Inventories: Additional Issues

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 the lower of cost and net realizable value rule used to value inventories. In addition, we investigate inventory estimation techniques, methods of simplifying LIFO, changes in inventory method, and inventory errors.

Learning Objectives

LO9-1Understand and apply the lower of cost and net realizable value rule used to value inventories.

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

LO9-3Estimate ending inventory and cost of goods sold using the retail inventory method, applying the various cost flow methods.

LO9-4Explain how the retail inventory method can be made to approximate the lower of cost and net realizable value rule.

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

LO9-6Explain the appropriate accounting treatment required when a change in inventory method is made.

LO9-7Explain the appropriate accounting treatment required when an inventory error is discovered.

LO9-8Discuss the primary differences between U.S. GAAP and IFRS with respect to the lower of cost and net realizable value rule for valuing inventory.

Lecture Outline

Part A: Reporting—Lower of Cost and Net Realizable Value

I.Determining Net Realizable Value (T9-1)

A.Inventories are reported at the lower of cost and net realizable value.

B.The lower of cost and net realizable value 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 and net realizable value. (T9-2)

II.Applying Lower of Cost and Net Realizable Value

A.The lower of cost and net realizable value rule can be applied to individual items, logical inventory categories, or the entire inventory. (T9-3)

B.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.

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

III.Adjusting Cost to Net Realizable Value

A.If inventory write-downs are commonplace for a company, losses usually are included in cost of goods sold.

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

Part B: Inventory Estimation Techniques

I.The Gross Profit Method (T9-4)

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

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 periods.

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. (T9-5)

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 (T9-6)

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 currentcost-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. (T9-7)

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. (T9-8)

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. (T9-9)

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. (T9-10)

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. (T9-11)

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

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. (T9-12)

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.

1. 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 side (at different amounts).

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

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 if 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. (T9-13)

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 Accounting Principle

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. (T9-14)

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.

1. 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. (T9-15)

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 is made, any previous years' financial statements that were incorrect as a result of the error are retrospectively restated to reflect the correction. (T9-16)

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.

Appendix 9: Purchase Commitments (T9-17)

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.

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.

PowerPoint Slides

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Teaching Transparency Masters

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LOWER OF COST and net realizable value

Inventories are reported at the lower of cost and net realizable value (NRV).

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.

These costs could include things such as sales commissions and shipping costs. Companies often estimate these “costs to sell” by applying a predetermined percentage to the selling price.

The Collins Company has five inventory items on hand at the end of 2016. The year-end unit costs (determined by applying the average cost method), current unit selling prices, and estimated costs to sell for each of the items are presented below:

Selling Estimated Costs

Item CostPriceTo Sell

A $ 50 $100 $15

B 100 120 30

C 80 85 10

D 90 100 15

E 95 120 24

For each item we first compute NRV, selling price less estimated costs to sell, and then compare it with cost. The item is valued at the lower of these two amounts.

Inventory

Item Cost NRV Value

A $50 $85* $50

B 100 90 90

C 80 75 75

D 90 85 85

E 95 96 95

*$100 – 15

Illustration 9-1

T9-1

international FINANCIAL REPORTING standards

Lower of cost and net realizable value. You just learned that in the United States inventory is valued at the lower of cost and net realizable value. International standards also value inventory this way.

However, there are some differences between U.S. GAAP and IFRS in this area. IAS No. 2 specifies that if circumstances indicate that an inventory write-down is no longer appropriate, it should be reversed. Reversals are not permitted under U.S. GAAP.

Under U.S. GAAP, the lower of cost and net realizable value rule can be applied to individual items, logical inventory categories, or the entire inventory. Using the international standard, the assessment usually is applied to individual items, although using logical inventory categories is allowed under certain circumstances.

Siemens AG, a German electronics and electrical engineering company, prepares its financial statements according to IFRS. The following disclosure note illustrates the valuation of inventory at the lower of cost and net realizable value.

Inventories (in part)

Inventory is valued at the lower of acquisition or production cost and net

realizablevalue, cost being generally determined on the basis of an average or

first-in, first-out method.

T9-2

APPLYING THE LOWER OF COST and net realizable value rule

The lower of cost and net realizable value rule can be applied to individual items, logical inventory categories, or the entire inventory.

