Chapter 9
Inventories: Additional
Issues
Copyright © 2015 McGraw-Hill Education. All rights reserved.
LO9-1
Reporting—Lower of Cost and Net Realizable Value
• Inventory must be reported at the lower of cost and
net realizable value
Inventory
Salability impaired
Sold
Company benefits
• Deterioration
• Obsolescence
• Changes in price levels
Advantages
• Avoids reporting inventory at an amount greater
than the benefits it can provide
• Losses are recognized in the period the value of
inventory declines below its cost
LO9-1
Determining Net Realizable Value
• Net Realizable Value (NRV):
• Estimated selling price of the product reduced by
reasonably predictable costs of completion,
disposal, and transportation
• Net amount a company expects to realize from the
sale of the inventory
Example:
If the selling price of Product A is $10 per unit, and the
company estimates that sales commissions and shipping
costs average approximately 10% of selling price:
NRV = ($10 − [10% × $10]) = $9
Illustration: Lower of Cost and Net Realizable LO9-1
Value (NRV)
The Collins Company has five inventory items on hand at the end
of 2016. The year-end unit costs (determined by applying the
average cost method), current unit selling prices, and estimated
costs to sell for each of the items are presented below:
Item
A
B
C
D
E
Cost
$ 50
100
80
90
95
Item
Cost
A
$ 50
B
100
C
80
D
90
E
95
Selling Price
Estimated Costs to Sell
$ 100
$100 - $15 $ 15
120
30
85
10
100
15
120
24
<
>
>
>
<
NRV
$ 85
90
75
85
96
Inventory Value
50
90
75
85
95
LO9-1
Illustration: Lower of Cost and Net Realizable Value—
Application at Different Levels of Aggregation
Lower of Cost and NRV
Item
Cost
A
$ 50,000
B
100,000
Total A+B
$ 150,000
C
$ 80,000
D
90,000
E
95,000
Total C, D, & E $ 265,000
Total
$ 415,000
Net
Realizable
Value
$ 85,000
90,000
$ 175,000
$ 75,000
85,000
96,000
$ 256,000
$ 431,000
By
Individual
Items
$ 50,000
90,000
By Product
Line
By Total
Inventory
$ 150,000
75,000
85,000
95,000
$ 395,000
256,000
$ 406,000
$ 415,000
Concept Check √
The following information pertains to one item of inventory of the Dodge
Company:
Per unit
Cost
$270
Replacement cost
225
Selling price
292
Costs to sell
52
Applying the lower of cost and net realizable value rule, this item should be
valued at:
a.
$225.
b.
$240.
c.
$270.
d.
$292.
NRV of $240 ($292 - 52) is lower than cost of $270
LO9-1
Adjusting Cost to Net Realizable Value
• If inventory write-downs are commonplace for a
company, losses usually are included in cost of
goods sold
• When a write-down is substantial and unusual,
GAAP requires that the loss be expressly disclosed
Journal Entries
Cost of goods sold................ xx
Inventory...............……….
xx
OR
Loss on write-down of inventory …………….
Inventory.........................
xx
xx
LO9-2
Inventory Estimation Techniques
Gross Profit Method
Inventory
Estimation
Techniques
Uses a cost of goods sold
estimate and cost of goods
available for sale to obtain an
estimate of ending inventory
Retail Inventory Method
Uses the cost-to-retail percentage
based on a current relationship
between cost and selling price
LO9-2
The Gross Profit Method (Gross Margin Method)
• Situations where this technique is valuable:
• In determining cost of inventory that has been lost,
destroyed, or stolen
• In estimating inventory and cost of goods sold for
interim reports, avoiding the expense of a physical
inventory count
• In auditors’ testing of the overall reasonableness of
inventory amounts reported by clients
• In budgeting and forecasting
• It is not acceptable for the preparation of annual
financial statements
LO9-2
The Gross Profit Method (continued)
Relationship between ending inventory and COGS
Ending
Inventory
Cost of
Goods
Sold
Cost of
Goods
Available
for Sale
Can be estimated from available
information
Beginning inventory
+ Net purchases
LO9-2
The Gross Profit Method (continued)
Usual Method of
Calculation
Gross Profit Method
of Calculation
Beginning inventory
Beginning inventory
(from the accounting records)
(from the accounting records)
+ Net purchases
+ Net purchases
(from the accounting records)
(from the accounting records)
Goods available for sale
− Ending inventory
Goods available for sale
− Cost of goods sold
(from a physical count)
(estimated)
Cost of goods sold
Ending inventory
(estimated)
LO9-2
Illustration: Gross Profit Method
Southern Wholesale Company began 2016 with inventory of $600,000,
and on March 17 a warehouse fire destroyed the entire inventory.
