat
or market?
inventory
be recorded at Cost.
McGraw-Hill/Irwin
Net Realizable
Value less Normal
Profit (Floor)
© 2004 The McGraw-Hill Companies, Inc.
Slide
9-9
LCM - Another Example
An inventory item is currently carried at
historical cost of $95.00 per unit. At the
Balance Sheet date we gather the
following per unit information: current
replacement cost = $80.00; NRV =
$100.00; and NRV reduced by normal
profit = $85.00.
How would we value the item on our
Balance Sheet?
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
9-10
Lower of Cost or Market
Another Example
Net Realizable Value
(Ceiling) = $100
?
Which one do
we use as
market value?
?
Replacement
Cost =$80
?
Net Realizable Value
less Normal Profit
(Floor) = $85
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
9-11
Lower of Cost or Market
Another Example
Net Realizable Value
(Ceiling) = $100
Market Value = Floor
$100
>
$85
>
$80
Should the inventory be carried at
Market Value or Cost?
Replacement
Cost =$80
Market = $85 < Cost = $95
Net Realizable Value
less Normal Profit
(Floor) = $85
Our inventory item will be written
down to the Market Value $85.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
9-12
Applying LCM
LCM can be applied 3 different ways.
3.1.Apply
ApplyLCM
LCMtotothe
each
entire
individual
inventory
itemasina
2. Apply LCM to each class of inventory.
inventory.
group.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
9-13
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

McGraw-Hill/Irwin
Adjust inventory directly or using an
allowance account.
© 2004 The McGraw-Hill Companies, Inc.
Slide
9-14
Inventory Estimation Techniques
Estimate instead of taking
physical inventory
Less costly
 Less time consuming

