978-1259722660 Chapter 9 Lecture Note Part 1

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CHAPTER 9

INVENTORIES: ADDITIONAL ISSUES

Overview

We covered most of the principal measurement and reporting issues involving the asset inventory

and the corresponding expense cost of goods sold in the previous chapter. In this chapter, we

complete our discussion of inventory measurement by explaining how inventories are measured at

the end of the period. In addition, we investigate inventory estimation techniques, methods of

simplifying LIFO, changes in inventory method, and inventory errors.

Learning Objectives

LO9–1 Understand and apply rules for measurement of inventory at the end of the reporting

period.

LO9–2 Estimate ending inventory and cost of goods sold using the gross profit method.

LO9–3 Estimate ending inventory and cost of goods sold using the retail inventory method,

applying the various cost flow methods.

LO9–4 Explain how the retail inventory method can be made to approximate the lower of cost or

market rule.

LO9–5 Determine ending inventory using the dollar-value LIFO retail inventory method.

LO9–6 Explain the appropriate accounting treatment required when a change in inventory method

is made.

LO9–7 Explain the appropriate accounting treatment required when an inventory error is

discovered.

LO9–8 Discuss the primary differences between U.S. GAAP and IFRS with respect to the lower of

cost or net realizable value rule for valuing inventory.

Lecture Outline

Part A: Subsequent Measurement of Inventory

I. Lower of Cost or Net Realizable Value (LCNRV)

A. For companies using FIFO, average cost, or any method other than LIFO or the retail

inventory method, inventories are reported at the lower of cost or net realizable value.

B. The lower of cost or net realizable value (LCNRV) approach to valuing inventory

recognizes losses in the period when the value of inventory declines below cost.

C. Net realizable value (NRV) is the estimated selling price of the product in the ordinary

course of business reduced by reasonably predictable costs of completion, disposal, and

transportation.

D. Under international financial reporting standards, inventory also is valued at the lower of

cost or net realizable value.

E. Applying Lower of Cost or Net Realizable Value

1. The lower of cost or net realizable value rule can be applied to individual items,

inventory categories, or the entire inventory.

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2. Applying the rule to groups of inventory items usually will cause a higher inventory

valuation than if applied item-by-item because group application permits decreases in

the net realizable value of some items to be offset by increases in others.

3. Each approach is acceptable but should be applied consistently from one period to

another.

F. Adjusting Cost to Net Realizable Value

1. If inventory write-downs are commonplace for a company, losses usually are included

in cost of goods sold.

2. When a write-down is substantial and unusual, GAAP requires that the loss be

expressly disclosed.

II. Lower of Cost or Market (LCM)

A. For companies using LIFO or the retail inventory method, inventories are reported at the

lower of cost or market (LCM).

B. The LCM approach to valuing inventory recognizes losses in the period when the value of

inventory declines below cost.

C. Market value for LCM purposes is the inventory’s current replacement cost (RC) except

that:

1. Market should not be greater than the net realizable value (this forms a “ceiling” on

market), and

2. Market should not be less than net realizable value reduced by an allowance for an

approximately normal profit margin (this forms a “floor” on market).

D. NRV provides a ceiling and NRV less a normal profit margin (NRV − NPM) a floor

between which market must fall. This means that the designated market value is the

number that falls in the middle of the three possibilities: RC, NRV, and NRV − NPM.

E. Replacement cost usually is a good indicator of the direction of change in selling price.

The upper and lower limits placed on replacement cost prevent certain types of profit

distortion.

F. Under international financial reporting standards, inventory is valued at the lower of cost

and net realizable value.

G. Applying Lower of Cost or Market

1. The LCM rule can be applied to individual items, inventory categories, or the entire

inventory.

2. Applying LCM to groups of inventory items usually will cause a higher inventory

valuation than if applied item-by-item because group application permits decreases in

the market value of some items to be offset by increases in others.

3. Each approach is acceptable but should be applied consistently from one period to

another.

H. Adjusting Cost to Market

1. If inventory write-downs are commonplace for a company, it usually will include the

losses as part of cost of goods sold.

2. A write-down loss that is substantial and unusual should be reported as a separate item

among operating expenses.

Part B: Inventory Estimation Techniques

I. The Gross Profit Method

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A. The gross profit method is useful in situations where estimates of inventory are desirable,

such as:

1. In determining the cost of inventory that has been lost, stolen, or destroyed.

2. In estimating inventory and cost of goods sold for interim reports, avoiding the

expense of a physical inventory count.

3. In auditors’ testing of the overall reasonableness of inventory amounts reported by

clients.

4. In budgeting and forecasting.

B. The gross profit method provides only an approximation of inventory and is not acceptable

for the presentation of annual financial statements.

C. The technique estimates cost of goods sold by multiplying net sales for the period by a

historical gross profit percentage and then subtracting this amount from net sales.

D. An estimate of ending inventory is then obtained by subtracting estimated cost of goods

sold from cost of goods available for sale.

II. The Retail Inventory Method

A. The retail inventory method estimation technique is similar to the gross profit method in

that it relies on the relationship between cost and selling price to estimate ending inventory

and cost of goods sold, thus avoiding the necessity to take a physical count of inventory.

B. The retail inventory method tends to provide more accurate estimates than the gross profit

method because it’s based on the current cost-to-retail percentage (the reciprocal of the

gross profit ratio) rather than a historical gross profit ratio.

C. The technique requires a company to maintain records of inventory and purchases not only

at cost but also at current selling price (retail).

D. In its simplest form, the retail inventory method estimates the amount of ending inventory

(at retail) by subtracting sales (at retail) from goods available for sale (at retail). This

estimated ending inventory at retail is then converted to cost by multiplying it by the

cost-to-retail percentage. This ratio is found by dividing goods available for sale at cost by

goods available for sale at retail.

