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.
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)
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
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.
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.
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
Chapter 9: Inventories: Additional Issues. In this chapter we complete our discussion of inventory measurement by explaining the lower-of-cost-or-market rule used to value inventories. In addition, we investigate inventory estimation techniques, methods of simplifying LIFO, changes in inventory method, and inventory errors.
Inventories are to be valued on the balance sheet at lower-of-cost-or-market. Initially, inventory items are recorded at their historical costs, but a departure from cost is warranted when the utility of an asset (the probable future economic benefits) is no longer as great as its cost. Deterioration, obsolescence, changes in price levels, or any situation that might comprise the inventory’s salability causes us to use a measure of lower-of-cost-or-market. Using LCM 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.
Ideally, market would be measured as replacement cost of the inventory item. However, the inventory’s current replace cost must fall between the NET REALIZABLE VALUE (estimated selling price in the ordinary course of business LESS reasonably predictable costs of completion and disposal), and the NET REALIZABLE VALUE REDUCED BY NORMAL PROFIT MARGIN. Net realizable value is referred to as the ceiling for market, and net realizable value reduced by normal profit margin is referred to as the floor for market. Market value is always the MIDDLE AMOUNT of the three values: replacement cost, net realizable value and net realizable value reduced by normal profit margin.
If replacement cost is greater than the ceiling, then market becomes ceiling. If replacement cost is less than the floor, then floor becomes market value. As long as replacement cost falls between the ceiling and the floor, it will be considered market value.
Let’s look at an example to demonstrate application of the lower of cost or market concept. Here we have an inventory item that has the historical cost of $20. Its replacement cost is $21.50. The normal selling price of the inventory item is $30, and it will cost four dollars to complete and dispose of the item in its current condition. The normal profit margin on this item is five dollars. Let’s begin by determining market value.
Part I We assume the market value will be replacement cost, as long as it falls between the floor and the ceiling. The ceiling is the selling price, $30, less the cost to complete and sell, four dollars, or $26. The floor is the ceiling of $26, less normal profit of five dollars, or $21. Which amount will we select as designated market? Part II Designated market is replacement cost of $21.50, because it falls between the ceiling of $26.00 and the floor of $21.00. Part III Because historical cost of $20.00 is less than designated market of $21.50, this inventory item will be valued at its historical cost of $20.00.
Part I We can apply lower-of-cost-or-market in one of three different ways. First, we can apply it to individual items of inventory, Part II. or we can apply it to groups of similar items in inventory, Part III or finally, we can apply it to the entire inventory.
We can adjust the cost of an inventory item to market in one of two ways. When market is lower than cost, we can recognize a separate loss for the decline in value and make the adjustment to inventory directly (or by using an allowance account). As an alternative, we can record the loss as part of cost of goods sold, and either adjust inventory directly or use an allowance account.
Part I International standards require inventory to be valued at the lower of cast or market, but the process is slightly different for the U.S. method of applying LCM. Part II From the perspective of the FASB, LCM requires selecting market from replacement cost, net realizable value or NRV reduced by the normal profit margin. Designated market is compared to historical cost to determine LCM. However, IAS No. 2, states that the designated market will always be net realizable value.
Part I International standards require inventory to be valued at the lower of cast or market, but the process is slightly different for the U.S. method of applying LCM. Part II From the perspective of the FASB, Under U.S. GAAP, the LCM rule can be applied to individual items, logical inventory categories, or the entire inventory. If an inventory write-down is not longer appropriate, it must be reversed. However, according to the IFRS: The LCM assessment usually is applied to individual items, although using logical inventory categories is allowed under certain circumstances. Allows companies to reverse write-downs later if NRV increases.
Most companies estimate their inventories at interim periods. In some cases, when inventory is extremely large and spread out over a wide geographical area, inventory estimation may be used to determine year-end inventory. It may be impossible or impractical to physically count such inventories. Inventory estimation is less costly than a physical count and less time consuming. The two most popular methods are known as the gross profit method and the retail inventory method. Both method rely on the company maintaining good accounting records.
The gross profit method is perhaps the most popular method for estimating ending inventory. Companies use it when they develop interim reports, and auditors often use the gross profit method to determine the reasonableness of ending inventory. The gross profit method can be used by insurance companies to estimate lost, destroyed, or stolen inventory. We can use the gross profit method in the budgeting process. It is important to remember that the gross profit method is not acceptable for use in the annual report distributed to external users.
Before we can use the gross profit method, there is some information we need to know. First, we need an estimate of the historical gross profit ratio. Then we need to know the beginning inventory and net purchases that can be obtained from the existing accounting records. In addition, we need to determine net sales from the accounting records. Once we have determined or estimated these amounts we can use the gross profit method to estimate ending inventory.
Matrix is interested in estimating its ending inventory at May 31 using the gross profit method. The controller has provided us with certain information. Perhaps the most critical amount in the process is the estimation of the companies gross profit ratio. This is usually developed from analysis of historical rates of gross profit. Review this information and make sure it’s adequate for us to apply the gross profit method.
