Chapter 9

Inventory:
Additional Issues

McGraw-Hill/Irwin

2004 The McGraw-Hill Companies, Inc.

Slide
9-2

Lower of Cost or Market (LCM)

GAAP
GAAP requires
requires that
that inventories
inventories be
be
carried
carried at
at cost
cost or
or current
current market
market
value,
value, whichever
whichever is
is lower.
lower.

LCM
LCM is
is aa departure
departure from
from historical
historical cost
cost
and
and is
is aa conservative
conservative accounting
accounting
method.
method.
McGraw-Hill/Irwin

2004 The McGraw-Hill Companies, Inc.

Slide
9-3

Determining Market Value

Market
Market value
valueis
isNOT
NOT

necessarily
necessarilythe
the
amount
amountfor
for which
which
inventory
inventorycan
canbe
be
sold.
sold.
Accounting
AccountingResearch
Research
Bulletin
Bulletin No.
No.43
43
defines
definesmarket
market
value
valuein
interms
termsof
of
current
current replacement
replacement
cost.
cost.
McGraw-Hill/Irwin

Net Realizable
Value (Ceiling)

Net Realizable Value

less Normal Profit
(Floor)
2004 The McGraw-Hill Companies, Inc.

Slide
9-4

Determining Market Value

Net
NetRealizable
RealizableValue
Value(NRV)
(NRV)is
is
the
theestimated
estimatedselling
sellingprice
price
less
lesscost
costof
ofcompletion
completionand
and
disposal.
disposal.

Net Realizable
Value (Ceiling)

Replacement
Replacement
Cost
Cost
The
Thedefinition
definitionof
ofmarket
market
value
valuevaries
varies
internationally.
internationally. In
Inthe
theUK,
UK,
Denmark,
Denmark,Finland,
Finland,and
and
New
NewZealand,
Zealand,market
market
value
valueis
isdefined
definedas
asNRV.
NRV.
McGraw-Hill/Irwin

Net Realizable Value

less Normal Profit
(Floor)
2004 The McGraw-Hill Companies, Inc.

Slide
9-5

Determining Market Value

If replacement cost
> Ceiling, then
Ceiling = Market
Value
Replacement
Replacement
Cost
Cost
If replacement
cost < Floor, then
Floor = Market
Value
McGraw-Hill/Irwin

Net Realizable
Value (Ceiling)

Net Realizable Value

less Normal Profit
(Floor)
2004 The McGraw-Hill Companies, Inc.

Slide
9-6

LCM - Example
An item in inventory is currently carried at
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; and
normal profit margin of = $5.

How would we value this item on the

Balance Sheet?
McGraw-Hill/Irwin

2004 The McGraw-Hill Companies, Inc.

Slide
9-7

LCM - Example
Net Realizable
Value (Ceiling)

Replacement
Replacement
Cost=$21.50
=$21.50
Cost

Which one do
we use?
Net Realizable
Value less Normal
Profit (Floor)

McGraw-Hill/Irwin

2004 The McGraw-Hill Companies, Inc.

Slide
9-8

LCM - Example
In
Inthis
thiscase,
case,market
marketvalue
valuewill
willbe
be
$21.50,
$21.50,because
becausethe
the
replacement
replacementcost
costis
isbetween
betweenthe
the
ceiling
ceilingand
andthe
thefloor.
floor.

Net Realizable
Value (Ceiling)

Replacement
Replacement
Cost=$21.50
=$21.50
Cost
Market
Marketvalue
value==$21.50
$21.50
Cost
Cost==$20.00
$20.00
Since
Should
Cost
<<Market,
inventory
the
LCM
Since
Should
Costthe
the
Market,
inventory
thebe
be
LCM
rule
recorded
would
at
or
inventory
rule
recorded
woulddictate
dictate
atcost
costthat
that
ormarket?
market?
inventory
be
berecorded
recordedat
atCost.
Cost.
McGraw-Hill/Irwin

Net Realizable
Value less Normal
Profit (Floor)

2004 The McGraw-Hill Companies, Inc.

Slide
9-9

LCM - Another Example

An
An inventory
inventory item
item is
is currently
currently carried
carried at
at
historical
historical cost
cost of
of $95.00
$95.00 per
per unit.
unit. At
At the
the
Balance
Balance Sheet
Sheet date
date we
we gather
gather the
the
following
following per
per unit
unit information:
information: current
current
replacement
replacement cost
cost == $80.00;
$80.00; NRV
NRV ==
$100.00;
$100.00; and
and NRV
NRV reduced
reduced by
by normal
normal
profit
profit == $85.00.
$85.00.
How
How would
would we
we value
value the
the item
item on
on our
our
Balance
Balance Sheet?
Sheet?
McGraw-Hill/Irwin

2004 The McGraw-Hill Companies, Inc.

Slide
9-10

Lower of Cost or Market

Another Example
Net Realizable Value
(Ceiling) = $100
?
Which
Whichone
onedo
do
we
weuse
useas
as
market
marketvalue?
value?