E. The retail inventory method can be used for financial reporting and for income tax

purposes.

F. Changes in selling prices must be included in the determination of ending inventory at

retail. Net markups and net markdowns are included in the retail column to determine

ending inventory at retail.

G. An advantage of the retail inventory method is that the various cost flow assumptions (in

particular average cost and LIFO) can be explicitly incorporated into the estimation

technique. We can even incorporate an approximation of the lower of cost and net

realizable value.

1. To approximate average cost, the cost-to-retail percentage is determined for all goods

available for sale. Net markups and net markdowns both are included in the retail

column before the cost-to-retail percentage is determined.

2. A commonly used variation of the retail method often is referred to as the

conventional retail method. This variation approximates average lower of cost and

net realizable value by excluding markdowns from the calculation of the cost-to-retail

percentage.

a. By not subtracting net markdowns from the denominator, the cost-to-retail

percentage is lower.

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b. The logic for using this approximation is that a markdown is evidence of a

reduction in the utility of inventory.

c. The lower of cost and net realizable value variation also could be applied to the

FIFO method but is not generally used in combination with LIFO.

3. To approximate LIFO cost in its simplest form, we assume that the retail prices of

goods remained stable during the period. With this assumption, we can compare

beginning and ending inventory at retail to determine what happened to inventory

quantity.

a. If inventory at retail increases during the year, a new layer is added.

b. If inventory at retail decreases, LIFO layer(s) are liquidated.

c. Each period’s LIFO layer will carry its own cost-to-retail percentage. Therefore,

beginning inventory is not included in the calculation of the current year’s

cost-to-retail percentage.

H. Other issues pertaining to the retail method

1. Freight-in is added only to the cost side in determining net purchases.

2. Purchase returns are deduced from purchases on both the cost and retail sides (at

different amounts).

3. If the gross method is used to record purchases, purchase discounts taken are deducted

in determining the cost of net purchases.

4. If sales are recorded net of employee discounts, the discounts are added to sales.

5. Normal shortage is deducted in the retail column after the calculation of the

cost-to-retail percentage. Abnormal shortage is deducted in both the cost and retail

columns before the calculation of the cost-to-retail percentage.

Part C: Dollar-Value LIFO Retail

I. Dollar-Value LIFO Retail Method

A. Using the LIFO retail method in combination with dollar-value LIFO (DVL) is referred to

as the dollar-value LIFO retail method.

B. DVL retail improves on LIFO retail by first determining whether there has been a real

increase in inventory quantity by eliminating any price changes before comparing

beginning and ending inventory at retail.

C. After determining year-end inventory at current retail prices, DVL retail employs a

three-step approach.

1. In step 1, the ending inventory at current retail prices is converted to base year retail by

dividing by the current year’s price index (relative to the base year).

2. In step 2, ending inventory at base year retail is then apportioned into layers, each at

base year retail.

3. In step 3, each layer is then converted to layer year cost using the layer year’s price

index and cost-to-retail percentage.

Part D: Change in Inventory Method and Inventory Errors

I. Change in Inventory Method

A. Changes in inventory method, other than a change to LIFO, are accounted for

retrospectively. This means reporting all previous periods’ financial statements as if the

new inventory method had been used in all prior periods.

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1. The first step is to revise prior years’ financial statements.

2. The second step is to create a journal entry to adjust book balances from their current

amounts to what those balances would have been using the new inventory method.

3. In addition, a disclosure note describes the change and justification for the change. The

note also would indicate the effects of the change on items not reported on the face of

the primary statements, as well as any per share amounts affected for the current

period and all prior periods presented.

B. For changes to the LIFO method, accounting records usually are inadequate for a company

to calculate the income effect on prior years.

1. The LIFO method is used from that point on.

2. A disclosure note explains the nature of the change and justification for it, the effect of

the change on current year’s income and earnings per share, and why retrospective

application was impracticable.

II. Inventory Errors

A. If an inventory error is discovered in the same accounting period that it occurred, the

original erroneous entry should simply be reversed and the appropriate entry recorded.

B. If a material inventory error is discovered in an accounting period subsequent to the period

in which the error was made, any previous years’ financial statements that were incorrect

as a result of the error are retrospectively restated to reflect the correction.

1. Incorrect balances are corrected.

2. A correction of retained earnings is reported as a prior period adjustment.

3. A disclosure note describes the nature and the impact of the error on income amounts.

III. Earnings Quality

A. A change in the accounting method a company uses to value inventory is one way

managers can artificially manipulate income; however, this method of income manipulation

is transparent.

B. The effect on income of switching from one inventory method to another must be

disclosed. That disclosure restores comparability between periods and enhances earnings

quality.

C. On the other hand, inventory write-downs are included in the broader category of “big

bath” accounting techniques some companies use to manipulate earnings. By overstating

the write-down, profits are increased in future periods as the inventory is used or sold.

D. 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 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.

B. Purchases made pursuant to a purchase commitment are recorded at the lower of contract

price or market price on the date the contract is executed.

C. If the contract period is contained within a single fiscal year:

1. If market price is equal to or greater than the contract price, the purchase is recorded at

the contract price.

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2. If market price is less than the contract price, the purchase is recorded at the market

price.

D. If the contract period extends beyond the fiscal year:

1. If the market price at year-end is less than the contract price for outstanding purchase

commitments, a loss and corresponding liability are recorded for the difference.

2. If market price on purchase date has not declined from year-end price, the purchase is

recorded at the year-end market price.

3. If market price on purchase date declines from year-end price, the purchase is recorded

at the market price.

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