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Slide 9­2 Lower of Cost or Market (LCM) Chapter 9 GAAP requires that inventories be GAAP requires that inventories be carried at cost or current market carried at cost or current market value, whichever is lower. value, whichever is lower. Inventory: Additional Issues
McGraw­Hill/Irwin © 2004 The McGraw­Hill Companies, Inc.
Slide 9­3 LCM is a departure from historical cost LCM is a departure from historical cost and is a conservative accounting and is a conservative accounting method.
method. © 2004 The McGraw­Hill Companies, Inc.
McGraw­Hill/Irwin
Slide 9­4 Determining Market Value • • Market value is NOT Market value is NOT necessarily the necessarily the amount for which amount for which inventory can be inventory can be sold. sold. • • Accounting Accounting Research Bulletin Research Bulletin No. 43 defines No. 43 defines “market value” in “market value” in terms of current terms of current replacement cost.
replacement cost. replacement cost. McGraw­Hill/Irwin
Net Realizable Value (Ceiling) Determining Market Value Net Realizable Value (NRV) is Net Realizable Value (NRV) is the estimated selling price the estimated selling price less cost of completion and less cost of completion and disposal. disposal. Net Realizable Value (Ceiling) Replacement Replacement Cost Cost The definition of market The definition of The definition ofmarket market value varies varies value value varies internationally. In the UK, internationally. In the UK, Denmark, Finland, and Denmark, Finland, and New Zealand, market value New Zealand, market value is defined as NRV.
is defined as NRV. is defined as NRV. Net Realizable Value less Normal Profit (Floor) © 2004 The McGraw­Hill Companies, Inc.
Slide 9­5 McGraw­Hill/Irwin
Net Realizable Value less Normal Profit (Floor) © 2004 The McGraw­Hill Companies, Inc.
Slide 9­6 Determining Market Value If replacement cost > Ceiling, then Ceiling = Market Value Replacement Replacement Cost Cost Net Realizable Value (Ceiling) LCM ­ Example An item in inventory is currently carried at historical cost of $20 per unit. At year­end we gather the following per unit information: current replacement cost = $21.50; selling price = $30; n cost to complete and dispose = $4; and n normal profit margin of = $5. n n If replacement cost < Floor, then Floor = Market Value
McGraw­Hill/Irwin
Net Realizable Value less Normal Profit (Floor) © 2004 The McGraw­Hill Companies, Inc.
How would we value this item on the Balance Sheet?
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© 2004 The McGraw­Hill Companies, Inc.
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Slide 9­7 Slide 9­8 LCM ­ Example Selling Cost to ­ = Ceiling Price Complete $ 30 ­ $ 4 = $ 26 Replacement Replacement Cost =$21.50 Cost =$21.50 Normal = Floor Profit $ 26 ­ $ 5 = $ 21 Ceiling ­ LCM ­ Example Net Realizable Value (Ceiling) In this case, market value will be In this case, market value will be $21.50, because the $21.50, because the replacement cost is between the replacement cost is between the ceiling and the floor.
ceiling and the floor. ceiling and the floor. Which one do we use?
Replacement Replacement Cost =$21.50 Cost =$21.50 © 2004 The McGraw­Hill Companies, Inc.
McGraw­Hill/Irwin
Market value = $21.50 Market value = $21.50 Cost = $20.00 Cost = $20.00 Net Realizable Value less Normal Profit (Floor) Slide 9­9 Since Cost < Market, the LCM Should the inventory be Since Cost < Market, the LCM Should the inventory be rule would dictate that inventory recorded at cost or market? rule would dictate that inventory recorded at cost or market? be recorded at Cost. be recorded at Cost. LCM ­ Another Example Lower of Cost or Market Another Example Net Realizable Value (Ceiling) = $100 An inventory item is currently carried at An inventory item is currently carried at historical cost of $95.00 per unit. At the historical cost of $95.00 per unit. At the Balance Sheet date we gather the Balance Sheet date we gather the following per unit information: current following per unit information: current replacement cost = $80.00; NRV = replacement cost = $80.00; NRV = $100.00; and NRV reduced by normal $100.00; and NRV reduced by normal profit = $85.00. profit = $85.00. How would we value the item on our How would we value the item on our Balance Sheet?