Company records indicate net purchases of $1,500,000 and net sales of
$2,000,000 prior to the fire. The gross profit ratio in each of the previous
three years has been very close to 40%.
Beginning inventory (from records)
$ 600,000
Plus: Net purchases (from records)
1,500,000
Goods available for sale
2,100,000
Less: Cost of goods sold:
Net sales
Less: Estimated gross profit of 40%
Estimated cost of goods sold
Estimated ending inventory
$2,000,000 × 40%
(800,000)
(1,200,000)
$ 900,000
Concept Check √
The records of Oregon Timber, Inc., revealed the following information
related to inventory destroyed in a fire:
Inventory, beginning of period
Purchases to date of fire
Net sales to date of fire
Gross profit ratio
$ 900,000
480,000
1,350,000
30%
The estimated amount of inventory destroyed by the fire is:
a.
$975,000.
b.
$ 30,000.
c.
$435,000.
d.
All of these answer choices are incorrect.
$900,000 (beginning inventory) + $480,000 (purchases)
- $945,000 (estimated cost of sales: $1,350,000 x 70%)
= $435,000
LO9-2
The Gross Profit Method: A Word of Caution
• The key to obtaining good estimates is the reliability
of the gross profit ratio
• The accuracy of the estimate can be improved by
grouping inventory into pools of products that have
similar gross profit relationships
• The company’s cost flow assumption should be
implicitly considered when estimating the gross
profit ratio
• Suspected theft or spoilage would require an
adjustment to estimates obtained using the gross
profit method
LO9-3
The Retail Inventory Method
• Relies on the relationship between cost and selling price
to estimate ending inventory and cost of goods sold
• Used by high-volume retailers selling many different
items at low unit prices
• More accurate than gross profit method because it’s
based on the current cost-to-retail percentage
Amount of ending =
inventory (at retail)
Cost-to-retail
percentage
=
Goods available
for sale (at retail)
Sales
(at retail)
Goods available for sale at cost
Goods available for sale at retail
LO9-3
Illustration: Retail Method
Beginning inventory
Plus: Net purchases
Goods available for sale
Cost-to-retail percentage:
Less: Net sales
Estimated ending inventory at retail
Estimated ending inventory at cost
Estimated cost of goods sold
Cost
Retail
$ 60,000
287,200
$347,200
$100,000
460,000
$560,000
= 62%
(400,000)
$160,000
(99,200)
$248,000
Goods available for sale − ending inventory = COGS
(at cost)
(at cost)
LO9-3
Illustration: Terminology Used in Applying the
Retail Method
Initial markup:
• Original amount of markup from cost to selling price
Additional markup:
• Increase in selling price subsequent to initial markup
Markup cancellation:
• Elimination of an additional markup
Markdown:
• Reduction in selling price below the original selling
price
Markdown cancellation:
• Elimination of a markdown
Illustration: Retail Inventory Method Terminology
LO9-3
• When applying the retail inventory method, net
markups and net markdowns must be included in the
determination of ending inventory at retail
LO9-3
Cost Flow Methods
• Cost-to-retail percentage is based on the
weighted averages of the costs and retail
Average Cost
amounts for all goods available for sale
Conventional • To approximate the lower of average cost
and net realizable value, markdowns are
Retail
not included in the calculation of the costMethod
to-retail percentage
LIFO Retail
Method
• If inventory at retail increases during the
year a new layer is added
• Beginning inventory is excluded from the
calculation of the cost-to-retail percentage
• Assume that retail prices of goods remained
stable during the period
LO9-3
Illustration: The Retail Inventory Method—
Various Cost Flow Methods
Home Improvement Stores, Inc., uses a periodic inventory
system and the retail inventory method to estimate ending
inventory and cost of goods sold. The following data are
available from the company’s records for the month of July
2016:
Cost
Retail
Beginning inventory
Net purchases
Net markups
Net markdowns
Net sales
$99,200
305,280
$160,000
470,000
10,000
8,000
434,000
LO9-3
Illustration: Retail Method—Average Cost
Beginning inventory
Plus: Net purchases
Net markups
Less: Net markdowns
Goods available for sale
Cost-to-retail percentage:
Less: Net sales
Estimated ending inventory at retail
Estimated ending inventory at cost
Estimated cost of goods sold
Cost
Retail
$ 99,200
305,280
$160,000
470,000
10,000
(8,000)
$632,000
$404,480
= 64%
(434,000)
$198,000
(126,720)
$277,760
Concept Check √
The Bowden Company uses the retail inventory method. The following
information is available for the year ended December 31, 2016:
Cost
Retail
Inventory 1/1/16
$ 780,000 $ 1,300,000
Net purchases for the year
2,804,000
3,670,000
Net markups
150,000
Net markdowns
90,000
Net sales
3,690,000
Applying the average cost retail inventory method, Bowden's inventory at
December 31, 2016, is estimated at:
a.