We were given the historic gross profit percentage, so the first step in our process is to multiply net sales times one minus the gross profit ratio. Estimated cost of goods sold is $691,410. The next step is to sum beginning inventory and net purchases to determine cost of goods available for sale. As you can see, cost of goods available for sale is $965,700. Now subtract cost of goods sold from cost of goods available for sale to get estimated ending inventory of $274,290.
As indicated by its name, the retail method was developed for retail establishments such as department stores. There is a major difference between the gross profit and retail method. In the retail method, we need to know both cost and selling price of certain accounts. Our objective in the retail method is to calculate ending inventory at retail, and then convert it from retail to cost.
To apply the retail inventory properly it is important to understand terminology in the retail industry. A retail company purchases an item for resale at cost. The initial markup is the markup from cost to selling price. For example, if a company purchases an item for $6 and plans to sell it for $10, there is on initial markup of $4. If demand for the product is high, the company may raise the selling price to $12, so there is an additional markup of $2. If demand for the product at $12 slackens to $10.50, the company would have a markup cancellation of $1.50.
Before we can successfully complete the retail inventory method, we need to know four pieces of information. We need to know sales for the period, net purchases at both retail price and cost, the value of beginning inventory at both retail and cost and, finally, whether there’s been an inventory adjustment to the retail price. These adjustments might include additional markups or additional markdowns and other items that apply to retail establishments.
Voice over reading part one The terms on your screen are associated with changing retail prices of merchandise inventory, and are very common in all retail establishments. We are all familiar with the term markdown, we usually associate it with the a sale of the items in the company’s inventory. What happens after the sale is over? When the sale ends we have a markdown cancellation which brings the product back to its original selling price. Voice over reading part two inserted after Group 12 to come up after Group 12 is on the screen Follow the example at the bottom of your slide closely and you will begin to understand the terminology used in many retail establishments.
Matrix, a retail establishment, wishes to estimate its ending inventory at May 31. Information is gathered by the controller to help us accomplish this task. Read through the information carefully and we’ll begin the process to estimate ending inventory using the retail inventory method.
First, we add together beginning inventory and net purchases for May both at cost and retail. We divide the cost of goods available for sale by the retail price of goods available for sale to arrive at the cost-to-retail percentage of 60%. Next, we subtract our sales for May from the selling price of goods available for sale, to arrive at ending inventory at retail.
Finally, we use our cost-to-retail percentage to convert our estimate of ending inventory at retail, $35,000, to our estimate of ending inventory at cost, $21,000.
Matrix, Inc. uses the retail method to estimate inventory at the end of July. 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, And net sales for July $300,000. Let’s estimate inventory at July 31.
We include the net markups (markups less markup cancellations) and net markdowns (markdowns less markdown cancellations) in the calculation of the cost-to profit ratio. Notice that net markups and net markdowns only impact only the retail column because they are normally applied to the recorded retail inventory tags. The next step it to determine the cost-to-retail percentage.
As you can see, the cost-to-retail percentage is 64.43 percent rounded ($221,000 Cost divided by $343,000 Retail). We subtract the sales for the month of July from the retail value of goods available for sale to determine the retail value of ending inventory of $43,000. Finally, we multiply the retail value of ending inventory by the cost-to-retail percent to arrive at the cost of ending inventory of $27,705. Remember, many companies use this method because it is an approximation of average cost of ending inventory.
To estimate ending inventory at lower of cost or market using the retail method, the cost-to-retail percentage excludes net markdowns. Otherwise, the cost-to-retail percent is exactly the same as we calculated in our example.
We can also use the retail method to estimate ending inventory using LIFO. Whenever we think about LIFO, we should think about layers. There is a natural layer between beginning inventory and purchases for the period.
Under the LIFO retail method, the beginning inventory will have its own cost-to-retail percentage. The cost-to-retail percentage for purchases is calculated by taking net purchases at cost and dividing this amount by the retail value of net purchases plus net markups minus net markdowns.
When we use LIFO retail, we separate beginning inventory for the activity in the current month. Beginning inventory has its own cost-to-retail percents. In our case that percentage is 60% ($21,000 divided by $35,000). We include both net markups and net markdowns for the current period with net purchases. The cost-to-retail percentage for the July activity is 64.94 percent rounded.
Next, we subtract the sales for July from the net purchases (including markups and markdowns) to determine the LIFO layer for the month of July. In our case, the LIFO layer is $8,000. The final step is to determine the estimated cost of ending inventory using the LIFO approach.
Beginning inventory contributes $21,000 to the cost of ending inventory. For July the LIFO layer contributed $5,195 – rounded to the cost of ending inventory. In our example we assumed stable prices. If there is an increase in the index used to determine LIFO, we would have to deflate the $8,000 layer back to base-period prices and re-inflate the amount for the current index.
