Chapter 9
INVENTORIES:
ADDITIONAL ISSUES
© 2009 The McGraw-Hill Companies, Inc.
Slide 2
Determining Market Value
 Accounting
Research Bulletin
No. 43 defines
“market value” in
terms of current
replacement cost.
 Replacement cost is
constrained to fall
between the “ceiling”
and the “floor.”
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Market Should Not
Exceed Net Realizable
Value (Ceiling)
Market Should Not Be
Less Than Net Realizable
Value less Normal Profit
(Floor)
Slide 3
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
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Cost
Slide 4
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 of = $5
How would we value this item in the
Balance Sheet?
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Slide 5
Lower of Cost or Market
Selling
Cost to
= Ceiling
Price
Complete
$ 30.00 - $
4.00 = $ 26.00
Replacement
Cost =$21.50
Normal
= Floor
Profit
$ 26.00 - $
5.00 = $ 21.00
Ceiling
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-
Designated
$21.50
Market?
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.
Slide 6
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.
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Slide 7
Adjusting Cost to Market
Record the Loss as a Separate Item
in the Income Statement
1.

Adjust inventory directly or by using an
allowance account.
Record the Loss as part of Cost of
Goods Sold
2.

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Adjust inventory directly or by using an
allowance account.
Slide 8
Inventory Estimation Techniques
 Estimate
instead of taking
physical inventory
Less costly
Less time consuming
 Two
popular methods are . . .
1. Gross Profit Method
2. Retail Inventory Method
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Slide 9
Gross Profit Method
Estimating inventory &
COGS for interim
reports.
Auditors are testing the
overall reasonableness
of client inventories.
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.
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Slide 10
Gross Profit Method
This method assumes that the historical gross
margin ratio is reasonably constant in the short-run.
Beginning Inventory
(from accounting records)
Plus: Net purchases
(from accounting records)
Goods available for sale
(calculated)
Less: Cost of goods sold
(estimated)
Ending inventory
(estimated)
Estimate the Historical Gross Profit Ratio
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Slide 11
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
•Estimated gross profit ratio = 43% of sales
Estimate Inventory at May 31.
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Slide 12
Gross Profit Method
Beginning Inventory
Plus: Net Purchases
= Goods Available for Sale
Less: Estimated COGS*
= Estimated Ending Inventory
$
237,400
728,300
965,700
(691,410)
$ 274,290
* COGS = Sales x (1 - GP%) = $ 1,213,000 x ( 1 - 43% )
= $ 691,410
NOTE: The key to successfully applying this method is a
reliable Gross Profit Ratio.
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Slide 13
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.
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Slide 14
The Retail Inventory Method
Retail Terminology
Term
Meaning
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.
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Slide 15
The Retail Inventory Method
Beginning inventory at
retail and cost.
Sales for the period.
We need to
know . . .
Net purchases at retail
and cost.
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Adjustments to the
original retail price.
Slide 16
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:
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.
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Slide 17
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
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Cost
Retail
$ 27,000 $
45,000
180,000
300,000
207,000
345,000
(310,000)
$
35,000
?
Slide 18
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%
x
Sales for May
(310,000)
Ending inventory at retail
$ 35,000
Ending inventory at cost
$ 21,000
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Slide 19
The Retail Inventory Method
Approximating Average Cost
Cost-toRetail %
=
Beginning Inventory + Net Purchases
Retail Value (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 %.
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Slide 20
The Retail Inventory Method
Approximating Average LCM
Cost-toRetail %
=
Beginning Inventory + Net Purchases
Retail Value (Beginning Inventory + Net
Purchases + Net Markups)
Net Markdowns are excluded in the
computation of the Cost-to-Retail %
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Slide 21
The Retail Inventory Method
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.

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Slide 22
The Retail Inventory Method
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.
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Slide 23
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
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Slide 24
Dollar-Value LIFO Retail
We need to eliminate the effect of
any price changes before we
compare the ending inventory
with the beginning inventory.
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Slide 25
Dollar-Value LIFO Retail
Let’s use this data from Matrix Inc. to estimate the
ending inventory using dollar-value LIFO retail.
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.
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Slide 26
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
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Step 3
Inventory Layers
Converted to LIFO
Cost
$
21,000.00
4,740.71
$
25,740.71
Slide 27
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.
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Slide 28
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.
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Slide 29
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.
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Slide 30
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.
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inventory
Slide 31
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.
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Purchase
Commitments
Appendix 9
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Slide 33
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 2009, Matrix, Inc. signed two purchase commitments. The
first requires Matrix to purchase inventory for $100,000 by
December 1, 2009. The inventory is purchased on December 1 and
paid for on December 31. On the purchase date, the inventory
had a market value of $90,000. The second requires Matrix
to purchase inventory items for $200,000 by March 1, 2010.
On December 31, 2009, the market value of the inventory items
was $188,000. On March 1, 2010, the market value of the inventory
items was $186,000. Matrix uses the perpetual inventory system
and is a calendar year-end company.
Let’s make the journal entries for these commitments.
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Slide 34
Purchase Commitments
Date
Description
12/1/09 Inventory
Loss on purchase commitment
Accounts payable
12/31/09 Accounts payable
Cash
Debit
90,000
10,000
100,000
100,000
Single year
commitment
100,000
12/31/09 Estimated loss on commitment
Estimated liability on commitment
12,000
3/1/10 Inventory
Estimated liability on commitment
Loss on purchase commitment
Cash
186,000
12,000
2,000
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Credit
12,000
200,000
Multi-year
Commitment
End of Chapter 9
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© 2008 The McGraw-Hill Companies, Inc.