Inventories:
Additional
Issues
9
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
9-2
Learning Objective
Understand and apply the lower-of-costor-market rule used to value inventories.
9-3
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.
9-4
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.
Net Realizable
Value (Ceiling)
Net Realizable Value
less Normal Profit
(Floor)
9-5
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 many
countries, for example
New Zealand market value
is defined as NRV.
Net Realizable Value
less Normal Profit
(Floor)
9-6
Determining Market Value
If replacement cost
> Ceiling, then
Ceiling = Market
Value
Replacement
Cost
If replacement
cost < Floor, then
Floor = Market
Value
Net Realizable
Value (Ceiling)
Net Realizable Value
less Normal Profit
(Floor)
9-7
Lower of Cost or Market
 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
normal profit margin of = $5
 How
would we value this item in the
Balance Sheet?
9-8
Lower of Cost or Market
Selling
Price
$ 30.00
Cost to
Complete
- $
4.00
=
Ceiling
=
$ 26.00
Replacement
Cost =$21.50
Normal
= Floor
Profit
$ 26.00 - $
5.00 = $ 21.00
Ceiling
-
Net Realizable
Value (Ceiling)
Which one do
we use?
Net Realizable
Value less Normal
Profit (Floor)
9-9
Lower of Cost or Market
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.
Net Realizable
Value less Normal
Profit (Floor)
9-10
Lower of Cost or Market
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
NRV reduced by normal profit = $85.00
How would we value the item on our
Balance Sheet?
9-11
Lower of Cost or Market
Net Realizable Value
(Ceiling) = $100
?
Which one do
we use as
market value?
?
Replacement
Cost =$80
?
Net Realizable Value
less Normal Profit
(Floor) = $85
9-12
Lower of Cost or Market
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.
9-13
Applying Lower of Cost or Market
Lower of cost or market can be applied 3
different ways.
3.1.Apply
ApplyLCM
LCMto
tothe
each
entire
individual
inventory
itemasina
2. Apply LCM to each class of inventory.
inventory.
group.
9-14
Adjusting Cost to Market - Options

Record the Loss as a Separate Item in
the Income Statement
Adjust inventory directly or by using an
allowance account.

Record the Loss as part of Cost of
Good Sold
Adjust inventory directly or by using an
allowance account.
9-15
Learning Objective
Estimate ending inventory and cost of
goods sold using the gross profit method.
9-16
Inventory Estimation Techniques
 Estimate
instead of taking
physical inventory
Less costly
Less time consuming
 Two
popular methods are . . .
Gross Profit Method
Retail Inventory Method
9-17
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 acceptable
for use in annual financial statements.
9-18
Gross Profit Method
This 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.
Net purchases for
the period.
9-19
Steps to the Gross Profit Method
1. Estimate Historical Gross Margin %.
2. Sales x (1 - Estimated Gross Margin %) =
Estimated COGS
3. Beg. Inventory + Net Purchases = Cost of
Goods Available for Sale (COGAS)
4. COGAS - Estimated COGS = Estimated
Cost of Ending Inventory
9-20
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:
•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.
9-21
Gross Profit Method
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 Percentage.
9-22
Learning Objective
Estimate ending inventory and cost of
goods sold using the retail inventory method,
9-23
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.
9-24
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.
9-25
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.
9-26
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:
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.
9-27
Retail Inventory Method
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
Cost
$ 27,000
180,000
207,000
Retail
$
45,000
300,000
345,000
(310,000)
$
35,000
?
9-28
Retail Inventory Method
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
$
21,000
?
9-29
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 %.
9-30
Retail Inventory Method - Average Cost
Matrix, 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
Net sales for June $300,000
Estimate inventory at June 30.
9-31
Retail Inventory Method - Average Cost
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
Cost
Retail
$ 21,000 $
35,000
200,000
304,000
8,000
(4,000)
221,000
343,000
(300,000)
$
43,000
?
9-32
Retail Inventory Method - Average Cost
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
$
x
27,705
?
(300,000)
$
43,000
9-33
Learning Objective
Explain how the retail inventory method
can be made to approximate the
lower-of-cost-or-market rule.
9-34
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 %
9-35
Retail Inventory Method - Average LCM
Matrix, 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
Net sales for June $300,000
Let’s estimate inventory at June 30.
9-36
Retail Inventory Method - Average LCM
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
$
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
?
9-37
Retail Inventory Method - Average LCM
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
$
Cost
Retail
35,000
21,000 $
200,000
304,000
8,000
347,000
(4,000)
343,000
221,000
63.69%
x
$
27,387
?
(300,000)
$
43,000
9-38
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.
9-39
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.
9-40
The LIFO Retail Method
 Use the data from Matrix Inc. to estimate
the LIFO ending inventory.
1. Beginning inventory at cost $21,000, at retail
$35,000;
2. Net purchases at cost $200,000, at retail
$304,000;
3. Net markups $8,000;
4. Net markdowns $4,000;
5. Net sales for June $300,000.
Estimate ending inventory.
9-41
The LIFO Retail Method
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
$
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
9-42
Other Issues of Retail Method
Purchase returns and purchase
discounts.
 Freight-in.
 Employee discounts.
 Spoilage, breakage, and theft.

9-43
Learning Objective
Determine ending inventory using the
dollar-value LIFO retail inventory
method.
9-44
Dollar-Value LIFO Retail
We need to eliminate the effect of
any price changes before we
compare the ending inventory
with the beginning inventory.
9-45
Dollar-Value LIFO Retail
Use the data from Matrix 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.
9-46
Dollar-Value LIFO Retail
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
Step 3
Inventory Layers
Converted to LIFO
Cost
$
21,000.00
4,740.71
$
25,740.71
9-47
Learning Objective
Explain the appropriate accounting
treatment required when a change
in inventory method is made.
9-48
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.
Change to
Changes in inventory methods,
other than a change to LIFO, are
treated retrospectively.
FIFO
Retrospective
Change from
LIFO
9-49
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.
9-50
Learning Objective
Explain the appropriate accounting
treatment when an inventory error is
discovered.
9-51
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.
9-52
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.
9-53
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.
9-54
Purchase
Commitments
Appendix 9
9-55
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 2006, Matrix, Inc. signed two purchase commitments. The
first requires Matrix to purchase raw materials for $100,000 by
December 1, 2006. On December 1, 2006, the raw materials
had a market value of $90,000. The second requires Matrix
to purchase inventory items for $200,000 by March 1, 2007.
On December 31, 2006, the market value of the inventory items
were $188,000. On March 1, 2007, the market value of the inventory
items were $186,000. Matrix uses the perpetual inventory system
and is a calendar year-end company.
Let’s make the journal entries for these commitments.
9-56
Purchase Commitments
Date
Description
7/1/06 Raw materials inventory
Accounts payable
12/1/06 Accounts payable
Cash
12/1/06 Loss on purchase commitment
Raw materials inventory
Debit
Credit
100,000
100,000
100,000
100,000
Single year
commitment
10,000
10,000
12/31/06 Estimated loss on commitment
Estimated liability on commitment
12,000
3/1/07 Inventory
Estimated liability on commitment
Loss on purchase commitment
Cash
186,000
12,000
2,000
12,000
Multi-year
Commitment
200,000
9-57
End of Chapter 9