Other items that impact the retail value of net purchases include purchase returns and allowances, purchase discounts, freight-in, employee discounts, and spoilage or theft. The treatment of these items is shown in the table on your screen.
The purpose of dollar-value LIFO retail is to eliminate the effects of price changes on ending inventory and beginning inventory.
When we examined LIFO Retail as a method to estimate ending inventory we assumed that if ending inventory was greater than beginning inventory, we added a LIFO layer. But this assumption is not always true. It may be that the dollar amount of ending inventory exceeded the beginning inventory amount simply because prices increased during the period, without an actual change in the quantity of goods. We use Dollar-Value LIFO Retail to eliminate the impact of inflation on inventory. Let’s use this information to estimate the ending inventory of Matrix, Inc. using the dollar-value LIFO retail method. Notice that during the month of June there was significant inflation, plus new information relating to the change in prices. At the beginning of June, the price index was 100. At the end of June, it was 102. Let’s use this new information to estimate inventory using dollar-value LIFO retail.
Voiceover one to insert after object 3 In the previous period, the retail price of ending inventory was determined. Voiceover one to insert after object 4 The first step is to deflate the $43,000 retail value of ending inventory to base year prices. To accomplish this, we divide the $43,000 by 1.02, the price index at the end of the period. The retail value of ending inventory in base year prices is $42,157. Voiceover one to insert after auto-shape 11 Our beginning inventory at retail was $35,000 and the price index was 100, so the beginning inventory layer will be converted to $21,000 using the 60% cost-to-retail percentage. The current layer in base year prices is $7,157. We first re-inflate this amount to the value at the end of the period by multiplying $7,157 times 1.02. Next, we convert the re-inflated amount from retail to cost by multiplying it times 64.94%. We have a current layer, at current prices, of $4,740.71. We add the layers together to determine LIFO retail inventory at $25,740.71.
Most voluntary changes in accounting principles involving inventory are reported retrospectively. This means that all previous financial statements disclosed are restated as though the new principal had been used.
When a company changes to the LIFO inventory method from any other method, it usually is impossible to calculate the income effect on prior years. To do so would require assumptions as to when specific LIFO inventory layers were created in years prior to the change. As a result, a company changing to LIFO usually does not report the change retrospectively. Instead, the LIFO method simply is used from that point on. The base year inventory for all future LIFO determinations is the beginning inventory in the year the LIFO method is adopted. A disclosure note is needed to explain the nature and justification for the change as well as the effect of the change on current year’s income and earnings per share. The note also must explain why retrospective application was impracticable.
When analyzing inventory errors, it’s helpful to visualize the way cost of goods sold, net income, and retained earnings are determined Beginning inventory and net purchases are added in the calculation of cost of goods sold. If either of these is overstated (understated) then cost of goods sold would be overstated (understated). On the other hand, ending inventory is deducted in the calculation of cost of goods sold, so if ending inventory is overstated (understated) then cost of goods sold is understated (overstated). Of course, errors that affect income also will affect income taxes. In the illustration that follows, we ignore the tax effects of the errors and focus on the errors themselves rather than their tax aspects.
This slide explains the impact of errors in ending inventory on cost of goods sold and pretax income. Because the error impacts cost of goods sold and pretax net income, it also will impact the balance in retained earning.
Here we show the impact of errors in beginning inventory on cost of goods sold in pretax income.
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. 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.
This slide shows the impact of errors in the recording of purchases on cost of goods sold and pretax income.
Many financial analysts believe that inventory write-downs or arbitrary changes in inventory methods represent manipulation of the earnings by management. Such a manipulation is considered to impair the earnings quality of the company. A financial analyst must carefully consider the effect of any significant asset write-down on the assessment of a company’s permanent earnings.
Appendix 9: Purchase Commitments.
A purchase commitment is a contract between two parties, requiring one of the parties to purchase a specified amount of inventory at a set price, on or before a particular date. 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.
Part I Let’s look at the single-period purchase commitment first. On the date of acquisition, the inventory items had a market price of $425,000, so Lassiter will debit inventory for $425,000, debit the loss on purchase commitment for $75,000, and credit accounts payable for $500,000. Had the market price of the inventory been $500,000 on the date of acquisition, the company would not experience a loss. The account payable was paid on December 15, 2011, so Lassiter would make the usual entry to debit accounts payable and credit cash for the commitment price of $500,000. Part II For the multi-period purchase commitment, Lassiter did not acquire the inventory until 2012, so at the end of 2011, the company would determine the market price of the inventory items and, in our case, debit estimated loss on purchase commitment and credit estimated liability on purchase commitment for $60,000 ($600,000 commitment price less $540,000 market price). On February 15, 2012, Lassiter purchase the inventory paying cash. The market price of the inventory at the time of acquisition was $510,000. Lassiter will prepare a somewhat complex journal entry to debit inventory for $510,000, debit loss on purchase commitment ($540,000 previous market price less $510,000 current market price), debit the estimated liability on purchase commitment for $60,000, and credit cash for the commitment price of $600,000.