$954,784.
b.
$790,318.
c.
$938,000.
d.
$810,700.
Ending inventory at retail: $1,340,000 [$1,300,000
(beginning inventory) + $3,670,000 (net purchases) +
$150,000 (net markups) - $90,000 (net markdowns) $3,690,000 (net sales)]. Cost ratio = 71.2525%
[$780,000 (beginning inventory) + $2,804,000 (net
purchases)]  [$1,300,000 (beginning inventory) +
$3,670,000 (net purchases) + $150,000 (net markups) $90,000 (net markdowns]. Ending inventory at cost:
$1,340,000 x 71.2525% = $954,784
LO9-3
Illustration: Retail Method—Conventional
Beginning inventory
Plus: Net purchases
Net markups
Less: Net markdowns
Cost-to-retail percentage:
Cost
Retail
$ 99,200
305,280
$160,000
470,000
10,000
(8,000)
= 63.2%
Less: Net markdowns
Goods available for sale
Less: Net sales
Estimated ending inventory at retail
Estimated ending inventory at cost
Estimated cost of goods sold
$404,480
(125,136)
$279,344
$640,000
(8,000)
$632,000
(434,000)
$198,000
Concept Check √
The Bowden Company uses the retail inventory method. The following
information is available for the year ended December 31, 2016:
Cost
Retail
Inventory 1/1/16
$ 780,000 $ 1,300,000
Net purchases for the year
2,804,000
3,670,000
Net markups
150,000
Net markdowns
90,000
Net sales
3,690,000
Applying the conventional retail inventory method, Bowden's inventory at
December 31, 2016, is estimated at:
a.
$954,784.
b.
$790,318.
c.
$938,000.
d.
$810,700.
Ending inventory at retail: $1,340,000 [$1,300,000
(beginning inventory) + $3,670,000 (net purchases) +
$150,000 (net markups) - $90,000 (net markdowns) $3,690,000 (net sales)]. Cost ratio = 70% [$780,000
(beginning inventory) + $2,804,000 (net purchases)] 
[$1,300,000 (beginning inventory) + $3,670,000 (net
purchases) + $150,000 (net markups)]. Ending
inventory at cost: $1,340,000 x 70% = $938,000
LO9-4
Illustration: LIFO Retail Method
Cost
Retail
Beginning inventory
$99,200 $160,000
Plus: Net purchases
305,280
470,000
10,000
Net markups
(8,000)
Less: Net markdowns
Goods available for sale (excluding beginning inventory) $305,280 $472,000
Goods available for sale (including beginning inventory) $404,480 $632,000
Beginning inventory cost-to-retail
= 62%
percentage:
July cost-to-retail percentage:
= 64.68%
Less: Net sales
(434,000)
Estimated ending inventory at retail
$198,000
Estimated ending inventory at cost $198,000 – 160,000
Retail
Cost
= $99,200
$160,000 ×
Beginning inventory
38,000 ×
= 24,578
Current period’s layer
$123,778 (123,778)
$198,000
Total
$280,702
Estimated cost of goods sold
Illustration: Recap of Other Retail Method
Elements
LO9-4
LO9-5
Dollar-Value LIFO Retail
$
Ending Inventory
exceeds
$
Beginning Inventory
New LIFO layer added or Increase in retail prices
• Each layer year carries its unique retail price index
and its unique cost-to-retail percentage
LO9-5
Illustration: The Dollar-Value LIFO Retail Method
Beginning inventory
Plus: Net purchases
Net markups
Less: Net markdowns
Goods available for sale (excluding beginning inventory)
Goods available for sale (including beginning inventory)
Beginning inventory cost-to-retail
62%
percentage:
Cost-to-retail percentage:
64.68%
Less: Net sales
Estimated ending inventory at retail
Estimated ending inventory at cost (see next slide)
Estimated cost of goods sold
Cost
Retail
$99,200
305,280
$160,000
470,000
10,000
(8,000)
$472,000
$632,000
$305,280
$404,480
(434,000)
$198,000
(113,430)
$291,050
LO9-5
Illustration: The Dollar-Value LIFO Retail
Inventory Method (continued)
Change in retail prices over the year of 10%:
An increase in the retail price index from 1 to 1.10.