Lower of Cost and NRV
Item / Cost / Net Realizable Value / By Individual Items / By Product Line / By Total Inventory
A / $ 50,000 / $ 85,000 / $ 50,000
B / 100,000 / 90,000 / 90,000
Total A + B / $150,000 / $175,000 / $150,000
C / $ 80,000 / $ 75,000 / 75,000
D / 90,000 / 85,000 / 85,000
E / 95,000 / 96,000 / 95,000
Total C, D, & E / $265,000 / $256,000 / 256,000
Total / $415,000 / $431,000 / $395,000 / $406,000 / $415,000

Illustration 9-2

T9-3

THE GROSS PROFIT METHOD

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

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

►In estimating inventory and cost of goods sold for interim reports, avoiding the expense of a physical inventory count.

►In auditors' testing of the overall reasonableness of inventory amounts reported by clients.

►In budgeting and forecasting.

Provides only an approximation of inventory and is not acceptable for the preparation of annual financial statements.

Estimates cost of goods sold by multiplying the period's net sales by a historical gross profit percentage and then subtracting that amount from net sales.

T9-4

GROSS PROFIT METHOD ILLUSTRATION

Southern Wholesale Company began 2016 with inventory of $600,000, and on March 17 a warehouse fire destroyed the entire inventory. Company records indicate net purchases of $1,500,000 and net sales of $2,000,000 prior to the fire. The gross profit percentage in each of the previous three years has been very close to 40%.

Beginning inventory(from records) $ 600,000

Plus: Net purchases(from records) 1,500,000

Goods available for sale 2,100,000

Less: Cost of goods sold:

Net sales $2,000,000
Less: Estimated gross profit of 40% (800,000)

Estimated cost of goods sold* (1,200,000)

Estimated ending inventory $ 900,000

*Alternatively, cost of goods sold can be calculated as $2,000,000 x (1 – .40) = $1,200,000.

Illustration 9-3

T9-5

THE RETAIL INVENTORY METHOD

Similar to the gross profit method, the retail inventory method relies on the relationship between cost and selling price to estimate ending inventory and cost of goods sold.

Ideal forhigh-volume retailers selling many different items at low unit prices.

Theprincipal benefit is that a physical count of inventory is not required to estimate ending inventory and cost of goods sold.

Provides a more accurate estimate than the gross profit method because it’s based on the currentcost-to-retail percentage rather than a historical gross profit percentage.

A company must maintain records of inventory and purchases not only at cost but also at current selling price.

Can be used for financial reporting and income tax purposes.

The various cost flow methods (FIFO, LIFO, and average cost) can be explicitly incorporated into the estimation technique, as can an approximation of the lower of cost and net realizable value.

T9-6

RETAIL INVENTORY METHOD ILLUSTRATION

Home Improvement Store’s bank has asked for monthly financial statements as a condition attached to a loan dated May 31, 2016. To avoid a physical count of inventory, the company intends to use the retail inventory method to estimate ending inventory and cost of goods sold for the month of June.

Cost / Retail
Beginning inventory / $ 60,000 / $100,000
Plus: Net purchases / 287,200 / 460,000
Goods available for sale / 347,200 / 560,000
$347,200
Cost-to-retail percentage: = 62%
$560,000
Less: Net sales / (400,000)
Estimated ending inventory at retail / $160,000
Estimated ending inventory at cost (62% x $160,000) / (99,200)
Estimated cost of goods sold —
goods available for sale (at cost) minus ending inventory
(at cost) equals cost of goods sold / $248,000

Illustration 9-4

T9-7

RETAIL TERMINOLOGY

Initial markup Original amount of markup from cost to selling price.

Additional markupIncrease in selling price subsequent to initial markup.

Markup cancellation Elimination of an additional markup.

MarkdownReduction in selling price below the original selling price.

Markdown cancellationElimination of a markdown.

Illustration 9-6

T9-8

COST FLOW METHODS

An advantage of the retail inventory method is that the various cost flow methods can be explicitly incorporated into the estimation technique.

Home Improvement Stores, Inc. uses a periodic inventory system and the retail inventory method to estimate ending inventory and cost of goods sold. The following data are available from the company’s records for the month of July 2016: