ACCT 340: Chapter 9 Notes

LOWER OF COST OR MARKET Inventories are reported at the lower of cost or market (LCM). For LCM purposes, market is defined as replacement cost, except that market should Not exceed the net realizable value (NRV). Not be less than NRV reduced by an allowance for an apprx normal profit margin (NRV-NP).

NRV provides a ceiling and NRV-NP a floor between which market must fall.

EXAMPLE: Memphis Wholesale Market applies lower-of-cost-or-market valuation to individual products and has collected the following data:

1. 2.

Determine the balance sheet inventory carrying value for Products A, B, and C. Determine the balance sheet inventory carrying value for Products A, B, and C assuming that Memphis Wholesale Market prepares its financial statements according to International Financial Reporting Standards.

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.

EXAMPLE: On March 17, 2011, a flood destroyed the entire inventory of Beatty Co. The following information
is available from its accounting records:

Required: Compute the estimated cost of inventory lost in the flood.

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 for high-volume retailers selling many different items at low unit prices. The principal 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 its based on the current cost-toretail 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 or market. EXAMPLE: Andover Stores uses the average cost retail method to estimate its ending inventory. Information as of June 30, 2011, is as follows:

Required: Use the retail method to estimate the June 30, 2011, inventory. INVENTORY ERRORS

The Barton Company uses a periodic inventory system. At the end of 2010, a mathematical error caused an $800,000 overstatement of ending inventory. Ending inventories for 2011 and 2012 are correctly determined. The way we correct this error depends on when the error is discovered. Assuming that the error is not discovered until after 2011, the 2010 and 2011 effects of the error, ignoring income tax effects, are shown below. The overstated and understated amounts are $800,000 in each instance. Analysis: 2010 Beginning inventory Plus: Net purchases Less: Ending inventory Cost of goods sold Revenues Less: Cost of goods sold Less: Other expenses Net income Retained earnings U = Understated O = Overstated 2011 Beginning inventory Plus: Net purchases O Less: Ending inventory U Cost of goods sold Revenues Less: Cost of goods sold Less: Other expenses Net income Retained earnings O

U O O

O U corrected

EXAMPLE: In the year 2011, the internal auditors of Goofy Co. discovered that goods costing $25 million that were purchased in December of 2010 were recorded for $20 million. The goods were properly measured in the December 31, 2010 ending physical inventory. Required: Prepare the journal entry needed in 2011 to correct the error. Also, briefly describe any other measures Goofy would take in connection with correcting the error. (Ignore Income Taxes)

TEACHING NOTES

Determine the balance sheet inventory carrying value for Products A, B, and C.

* Selling price less disposal costs **NRV less normal profit margin Determine the balance sheet inventory carrying value for Products A, B, and C assuming that Memphis Wholesale Market prepares its financial statements according to International Financial Reporting Standards.

* Selling price less disposal costs ** Lower of cost or NRV

Andover Stores uses the average cost retail method to estimate its ending inventory. Information as of June 30, 2011, is as follows:

Required: Use the retail method to estimate the June 30, 2011, inventory.

 The 2010 financial statements that were incorrect as a result of the error would be retroactively restated to reflect the correct cost of goods sold, (income tax expense if taxes are considered), net income, accounts payable, and retained earnings when those statements are reported again for comparative purposes in the 2011 annual report. Because retained earnings is one of the incorrect accounts, the correction to that account is reported as a prior period adjustment to the 2011 retained earnings balance in the comparative statements of shareholders' equity. Also, a disclosure note should describe the nature of the error and the impact of its correction on each year's net income, income before extraordinary items, and earnings per share.