Replacement
Replacement
Cost
Cost=$80
=$80

?
Net Realizable Value
less Normal Profit
(Floor) = $85
McGraw-Hill/Irwin

2004 The McGraw-Hill Companies, Inc.

Slide
9-11

Lower of Cost or Market

Another Example
Net Realizable Value
(Ceiling) = $100

Should
Shouldthe
theinventory
inventorybe
becarried
carriedat
at
Market
Market Value
Valueor
or Cost?
Cost?

Market
Market == $85
$85 << Cost
Cost == $95
$95
Our
Ourinventory
inventoryitem
itemwill
willbe
be written
written
down
downto
tothe
theMarket
MarketValue
Value$85.
$85.
McGraw-Hill/Irwin

Replacement
Replacement
Cost
Cost=$80
=$80

Net Realizable Value

less Normal Profit
(Floor) = $85
2004 The McGraw-Hill Companies, Inc.

Slide
9-12

Applying LCM
LCM can be applied 3 different ways.

3.
1.
Apply
Apply
LCM
LCM
to
to
the
each
entire
individual
inventory
item
as
in
aa
3.
1.
Apply
Apply
LCM
LCM
to
to
the
each
entire
individual
inventory
item
as
in
2.
each
class
of
inventory.
2. Apply
Apply LCM
LCM to
toinventory.
each
class
of
inventory.
group.
inventory.
group.
McGraw-Hill/Irwin

2004 The McGraw-Hill Companies, Inc.

Slide
9-13

Adjusting Cost to Market Options

Record the Loss as a Separate
Item in the Income Statement

Adjust inventory directly or using an

allowance account.

Record the Loss as part of COGS

McGraw-Hill/Irwin

Adjust inventory directly or using an

allowance account.
2004 The McGraw-Hill Companies, Inc.

Slide
9-14

Inventory Estimation Techniques

Estimate instead of taking
physical inventory
Less costly
Less time consuming

Two popular methods are . . .

Gross Profit Method
Retail Inventory Method

McGraw-Hill/Irwin

2004 The McGraw-Hill Companies, Inc.

Slide
9-15

Gross Profit Method

Auditors
Auditorsare
aretesting
testing
the
theoverall
overall
reasonableness
reasonablenessof
of
client
client inventories.
inventories.

Estimating
Estimatinginventory
inventory
&&COGS
COGSfor
forinterim
interim
reports.
reports.
Useful
Useful
when
when.. ....
Determining
Determiningthe
the
cost
costof
ofinventory
inventory
lost,
lost,destroyed,
destroyed,or
or
stolen.
stolen.

Preparing
Preparingbudgets
budgets
and
andforecasts.
forecasts.

NOTE:
NOTE: The
TheGross
GrossProfit
Profit Method
Methodis
isnot
notaccepted
acceptedby
byGAAP.
GAAP.
McGraw-Hill/Irwin

2004 The McGraw-Hill Companies, Inc.

Slide
9-16

Gross Profit Method

Assumes
Assumes that
that the
the historical
historical gross
gross margin
margin
rate
rate is
is reasonably
reasonably constant
constant in
in the
the short
short run.
run.
Net
Netsales
salesfor
forthe
the
period.
period.

Cost
Costof
ofbeginning
beginning
inventory.
inventory.
We
We need
need to
to
know
know ......

Historical
Historical gross
gross
margin
marginrate.
rate.
McGraw-Hill/Irwin

Net
Net purchases
purchasesfor
for
the
the period.
period.
2004 The McGraw-Hill Companies, Inc.

Slide
9-17

Steps to the Gross Profit Method

1.
2.
3.

4.

McGraw-Hill/Irwin

Estimate historical Gross Margin %.

Sales x (1 - Estimated Gross Margin
%) = Estimated COGS
Beg. Inventory + Net Purchases =
Cost of Goods Available for Sale
(COGAS)
Estimated COGS - COGAS =
Estimated Cost of Ending Inventory

2004 The McGraw-Hill Companies, Inc.

Slide
9-18

Gross Profit Method

Example
NoteCo,
NoteCo, Inc.
Inc. uses
uses the
the gross
gross profit
profit method
method to
to
estimate
estimate end
end of
of month
month inventory.
inventory. At
At the
the end
end
of
of May,
May, the
the controller
controller has
has the
the following
following data:
data:
Net
Net sales
sales for
for May
May == $1,213,000;
$1,213,000;
Net
Net purchases
purchases for
for May
May == $728,300;
$728,300;
Inventory
Inventory at
at May
May 11 == $237,400;
$237,400;
Gross
Gross margin
margin == 43%
43% of
of sales.
sales.

