Chapter 9

INVENTORIES:
ADDITIONAL ISSUES

© 2013 The McGraw-Hill Companies, Inc.

 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.

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 Determining Market Value

 IAS No. 2 defines

“market value” as the
net realizable value
(NRV). + Estimated selling price
− Cost of Completion
 NRV is the estimated − Cost to sell
selling price in the
ordinary course of = Net Realizable Value /
business less Market Value
estimated cost of
completion and
disposal (cost to sell).
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 Determining Market Value
Step 1 Step 2
Determine Designated Market Compare Designated Market with Cost

(1) Selling (3) Net

Price in Realizable
ordinary Value
course of
business

Designated Cost
Or
Market
(2) less: Estimated
cost of completion
and disposal
Lower of Cost
Or Market

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 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:
• selling price = $30
• cost to complete and dispose = $4

• How would we value this item in the

statement of financial position?

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 Lower of Cost or Market

Cost to Net
Selling
- Complete & = Realizable
Price
Dispose Value (NRV)
$ 30.00 - $ 4.00 = $ 26.00
Designated
$21.50
Market?

Lower of.. Historical cost of $20.00 is

Market less than the NRV of 26,
NRV Cost so this inventory item will
Price
$ 26.00 $ 20.00 $ 20.00 be valued at cost of
$20.00.

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 Applying Lower of Cost or Market
Lower of cost or market can be applied 2
different ways.

1. Apply
2. Apply1)
LCM Individual
LCMto each Items
to logical
individual
inventory
item in
categories.
2) Group of similarinventory.
or related inventory items

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 Adjusting Cost to Market
1. Record the Loss as a Separate Item in
the Income Statement

Loss on write-down of inventory XX

Inventory XX

2. Record the Loss as part of Cost of Goods

Sold.

Cost of goods sold XX

Inventory XX

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 Reversal of Write-Downs

• Re-assess NRV at the end of every

After Write subsequent period
Down

• If current carrying value is lower

than the revised NRV
Write-Up • Write-up allowed up to the lower of
Allowed the revised NRV and original cost

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 U. S. GAAP vs. IFRS
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.

• LCM requires selecting market • IAS No. 2, states that the

from replacement cost, net designated market will always
realizable value or NRV be net realizable value.
reduced by the normal profit
margin.
• Designated market is
compared to historical cost to
determine LCM.

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 U. S. GAAP vs. IFRS
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.

• Under U.S. GAAP, the LCM • The LCM assessment usually

rule can be applied to is applied to individual items,
individual items, logical although using logical
inventory categories, or the inventory categories is allowed
entire inventory. under certain circumstances.
• Reversals are not permitted • If an inventory write-down is
under GAAP. not longer appropriate, it must
be reversed.

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 Inventory Estimation Techniques
 Estimate instead of taking physical inventory
1. Less costly
2. Less time consuming
 Two popular methods of estimating ending
inventory are the . . .
1. Gross Profit Method
2. Retail Inventory Method

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 Gross Profit Method
Estimating inventory Auditors are testing the
and COGS for interim overall reasonableness
reports. of client inventories.

Useful
when . . .

Determining the cost of

Preparing budgets and
inventory lost,
forecasts.
destroyed, or stolen.

NOTE: The Gross Profit Method is not acceptable

for use in annual financial statements.
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 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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 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:

1. Net sales for May = $1,213,000

2. Net purchases for May = $728,300
3. Inventory at May 1 = $237,400
4. Estimated gross profit ratio = 43% of sales

Estimate Inventory at May 31.

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 Gross Profit Method
Beginning Inventory $ 237,400
Plus: Net Purchases 728,300
= Goods Available for Sale 965,700
Less: Estimated COGS* (691,410)
= Estimated Ending Inventory $ 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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 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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 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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 The Retail Inventory Method

Beginning inventory at
Sales for the period.
retail and cost.

We need to
know . . .

Net purchases at retail Adjustments to the

and cost. original retail price.

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 Retail Terminology

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 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:

1) Beginning inventory at cost $27,000, at retail

$45,000
2) Net purchases at cost $180,000 at retail
$300,000
3) Net sales for May $310,000

Estimate the inventory at May 31.

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 The Retail Inventory Method

Cost Retail
Inventory, May 1 $ 27,000 $ 45,000
Net purchases for May 180,000 300,000
Goods available for sale 207,000 345,000
Cost-to-Retail Percentage:
(207,000 ÷ 345,000) = 60%
Sales for May (310,000)
Ending inventory at retail $ 35,000
Ending inventory at cost ?

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 The Retail Inventory Method

Cost Retail
Inventory, May 1 $ 27,000 $ 45,000
Net purchases for May 180,000 300,000
Goods available for sale 207,000 345,000
Cost-to-Retail Percentage:
(207,000 ÷ 345,000) = 60%
Sales for May x (310,000)
Ending inventory at retail × $ 35,000
Ending inventory at cost $ 21,000

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 Retail Inventory Method
Markups and Markdowns
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.

Estimate inventory at July 31.

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 Retail Inventory Method
With Markups and Markdowns
Cost Retail
Inventory, July 1 $ 21,000 $ 35,000
Plus: Net Purchases 200,000 304,000
Net Markups 8,000
Less: Net Markdowns (4,000)
Goods available for sale 221,000 343,000

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 Retail Inventory Method
With Markups and Markdowns
Cost Retail
Inventory, July 1 $ 21,000 $ 35,000
Plus: Net Purchases 200,000 304,000
Net Markups 8,000
Less: Net Markdowns (4,000)
Goods available for sale 221,000 343,000
Cost ratio:
(221,000 ÷ 343,000) = 64.43% x
Less: Sales for July (300,000)
Ending inventory at retail $ 43,000
Ending inventory at cost $ 27,705

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 The Retail Inventory Method
We can estimate ending inventory at
average LCM using the cost-to-retail
percentage shown below:
Cost-to- Beginning Inventory + Net Purchases
=
Retail % Retail Value (Beginning Inventory + Net
Purchases + Net Markups)

Net Markdowns are excluded in the computation of

the cost-to-retail percentage. This is referred to as the
Conventional Retail Method

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 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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 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, Except when it is
impracticable to determine either the period-
specific effects or the cumulative effects of the
changes, are treated retrospectively.
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 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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 Analyzing Inventory Errors

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 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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 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.

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 Inventory Errors
When the Inventory Error is Discovered the Following Year
If an error was made in 2012, but not discovered until 2013, the 2012
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 2012 and 2013 financial statements are issued in 2013.

When the Inventory Error is Discovered Subsequent

to the Following Year
If an error was made in 2012, but not discovered until 2014, the 2013
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.

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 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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 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.

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 End of Chapter 9

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