Balance Sheet? Balance Sheet? © 2004 The McGraw­Hill Companies, Inc.
McGraw­Hill/Irwin
Slide 9­11 Lower of Cost or Market Another Example Net Realizable Value (Ceiling) = $100 Market Value = Floor $100 > $85 > ? Which one do Which one do we use as we use as market value?
market value? ? Replacement Replacement Cost =$80 Cost =$80 ? Net Realizable Value less Normal Profit (Floor) = $85 McGraw­Hill/Irwin
© 2004 The McGraw­Hill Companies, Inc.
Slide 9­12 Applying LCM LCM can be applied 3 different ways.
$80 Should the inventory be carried at Should the inventory be carried at Market Value or Cost? Market Value or Cost? Market = $85 < Cost = $95 Market = $85 < Cost = $95 Our inventory item will be written Our inventory item will be written down to the Market Value $85. down to the Market Value $85. McGraw­Hill/Irwin
Net Realizable Value less Normal Profit (Floor) © 2004 The McGraw­Hill Companies, Inc.
McGraw­Hill/Irwin
Slide 9­10 Net Realizable Value (Ceiling) Replacement Replacement Cost =$80
Cost =$80 Net Realizable Value less Normal Profit (Floor) = $85 © 2004 The McGraw­Hill Companies, Inc.
3. Apply LCM to the entire 1. Apply LCM to each individual item each individual item in entire inventory as a inventory as a in 3. Apply LCM to the 1. Apply LCM to 3. Apply LCM to the entire inventory as a 1. Apply LCM to each individual item in 2. Apply LCM to each class class of inventory. of inventory. 2. Apply LCM to each 2. Apply LCM to each class of inventory. inventory. group. inventory. group. McGraw­Hill/Irwin
© 2004 The McGraw­Hill Companies, Inc.
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Slide 9­13 Adjusting Cost to Market ­ Options Slide 9­14 Inventory Estimation Techniques Record the Loss as a Separate Item in the Income Statement n Estimate instead of taking physical inventory Adjust inventory directly or using an allowance account. n Less costly n Less time consuming Two popular methods are . . . Record the Loss as part of COGS n n Gross Profit Method Adjust inventory directly or using an allowance account.
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Slide 9­15 n Retail Inventory Method
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Slide 9­16 Gross Profit Method Gross Profit Method Auditors are testing Auditors are testing the overall the overall reasonableness of reasonableness of client inventories. client inventories. Estimating Estimating inventory & COGS inventory & COGS for interim reports. for interim reports. Useful Useful when . . . when . . . Determining the Determining the cost of inventory cost of inventory lost, destroyed, or lost, destroyed, or stolen. stolen. Net sales for the Net sales for the period. period. © 2004 The McGraw­Hill Companies, Inc.
Slide 9­17 Historical gross Historical gross margin rate. margin rate. 1. Estimate historical Gross Margin %. 2. Sales x (1 ­ Estimated Gross Margin %) = Estimated COGS Net purchases for Net purchases for the period. the period. © 2004 The McGraw­Hill Companies, Inc.
McGraw­Hill/Irwin
Slide 9­18 Steps to the Gross Profit Method Cost of beginning Cost of beginning inventory. inventory. We need to We need to know . . .
know . . . Preparing budgets Preparing budgets and forecasts. and forecasts. NOTE: The Gross Profit Method is not accepted by GAAP.