Estimate
Estimate Inventory
Inventory at
at May
May 31.
31.
McGraw-Hill/Irwin

2004 The McGraw-Hill Companies, Inc.

Slide
9-19

Gross Profit Method

Example

NOTE:
NOTE: The
Thekey
keyto
tosuccessfully
successfullyapplying
applyingthis
this
method
methodis
isaareliable
reliableGross
GrossMargin
Margin%.
%.
McGraw-Hill/Irwin

2004 The McGraw-Hill Companies, Inc.

Slide
9-20

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 ratio.
Objective:
Objective: Convert
Convert ending
ending
inventory
inventory at
at retail
retail to
to ending
ending
inventory
inventory at
at cost.
cost.
McGraw-Hill/Irwin

2004 The McGraw-Hill Companies, Inc.

Slide
9-21

Retail Inventory Method

Beginning
Beginning
inventory
inventoryat
atretail
retail
and
and cost.
cost.

Sales
Salesfor
forthe
the
period.
period.
We
Weneed
needto
to
know
know .... ..
Net
Netpurchases
purchasesat
at
retail
retailand
andcost.
cost.
McGraw-Hill/Irwin

Adjustments
Adjustmentsto
tothe
the
original
originalretail
retailprice.
price.
2004 The McGraw-Hill Companies, Inc.

Slide
9-22

Steps to the Retail Inventory

Method
1. Determine cost and retail value of goods

sold.
2. Calculate the cost-to-retail %.
3. Retail value of goods available for sale sales = ending inventory at retail.
4. Cost-to-retail % x Ending inventory at
retail = Estimated ending inventory at
cost.

McGraw-Hill/Irwin

2004 The McGraw-Hill Companies, Inc.

Slide
9-23

Retail Inventory Method

Example
Webb
Webb Clothiers,
Clothiers, Inc.
Inc. uses
uses the
the retail
retail method
method to
to
estimate
estimate inventory
inventory at
at the
the end
end of
of each
each month.
month. For
For
the
the month
month of
of May
May the
the controller
controller gathers
gathers the
the
following
following information:
information:
Beg.
Beg. inventory
inventory at
at cost
cost $27,000
$27,000 (at
(at retail
retail
$45,000),
$45,000), net
net purchases
purchases at
at cost
cost $180,000
$180,000 (at
(at
retail
retail $300,000);
$300,000); net
net sales
sales for
for May
May $310,000.
$310,000.

Estimate
Estimate the
the inventory
inventory at
at May
May 31.
31.
McGraw-Hill/Irwin

2004 The McGraw-Hill Companies, Inc.

Slide
9-24

Retail Inventory Method

Example

McGraw-Hill/Irwin

2004 The McGraw-Hill Companies, Inc.

Slide
9-25

Retail Inventory Method

Example

McGraw-Hill/Irwin

2004 The McGraw-Hill Companies, Inc.

Slide
9-26

Approximating Average Cost

The
Theprimary
primarydifference
difference
between
between this
thisand
andour
our earlier,
earlier,
simplified
simplifiedexample,
example,is
isthe
the
inclusion
inclusionof
of markups
markupsand
and
markdowns
markdownsin
inthe
thecomputation
computation
of
ofthe
the Cost-to-Retail
Cost-to-Retail%.
%.
McGraw-Hill/Irwin

2004 The McGraw-Hill Companies, Inc.

Slide
9-27

Retail Inventory Method

Average Cost Example

Webb,
Webb, Inc.
Inc. uses
uses the
the average
average cost
cost retail
retail method
method to
to
estimate
estimate inventory
inventory at
at the
the end
end of
of June.
June. The
The
controller
controller gathers
gathers the
the following
following information:
information:
Beginning
Beginning inventory
inventory at
at cost
cost $21,000
$21,000 (at
(at retail
retail
$35,000),
$35,000), net
net purchases
purchases at
at cost
cost $200,000
$200,000 (at
(at
retail
retail $304,000),
$304,000), net
net markups
markups $8,000,
$8,000, net
net
markdowns
markdowns $4,000,
$4,000, and
and net
net sales
sales for
for June
June
$300,000.
$300,000.

Estimate
Estimate inventory
inventory at
at June
June 30.
30.
McGraw-Hill/Irwin

2004 The McGraw-Hill Companies, Inc.

Slide
9-28

Retail Inventory Method

Average Cost Example

McGraw-Hill/Irwin

2004 The McGraw-Hill Companies, Inc.

Slide
9-29

Retail Inventory Method

Average Cost Example

McGraw-Hill/Irwin

2004 The McGraw-Hill Companies, Inc.

Slide
9-30

Retail Inventory Method

Average LCM
Approximating Average LCM

Net
Net Markdowns
Markdowns are
are
excluded
excluded in
in the
the
computation
computation of
of the
the
Cost-to-Retail
Cost-to-Retail %
%
McGraw-Hill/Irwin

2004 The McGraw-Hill Companies, Inc.

Slide
9-31

Retail Inventory Method

Average LCM Example

Webb,
Webb, Inc.
Inc. uses
uses the
the average
average cost
cost retail
retail method
method to
to
estimate
estimate inventory
inventory at
at the
the end
end of
of June.
June. The
The
controller
controller gathers
gathers the
the following
following information:
information:
Beginning
Beginning inventory
inventory at
at cost
cost $21,000
$21,000 (at
(at retail
retail
$35,000),
$35,000), net
net purchases
purchases at
at cost
cost $200,000
$200,000 (at
(at
retail
retail $304,000),
$304,000), net
net markups
markups $8,000,
$8,000, net
net
markdowns
markdowns $4,000,
$4,000, and
and net
net sales
sales for
for June
June
$300,000.
$300,000.

Lets
Lets estimate
estimate inventory
inventory at
at June
June 30.
30.
McGraw-Hill/Irwin

2004 The McGraw-Hill Companies, Inc.

Slide
9-32

Retail Inventory Method

Average LCM Example

McGraw-Hill/Irwin

2004 The McGraw-Hill Companies, Inc.

Slide
9-33

Retail Inventory Method

Average LCM Example

McGraw-Hill/Irwin

2004 The McGraw-Hill Companies, Inc.

Slide
9-34

The LIFO Retail Method

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.
McGraw-Hill/Irwin

2004 The McGraw-Hill Companies, Inc.

Slide
9-35

The LIFO Retail Method

Beginning
Beginning inventory
inventory has
has its
its own
own
cost-to-retail
cost-to-retail percentage.
percentage.

McGraw-Hill/Irwin

2004 The McGraw-Hill Companies, Inc.

Slide
9-36

The LIFO Retail Method

Example
Use the data from Webb Inc. to estimate
the LIFO ending inventory.

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.

Estimate ending inventory.

McGraw-Hill/Irwin

2004 The McGraw-Hill Companies, Inc.

Slide
9-37

The LIFO Retail Method

Example

McGraw-Hill/Irwin

2004 The McGraw-Hill Companies, Inc.

Slide
9-38

Others Issues of Retail Method

Purchase returns and purchase
discounts.
Freight-in.
Employee discounts.
Spoilage, breakage, and theft.

McGraw-Hill/Irwin

2004 The McGraw-Hill Companies, Inc.

Slide
9-39

Dollar-Value LIFO Retail

We need to eliminate the effect of any
price changes before we compare
the ending inventory with the
beginning inventory.

McGraw-Hill/Irwin

2004 The McGraw-Hill Companies, Inc.

Slide
9-40

Dollar-Value LIFO Retail

Example
Use
Use the
the data
data from
from Webb
Webb Inc.
Inc. to
to estimate
estimate the
the LIFO
LIFO
ending
ending inventory.
inventory.
Beginning inventory at cost $21,000, at retail
Beginning inventory at cost $21,000, at retail

$35,000;
$35,000;
Net purchases at cost $200,000, at retail $304,000;
Net purchases at cost $200,000, at retail $304,000;
Net markups $8,000; Net markdowns $4,000;
Net markups $8,000; Net markdowns $4,000;
Net sales for June $300,000.
Net sales for June $300,000.

Price
Price index
index at
at June
June 11 is
is 100
100 and
and at
at June
June 30
30 the
the index
index
is
is 102.
102. Estimate
Estimate ending
ending inventory.
inventory.
McGraw-Hill/Irwin

2004 The McGraw-Hill Companies, Inc.

Slide
9-41

Dollar-Value LIFO Retail

Example

McGraw-Hill/Irwin

2004 The McGraw-Hill Companies, Inc.

Slide
9-42

Changes in Inventory Method

Changes not involving LIFO

Report the cumulative effect of the change, net of

tax, on the current income statement.

Changes to LIFO from other methods

Usually impossible to determine the cumulative

effect.

Changes from LIFO to other methods

Retroactively restate financial statements for each

year reported.

McGraw-Hill/Irwin

2004 The McGraw-Hill Companies, Inc.

Slide
9-43

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.

McGraw-Hill/Irwin

2004 The McGraw-Hill Companies, Inc.

Slide
9-44

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.

McGraw-Hill/Irwin

2004 The McGraw-Hill Companies, Inc.

Slide
9-45

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.

McGraw-Hill/Irwin

2004 The McGraw-Hill Companies, Inc.

Slide
9-46

End of Chapter 9

McGraw-Hill/Irwin

2004 The McGraw-Hill Companies, Inc.