PowerPoint Authors:Susan Coomer Galbreath, Ph.D., CPACharles W. Caldwell, D.B.A., CMAJon A. Booker, Ph.D., CPA, CIACynthia J. Rooney, Ph.D., CPA

Inventories:Additional Issues

9

McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.

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Five Major Topics

1. Lower of cost or market (LCM)– pages 448-456

2. Gross profit method (“inventory estimation”)– pages 456-457

3. Conventional retail method– pages 458-465

4. DVL retail method– pages 465-469

5. Change in method & errors– Pages 469-474

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1) Lower of Cost or Market

Inventories are valued at the lower-of-cost (e.g., FIFO) - or market.

(replacement cost)

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.

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.

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LCM Terminology

• Replacement cost (RC) = cost to buy (or manufacture) another item of inventory

• RC Ceiling = net realizable value (NRV):

– selling price less cost to dispose

• RC Floor = NRV less normal profit margin

• Ceiling: RC should be no higher than this #

• Floor: RC should be no lower than this #

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Determining Market Value (page 449)

CeilingCeilingNRVNRV

CeilingCeilingNRVNRV

ReplacementReplacementCostCost

ReplacementReplacementCostCost

NRV – NPNRV – NPFloorFloor

NRV – NPNRV – NPFloorFloor

DesignatedDesignatedMarketMarket

DesignatedDesignatedMarketMarket

CostCostCostCostNot More Than

Not Less Than

Or

Step 1Determine Designated Market

Step 2Compare Designated Market with Cost

Lower of CostLower of CostOr MarketOr Market

Lower of CostLower of CostOr MarketOr Market

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LCM: exercise 9-3 (page 481)

Microsoft Excel Worksheet

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Recording a LCM Adjustment:two choices

1. Record the Loss as a Separate Item in the Income Statement (if unusual)

Loss on write-down of inventory XX Inventory XX

2. Record the Loss as part of Cost of Goods Sold. (if commonplace)

Cost of goods sold XX Inventory XX

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U. S. GAAP vs. IFRS

• LCM requires market to be replacement cost, but with a ceiling/floor limitation.

• LCM reversals (back to cost) are not permitted under GAAP.

• IAS No. 2, states that the designated market will always be net realizable value.

• If an inventory write-down is not longer appropriate, it must be reversed.

International standards require inventory to be valued at the lower of cost or market, but the process is slightly

different for the U.S. method of applying LCM.

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2) Gross Profit Method (pages 456-457)

Estimate ending inventory instead of physically counting the inventory – Less costly / Less time consuming– Sometimes necessary (natural disaster)

Two popular methods of estimating ending inventory are the . . .– Gross Profit Method– Retail Inventory Method

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Gross Profit Method

Useful when . . .Useful

when . . .

Estimating inventory and COGS for interim

reports.

Determining the cost of inventory lost,

destroyed, or stolen.

Auditors are testing the overall reasonableness

of client inventories.

Preparing budgets and forecasts.

NOTE: The Gross Profit Method is not acceptable for use in annual financial statements.

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Gross Profit Method:Exercise 9-9 (page 482)

Exercise 9-9

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3) Retail Inventory Method

• This method was developed for retail operations like department stores who have ….

• High volumes of sales over many inventory items

The Method: The Method: ConverConvert ending inventory t ending inventory at at retailretail to ending inventory to ending inventory at costat cost..

The Method: The Method: ConverConvert ending inventory t ending inventory at at retailretail to ending inventory to ending inventory at costat cost..

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Terminology

1. Initial markup - from cost to selling price

2. Additional markup - increase in selling price subsequent to #1

3. Markup cancellation - elimination of #2

4. Markdown – reduction in the selling price below the original selling price

5. Markdown cancellation – elimination of #4

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Retail Method Examples

• Use Exercise 9-14 (p. 483) as example of:

– “conventional method” (includes LCM)

– another example of this method is Illust 9-6 (p. 461)

• Use Illust 9-5 (p. 461) as example of:

– “average cost method” (does not include LCM)

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Exercise 9-14 (p. 483)

Conv. Retail Method

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LIFO Retail Inventory Illustration 9-7 on page 462

• Notice that there are two calculations of the cost-to-retail %:1. For the beginning inventory

2. For the purchases

• Therefore, we have “lifo layers” (as used in “regular LIFO” - Chapter 8)

• In this illustration, the Ending inventory (and the next period’s beginning inventory) will have two layers!

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4) Dollar Value LIFO Retail Example

• Exercise 9-19 (page 484)

• When studying, compare this Exercise to Exercise 8-23 (page 432) – dollar value lifo

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Exercise 9-19 (page 484)

DVL Retail Method

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5a) Changes in Inventory Method

• Recall that most voluntary changes in accounting principles are reported retrospectivelyretrospectively.

• This means reporting all previous periods’ financial statements as though the new method had been used in all prior periods.

• LIFO is the reason for the word “most”

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Change To The LIFO Method

• When a company elects to change toto LIFO, it is usually impossibleimpossible 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.

• disclosure note explains the effect of thechange on current year’s income andearnings per share,

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5b) Ending Inventory Errors

Overstatement of ending inventory◦ Understates cost of goods sold andUnderstates cost of goods sold and◦ Overstates pretax income.Overstates pretax income.

Understatement of ending inventory◦ Overstates cost of goods sold andOverstates cost of goods sold and◦ Understates pretax income.Understates pretax income.

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5c) Beginning Inventory Errors

Overstatement of beginning inventory◦ Overstates cost of goods sold andOverstates cost of goods sold and◦ Understates pretax income.Understates pretax income.

Understatement of beginning inventory◦ Understates cost of goods sold andUnderstates cost of goods sold and◦ Overstates pretax income.Overstates pretax income.

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Inventory error in 2010is discovered late in 2011

• The 2010 financials were incorrect• Hence, when comparative 2011/2010 financials

are presented, we must (retrospectively) restate the 2010 figures:– Ending inventory on balance sheet– Cost of goods sold & net income on income statement– Ending retained earnings on balance sheet

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Inventory error in 2010is discovered in 2012 (or later)

• When comparative 2012/ 2011/ 2010 financials are presented, we must (retrospectively) restate the 2010 figures:– Inventory on balance sheet– Cost of goods sold & net income on inc. statement– Retained earnings (“prior-period adjustment”) on

balance sheet

• And, we must restate the 2011 figures:– Cost of goods sold & net income – because the

beginning inventory was misstated!– Balance sheet is OK

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End of Chapter 9