Two popular methods are . . .
Gross Profit Method
 Retail Inventory Method

McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
9-15
Gross Profit Method
Auditors are testing
the overall
reasonableness of
client inventories.
Estimating inventory
& 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 accepted by GAAP.
McGraw-Hill/Irwin
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Slide
9-16
Gross Profit Method
Assumes that the historical gross margin
rate is reasonably constant in the short run.
Net sales for the
period.
Cost of beginning
inventory.
We need to
know . . .
Historical gross
margin rate.
McGraw-Hill/Irwin
Net purchases for
the period.
© 2004 The McGraw-Hill Companies, Inc.
Slide
9-17
Steps to the Gross Profit Method
1.
2.
3.
4.
McGraw-Hill/Irwin
Estimate historical Gross Margin %.
Sales x (1 - Estimated Gross Margin
%) = Estimated COGS
Beg. Inventory + Net Purchases =
Cost of Goods Available for Sale
(COGAS)
Estimated COGS - COGAS =
Estimated Cost of Ending Inventory
© 2004 The McGraw-Hill Companies, Inc.
Slide
9-18
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.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
9-19
Gross Profit Method
Example
Beginning Inventory
Plus: Net Purchases
= Goods Available for Sale
Less: Estimated COGS*
= Estimated Ending Inventory
$
$
* COGS = Sales x (1 - GM%) = $
= $
237,400
728,300
965,700
(691,410)
274,290
1,213,000 x ( 1 - 43% )
691,410
NOTE: The key to successfully applying this
method is a reliable Gross Margin %.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
9-20
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
inventory at retail to ending
inventory at cost.
McGraw-Hill/Irwin
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Slide
9-21
Retail Inventory Method
Beginning
inventory at retail
and cost.
Sales for the
period.
We need to
know . . .
Net purchases at
retail and cost.
McGraw-Hill/Irwin
Adjustments to the
original retail price.
© 2004 The McGraw-Hill Companies, Inc.
Slide
9-22
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.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
9-23
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.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
9-24
Retail Inventory Method
Example
Inventory, May 1
Net purchases for May
Goods available for sale
Cost ratio:
(207,000 ÷ 345,000) = 60%
Sales for May
Ending inventory at retail
Ending inventory at cost
McGraw-Hill/Irwin
Cost
$ 27,000
180,000
207,000
Retail
$
45,000
300,000
345,000
(310,000)
$
35,000
?
© 2004 The McGraw-Hill Companies, Inc.
Slide
9-25
Retail Inventory Method
Example
Cost
$ 27,000
180,000
207,000
Retail
$
45,000
300,000
345,000
x
(310,000)
$
35,000
Inventory, May 1
Net purchases for May
Goods available for sale
Cost ratio:
(207,000 ÷ 345,000) = 60%
Sales for May
Ending inventory at retail
Ending inventory at cost
$
McGraw-Hill/Irwin
21,000
?
© 2004 The McGraw-Hill Companies, Inc.
Slide
9-26
Approximating Average Cost
Cost-toRetail %
=
Beginning Inventory + Net Purchases
Retail Value of (Beginning Inventory + Net
Purchases + Net Markups - Net Markdowns)
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 %.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
9-27
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.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
9-28
Retail Inventory Method
Average Cost Example
Inventory, June 1
Plus: Net Purchases
Net Markups
Less: Net Markdowns
Goods available for sale
Cost ratio:
(221,000 ÷ 343,000) = 64.43%
Less: Sales for June
Ending inventory at retail
Ending inventory at cost
McGraw-Hill/Irwin
Cost
Retail
$ 21,000 $
35,000
200,000
304,000
8,000
(4,000)
221,000
343,000
(300,000)
$
43,000
?
© 2004 The McGraw-Hill Companies, Inc.
Slide
9-29
Retail Inventory Method
Average Cost Example
Cost
Retail
$ 21,000 $
35,000
200,000
304,000
8,000
(4,000)
221,000
343,000
Inventory, June 1
Plus: Net Purchases
Net Markups
Less: Net Markdowns
Goods available for sale
Cost ratio:
343,000) == 64.43%
(221,000 ÷ 343,000)
Less: Sales for June
Ending inventory at retail
Ending inventory at cost
$
McGraw-Hill/Irwin
x
(300,000)
$
43,000
27,705
?
© 2004 The McGraw-Hill Companies, Inc.
Slide
9-30
Retail Inventory Method
Average LCM
Approximating Average LCM
Cost-toRetail %
=
Beginning Inventory + Net Purchases
Retail Value of (Beginning Inventory + Net
Purchases + Net Markups)
Net Markdowns are
excluded in the
computation of the
Cost-to-Retail %
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
9-31
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.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
9-32
Retail Inventory Method
Average LCM Example
Inventory, June 1
Plus: Net Purchases
Net Markups
Less: Net Markdowns
Goods Available for Sale
Cost ratio:
(221,000 ÷ 347,000) =
Less: Sales for June
Ending inventory at retail
Ending inventory at cost
McGraw-Hill/Irwin
$
Cost
Retail
21,000 $
35,000
200,000
304,000
8,000
347,000
(4,000)
221,000
343,000
63.69%
(300,000)
$
43,000
?
© 2004 The McGraw-Hill Companies, Inc.
Slide
9-33
Retail Inventory Method
Average LCM Example
Inventory, June 1
Plus: Net Purchases
Net Markups
Less: Net Markdowns
Goods Available for Sale
Cost ratio:
(221,000 ÷ 347,000) =
Less: Sales for June
Ending inventory at retail
Ending inventory at cost
McGraw-Hill/Irwin
$
Cost
Retail
35,000
21,000 $
200,000
304,000
8,000
347,000
(4,000)
343,000
221,000
63.69%
x
$
(300,000)
$
43,000
27,387
?
© 2004 The McGraw-Hill Companies, Inc.
Slide
9-34
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.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
9-35
The LIFO Retail Method
LIFO Costto-Retail %
=
Net Purchases
Retail Value of (Net Purchases + Net
Markups-Net Markdowns)
Beginning inventory has its own
cost-to-retail percentage.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
9-36
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.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
9-37
The LIFO Retail Method
Example
Current
Period
LIFO
Cost ratio:
Inventory,
June
1 (60%)
$
(200,000
÷ 308,000) =
64.94%
Plus:
Net Purchases
Retail
Net Markups
Beginning
$
35,000 x
Less: NetInventory
Markdowns
Current
Layer
8,000 x
GoodsPeriod's
Available
(Less Beg. Inv.)
Total Available (Incl. Beg.
$ Inv.)
43,000
Goods
* $21,000
÷ $35,000
LIFO Cost
ratio: = 60%
** rounded
Requires
(200,000
a composite
÷ 308,000)ratio
= 64.94%
Less: Sales for June
Ending inventory at retail
Ending inventory at cost
$
McGraw-Hill/Irwin
Cost
Retail
21,000 $
35,000
200,000
304,000
Cost
8,000
60%*
=
21,000
(4,000)
64.94% =
5,195 **
200,000
308,000
26,195
221,000
343,000
(300,000)
$
43,000
?26,195
© 2004 The McGraw-Hill Companies, Inc.
Slide
9-38
Others Issues of Retail Method
Purchase returns and purchase
discounts.
Freight-in.
Employee discounts.
Spoilage, breakage, and theft.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
9-39
Dollar-Value LIFO Retail
We need to eliminate the effect of any
price changes before we compare
the ending inventory with the
beginning inventory.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
9-40
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.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
9-41
Dollar-Value LIFO Retail
Example
Ending Inventory
at Year-end Retail
Prices
$
43,000
(Determined earlier)
Step 1
Ending Inventory at Base
Year Retail Prices
$ 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
McGraw-Hill/Irwin
Step 3
Inventory Layers
Converted to LIFO
Cost
$
21,000.00
4,740.71
$
25,740.71
© 2004 The McGraw-Hill Companies, Inc.
Slide
9-42
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.
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
9-43
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.

McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
9-44
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.

McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
9-45
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.

McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.
Slide
9-46
End of Chapter 9
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc.