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INVENTORIES: ADDITIONAL ISSUES

Chapter 9. INVENTORIES: ADDITIONAL ISSUES. Reporting -- Lower of Cost or Market. GAAP requires that inventories be carried at cost or current market value, whichever is lower. LCM is a departure from historical cost. Determining Market Value. Market Should Not Exceed Net Realizable

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INVENTORIES: ADDITIONAL ISSUES

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  1. Chapter 9 INVENTORIES:ADDITIONAL ISSUES

  2. Reporting -- Lower of Cost or Market GAAP requires that inventories be carried at cost or current market value, whichever is lower. LCM is a departure from historical cost.

  3. Determining Market Value Market Should Not Exceed Net Realizable Value (Ceiling) • 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.” Market Should Not Be Less Than Net Realizable Value less Normal Profit (Floor)

  4. Determining Market Value Step 1Determine Designated Market Step 2Compare Designated Market with Cost CeilingNRV Not More Than DesignatedMarket Cost ReplacementCost Or Not Less Than Lower of CostOr Market NRV – NPFloor

  5. 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? Lower of Cost or Market

  6. Lower of Cost or Market DesignatedMarket? Replacement Cost =$21.50 $21.50 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 Lower of cost or market can be applied 3 different ways. 1. Apply LCM to each individual item in inventory. 2. Apply LCM to each class of inventory. 3. Apply LCM to the entire inventory as a group.

  8. Record the Loss as a Separate Item in the Income Statement Adjust inventory directly or by using an allowance account. Record the Loss as part of Cost of Goods Sold Adjust inventory directly or by using an allowance account. Adjusting Cost to Market

  9. Estimate instead of taking physical inventory Less costly Less time consuming Two popular methods are . . . Gross Profit Method Retail Inventory Method Inventory Estimation Techniques

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

  11. 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

  12. 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.

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

  14. 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. The Retail Inventory Method Objective: Convert ending inventory at retail to ending inventory at cost.

  15. The Retail Inventory Method Retail Terminology

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

  17. 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.

  18. The Retail Inventory Method

  19. x The Retail Inventory Method

  20. The Retail Inventory Method Approximating Average Cost 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 %.

  21. The Retail Inventory Method Approximating Average LCM Net Markdowns areexcludedin the computation of the Cost-to-Retail %

  22. 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. The Retail Inventory Method The LIFO Retail Method

  23. The Retail Inventory Method The LIFO Retail Method Beginning inventory has its own cost-to-retail percentage.

  24. Other Issues of Retail Method

  25. We need to eliminate the effect of any price changes before we compare the ending inventory with the beginning inventory. Dollar-Value LIFO Retail

  26. 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.

  27. Dollar-Value LIFO Retail

  28. 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.

  29. 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) thenature of the change; (b) the effect of thechange on current year’s income andearnings per share, and (c) why retrospective application was impracticable.

  30. 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. Inventory Errors

  31. 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. Inventory Errors

  32. Overstatement of purchases Overstates cost of goods sold and Understates pretax income. Understatement of purchases Understates cost of goods sold and Overstates pretax income. Inventory Errors

  33. PurchaseCommitments Appendix 9

  34. 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 raw materials for $100,000 byDecember 1, 2009. On December 1, 2009, the raw materialshad a market value of $90,000. The second requires Matrixto purchase inventory items for $200,000 by March 1, 2010.On December 31, 2009, the market value of the inventory itemswas $188,000. On March 1, 2010, the market value of the inventoryitems was $186,000. Matrix uses the perpetual inventory systemand is a calendar year-end company.Let’s make the journal entries for these commitments.

  35. Purchase Commitments Single year commitment Multi-year Commitment

  36. End of Chapter 9

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