1. Inventories: Additional Issues 9 McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.

2. Reporting -- Lower of Cost or Market Inventories are valued at the lower-of-cost-or market. 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.

4. Determining Market Value Ceiling NRV Replacement Cost NRV – NP Floor Designated Market Cost Not More Than Not Less Than Or Step 1 Determine Designated Market Step 2 Compare Designated Market with Cost Lower of Cost Or Market

6. Lower of Cost or Market Replacement Cost =$21.50 $21.50 Designated 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.

7. Applying Lower of Cost or Market 1. Apply LCM to each individual item in inventory. 2. Apply LCM to logical inventory categories . 3. Apply LCM to the entire inventory as a group. Lower of cost or market can be applied 3 different ways.

12. Gross Profit Method 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.

13. Gross Profit Method This method assumes that the historical gross margin ratio is reasonably constant in the short-run. Estimate the Historical Gross Profit Ratio 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)

15. Gross Profit Method NOTE: The key to successfully applying this method is a reliable Gross Profit Ratio.

17. The Retail Inventory Method 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. Retail Terminology

18. The Retail Inventory Method We need to know . . . Sales for the period. Beginning inventory at retail and cost. Adjustments to the original retail price. Net purchases at retail and cost.

19. Retail Terminology An Example of the Terminology

21. The Retail Inventory Method

22. The Retail Inventory Method × x

24. Retail Inventory Method With Markups and Markdowns

25. Retail Inventory Method With Markups and Markdowns x

26. The Retail Inventory Method We can estimate ending inventory at average LCM using the cost-to-retail percentage shown below: Net Markdowns are excluded in the computation of the cost-to-retail percentage. This is referred to as the Conventional Retail Method

28. The Retail Inventory Method The LIFO Retail Method Beginning inventory has its own cost-to-retail percentage. LIFO Cost- = Net Purchases to-Retail % Retail Value (Net Purchases + Net Markups - Net Markdowns)

29. Retail Inventory Method LIFO Retail

30. Retail Inventory Method LIFO Retail

31. Retail Inventory Method LIFO Retail

32. 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

35. Dollar-Value LIFO Retail

36. 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 .

37. 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.

38. Analyzing Inventory Errors

41. Inventory Errors When the Inventory Error is Discovered the Following Year If an error was made in 2010, but not discovered until 2011, the 2010 financial statements were incorrect as a result of the error. The error should be retrospectively restated to reflect the correct inventory amount, cost of goods sold, net income, and retained earnings when the comparative 2011 and 2010 financial statements are issued in 2011. When the Inventory Error is Discovered Subsequent to the Following Year If an error was made in 2010, but not discovered until 2012, the 2011 financial statements also are retrospectively restated to reflect the correct cost of goods sold and net income even though no correcting entry is needed. The error has self-corrected and no prior period adjustment is needed.

43. Earnings Quality Many believe that manipulating income reduces earnings quality because it can mask permanent earnings. Inventory write-downs and changes in inventory method are two additional inventory-related techniques a company could use to manipulate earnings.

44. Appendix 9 Purchase Commitments

45. 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 2011, the Lassiter Company. signed two purchase commitments. The first requires Lassiter to purchase inventory for $500,000 by November 15, 2011. The inventory is purchased on November 14, and paid for on December 15. On the date of acquisition, the inventory had a market value of $425,000. The second requires Lassiter to purchase inventory for $600,000 by February 15, 2012. On December 31, 2011, the market value of the inventory items was $540,000. On February 15, 2012, the market value of the inventory items was $510,000. Lassiter uses the perpetual inventory system and is a calendar year-end company. Let’s make the journal entries for these commitments.

46. Purchase Commitments Single-period commitment November 14, 2011 Inventory (market price) 425,000 Loss on purchase commitment 75,000 Accounts payable 500,000 December 15, 2011 Accounts payable 500,000 Cash 500,000 Multi-period commitment December 31, 2011 Estimated loss on commitment 60,000 Estimated liability on commitment 60,000 February 15, 2012 Inventory (market price) 510,000 Loss on purchase commitment 30,000 Estimated liability on commitment 60,000 Cash 600,000

47. End of Chapter 9