Ending
Inventory at
Year-End
Retail Prices
Step 1
Ending Inventory
at Base Year Retail
Prices
Step 2
Inventory Layers at
Base Year Retail
Prices
Step 3
Inventory Layers
Converted to Cost
$198,000
= $180,000 $180,000
1.10
(determined)
$180,000 – 160,000
160,000 (base) X 1.00 X .62 = $99,200
20,000 (2016) X 1.10 X .6468 = 14,230
$198,000
Total ending inventory at dollar-value LIFO retail cost
$113,430
Cost-to-retail percentage
LO9-5
Illustration: The Dollar-Value LIFO Retail
Inventory Method (continued)
An increase in the retail price index from 1 to 1.16.
Ending
Inventory at
Year-End
Retail Prices
$226,200
Step 1
Ending Inventory
at Base Year Retail
Prices
$226,200
= $195,000
1.16
Step 2
Inventory Layers at
Base Year Retail
Prices
Step 3
Inventory Layers
Converted to Cost
$195,000
(assumed)
160,000 (base) X 1.00 X .62 = $ 99,200
20,000 (2016) X 1.10 X .6468 = 14,230
15,000 (2017) X 1.16 X .63 = 10,962
Total ending inventory at dollar-value LIFO retail cost
$124,392
LO9-5
Illustration: The Dollar-Value LIFO Retail
Inventory Method
Ending
Inventory at
Year-End
Retail Prices
$204,160
Step 1
Ending Inventory
at Base Year Retail
Prices
$204,160
= $176,000
1.16
Step 2
Inventory Layers at
Base Year Retail
Prices
Step 3
Inventory Layers
Converted to Cost
$176,000
(assumed)
160,000 (base) X 1.00 X .62 = $ 99,200
16,000 (2016) X 1.10 X .6468 = 11,384
Total ending inventory at dollar-value LIFO retail cost
$110,584
Concept Check √
On January 1, 2016, the Bowden Corporation adopted the dollar-value LIFO
retail inventory method. Beginning inventory at cost and at retail were
$60,000 and $94,000, respectively. Purchases during the year at cost and at
retail were $201,500 and $310,000, respectively. There were no
markdowns or markups during the year. 2016 net sales totaled $300,000.
The retail price index at the end of 2016 was 1.04.
Ending inventory at dollar-value LIFO cost is:
a.
$ 65,000.
b.
$ 67,600.
c.
$ 64,056.
d.
$100,000.
Cost to retail percentage for 2016: $201,500 ÷
$310,000 = 65%. Ending inventory at retail = $104,000
($94,000 + 310,000 – 300,000). $104,000 ÷ 1.04 =
$100,000. $100,000 – 94,000 = $6,000 x 1.04 x .65 =
$4,056 (2016 layer) + 60,000 (base layer) = $64,056
LO9-6
Change in Inventory Method
Most
Inventory
Changes:
Retrospective
Treatment
Change in
Inventory
Method
Change to
the LIFO
Method
Step 1:
Revising comparative
statements
Step 2:
Affected accounts are adjusted
Step 3:
Disclosure provides additional
Information
The LIFO method is used from
the point the change is
adopted and that period’s
beginning balance is
considered as the base year
inventory
Change in Inventory Method (continued)
Autogeek, Inc., a wholesale distributor of auto parts, began
business in 2013. Inventory reported in the 2015 year-end
balance sheet, determined using the average cost method, was
$123,000. In 2016, the company decided to change its inventory
method to FIFO.
If the company had used the FIFO method in 2015, ending
inventory would have been $146,000. Ignoring income taxes,
what steps should Autogeek take to report this change?
$146,000 – $123,000
Journal Entry
Inventory
Retained earnings
Debit
Credit
23,000
23,000
LO9-6
Illustration: Disclosure of Change in Inventory
Method—CVS Caremark Corporation
LO9-6
Illustration: Change in Inventory Method
Disclosure—Seneca Foods Corporation
Nature and justification of change
LO9-6
Illustration: Change in Inventory Method
Disclosure—Seneca Foods Corporation (continued)
Why retrospective application was impracticable
LO9-6
Illustration: Change in Inventory Method
Disclosure—Seneca Foods Corporation (continued)
The effect of change
Concept Check √
In 2016, the Beldre Company switched its inventory method from average
cost to FIFO. Inventories at the end of 2015 were reported in the balance
sheet at $55 million. If the FIFO method had been used, 2015 ending
inventory would have been $50 million. The company's tax rate is 40%.
The adjustment to 2016’s beginning retained earnings would be:
a.
Zero.
b.
A $5 million decrease.
c.
A $3 million decrease.
d.
A $3 million increase.
2015 cost of goods sold would have been higher by $5
million, reducing pretax income by $5 million. Of that,
taxes would have been reduced by $2 million, leaving a
$3 million decrease in net income.
LO9-7
Inventory Errors
Inventory errors
Over or understatement of ending inventory
or purchases
(1) Mistake in physical count or pricing
(2) Cutoff errors
Error Types
Error Treatments
Error in same
• Original erroneous entry should be reversed
accounting period • Appropriate entry recorded
Error discovered • Previous year financial statement should be
in subsequent
retrospectively restated
accounting period • Incorrect account balances are corrected by journal
entry
• Correction of retained earnings is reported as a prior
period adjustment to the beginning balance in the
statement of shareholders’ equity
• Disclosure note describing the nature and impact of
error
LO9-7
Illustration: Visualizing the Effect of Inventory
Errors
LO9-7
Illustration: Inventory Error Correction
LO9-7
Illustration: Inventory Error Correction (continued)
The Barton Company uses a periodic inventory system. At the end
of 2015, a mathematical error caused an $800,000 overstatement
of ending inventory. Ending inventories for 2016 and 2017 are
correctly determined.
When the Inventory Error is Discovered the Following Year
This journal entry, ignoring income taxes, corrects the error:
Journal Entry
Retained earnings
Inventory
Debit
Credit
800,000
800,000
LO9-7
Illustration: Inventory Error Correction (continued)
The Barton Company uses a periodic inventory system. At the end
of 2015, a mathematical error caused an $800,000 overstatement
of ending inventory. Ending inventories for 2016 and 2017 are
correctly determined.
When the Inventory Error is Discovered Two Years Later
• No correcting entry required as the error has self-corrected
• A disclosure note in the company’s annual report should
describe the nature of the error and its impact on each year’s:
• Net income—overstated by $800,000 in 2015; understated
by $800,000 in 2016 (ignoring income taxes)
• Earnings per share
Concept Check √
Hightower Co. uses a periodic inventory system. Beginning inventory on
January 1, 2016 was overstated by $49,000, and ending inventory on
December 31, 2016 was understated by $79,000. These errors were not
discovered until 2017. As a result, Hightower's cost of goods sold for 2016
was:
a.
Understated by $128,000.
b.
Overstated by $30,000.
c.
Overstated by $128,000.
d.
Understated by $30,000.
$49,000 + 79,000 = $128,000 overstatement of cost of
goods sold
LO9-8
Differences between U.S. GAAP and IFRS
U.S. GAAP
IFRS
Lower of cost and net realizable value
Reversals are not permitted
If circumstances indicate that an
inventory write-down is no
longer appropriate, it must be
reversed
Can be applied to individual
items, logical inventory
categories, or the entire
inventory
Usually applied to individual
items, although using logical
inventory categories is allowed
under certain circumstances
Purchase commitments
• Contracts that obligate a company to purchase a
specified amount of merchandise or raw materials
at specified prices on or before specified dates
• Protects the buyer against increases in purchase
price and provides a supply of product
• Recorded at the lower of contract price or market
price on the date the contract is executed
APPENDIX 9
Illustration: Purchase Commitments
In July 2016, the Lassiter Company signed two purchase commitments. The
first requires Lassiter to purchase inventory for $500,000 by November 15,
2016. The second requires the company to purchase inventory for $600,000 by
February 15, 2017. Lassiter’s fiscal year-end is December 31. The company
uses a perpetual inventory system.
Contract Period within Fiscal Year
When the market price is at least equal to the contract price
Journal Entry
Inventory (contract price)
Cash (or accounts payable)
Debit
Credit
500,000
500,000
APPENDIX 9
Illustration: Purchase Commitments (continued)
In July 2016, the Lassiter Company signed two purchase commitments. The
first requires Lassiter to purchase inventory for $500,000 by November 15,
2016. The market price is $425,000. The second requires the company to
purchase inventory for $600,000 by February 15, 2017. Lassiter’s fiscal yearend is December 31. The company uses a perpetual inventory system.
$500,000 − $425,000
Contract Period within Fiscal Year
When the market price is less than the contract price
Journal Entry
Inventory (market price)
Loss on purchase commitment
Cash (or accounts payable)
Debit
Credit
425,000
75,000
500,000
APPENDIX 9
Illustration: Purchase Commitments (continued)
In July 2016, the Lassiter Company signed two purchase commitments. The
first requires Lassiter to purchase inventory for $500,000 by November 15,
2016. The second requires the company to purchase inventory for $600,000 by
February 15, 2017. The year-end market price of the inventory for Lassiter’s
second purchase commitment is $540,000. Lassiter’s fiscal year-end is
December 31. The company uses a perpetual inventory system.
$600,000 − $540,000
Contract Period Extends beyond Fiscal Year
When the market price is at least equal to the contract price
Journal Entry – December 31, 2016
Estimated loss on purchase commitment
Estimated liability on purchase
commitment
Debit
Credit
60,000
60,000
APPENDIX 9
Illustration: Purchase Commitments (continued)
In July 2016, the Lassiter Company signed two purchase commitments. The
first requires Lassiter to purchase inventory for $500,000 by November 15,
2016. The second requires the company to purchase inventory for $600,000 by
February 15, 2017. The year-end market price of the inventory for Lassiter’s
second purchase commitment is $540,000. Lassiter’s fiscal year-end is
December 31. The company uses a perpetual inventory system.
Contract Period Extends beyond Fiscal Year
When market price is unchanged or increased from year-end price
Journal Entry
Debit
Credit
Inventory (accounting cost)
540,000
Estimated liability on purchase commitment 60,000
Cash (or accounts payable)
600,000
APPENDIX 9
Illustration: Purchase Commitments (continued)
In July 2016, the Lassiter Company signed two purchase commitments. The
first requires Lassiter to purchase inventory for $500,000 by November 15,
2016. The second requires the company to purchase inventory for $600,000 by
February 15, 2017. The year-end market price of the inventory for Lassiter’s
second purchase commitment is $540,000. Lassiter’s fiscal year-end is
December 31. The market price of the inventory covered by the commitment
further declines to $510,000. The company uses a perpetual inventory system.
Contract Period Extends beyond Fiscal Year
When market price declines even further from year-end levels
$540,000 − $510,000
Journal Entry
Debit
Credit
Inventory (market price)
510,000
Loss on purchase commitment
30,000
Estimated liability on purchase commitment 60,000
Cash (or accounts payable)
600,000
Concept Check √
On August 15, 2016, Pesky Corporation signed a purchase commitment to
purchase inventory for $300,000 on or before February 20, 2017. The
company’s fiscal year-end is December 31. The contract was exercised on
February 3, 2017, and the inventory was purchased for cash at the contract
price. On the purchase date of February 3, the market price of the
inventory was $315,000. The market price of the inventory on December
31, 2016, was $270,000. The company uses a perpetual inventory system.
How much loss on purchase commitment will Pesky recognize in 2016?
a.
$45,000.
b.
$30,000.
c.
$15,000.
d.
None.
$300,000 – 270,000 = $30,000 loss
End of Chapter 9