NOTE: The Gross Profit Method is not accepted by GAAP. McGraw­Hill/Irwin
Assumes that the historical gross margin Assumes that the historical gross margin rate is reasonably constant in the short run. rate is reasonably constant in the short run. Gross Profit Method Example NoteCo, Inc. uses the gross profit method to NoteCo, Inc. uses the gross profit method to estimate end of month inventory. At the end estimate end of month inventory. At the end of May, the controller has the following data: of May, the controller has the following data: 3. Beg. Inventory + Net Purchases = •Net sales for May = $1,213,000; •Net sales for May = $1,213,000; •Net purchases for May = $728,300; •Net purchases for May = $728,300; •Inventory at May 1 = $237,400; •Inventory at May 1 = $237,400; •Gross margin = 43% of sales. •Gross margin = 43% of sales. Cost of Goods Available for Sale (COGAS) 4. Estimated COGS ­ COGAS = Estimated Cost of Ending Inventory
Estimate Inventory at May 31.
Estimate Inventory at May 31. Estimate Inventory at May 31. McGraw­Hill/Irwin
© 2004 The McGraw­Hill Companies, Inc.
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© 2004 The McGraw­Hill Companies, Inc.
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Slide 9­19 Slide 9­20 Gross Profit Method Example Beginning Inventory Plus: Net Purchases = Goods Ava ilable for Sale Less: Estimated COGS* = Estimated Ending Inventory $ $ * COGS = Sales x (1 ­ GM%) = $ = $ Retail Inventory Method 1,213,000 x ( 1 ­ 43% ) 691,410 NOTE: The key to successfully applying this NOTE: The key to successfully applying this method is a reliable Gross Margin %.
method is a reliable Gross Margin %. © 2004 The McGraw­Hill Companies, Inc.
McGraw­Hill/Irwin
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. 237,400 728,300 965,700 (691,410) 274,290 Slide 9­21 Objective: Convert ending Objective: Convert ending inventory at retail to ending inventory at retail to ending inventory at cost.
inventory at cost. inventory at cost. Slide 9­22 Retail Inventory Method Beginning Beginning inventory at retail inventory at retail and cost. and cost. Sales for the Sales for the period. period. © 2004 The McGraw­Hill Companies, Inc.
McGraw­Hill/Irwin
Steps to the Retail Inventory Method 1. Determine cost and retail value of goods sold. 2. Calculate the cost­to­retail %. 3. Retail value of goods available for sale ­ We need to We need to know . . . know . . . Net purchases at Net purchases at retail and cost.
retail and cost. McGraw­Hill/Irwin
Slide 9­23 sales = ending inventory at retail. 4. Cost­to­retail % x Ending inventory at © 2004 The McGraw­Hill Companies, Inc.
Retail Inventory Method Example Webb Clothiers, Inc. uses the retail method to Webb Clothiers, Inc. uses the retail method to estimate inventory at the end of each month. For estimate inventory at the end of each month. For the month of May the controller gathers the the month of May the controller gathers the following information: following information: Beg. inventory at cost $27,000 (at retail Beg. inventory at cost $27,000 (at retail $45,000), net purchases at cost $180,000 (at $45,000), net purchases at cost $180,000 (at retail $300,000); net sales for May $310,000. retail $300,000); net sales for May $310,000. Estimate the inventory at May 31.
Estimate the inventory at May 31. McGraw­Hill/Irwin
retail = Estimated ending inventory at cost.
Adjustments to the Adjustments to the original retail price. original retail price. © 2004 The McGraw­Hill Companies, Inc.
© 2004 The McGraw­Hill Companies, Inc.
McGraw­Hill/Irwin
Slide 9­24 Retail Inventory Method Example Cost Inventory, May 1 $ 27,000 $ Net purchases for May 180,000 Goods available for sale 207,000 Cost ratio: (207,000 ÷ 345,000) = 60% Sales for May Ending inventory at retail $ Ending inventory at cost McGraw­Hill/Irwin
Retail 45,000 300,000 345,000 (310,000) 35,000 ?
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Slide 9­25 Cost Inventory, May 1 $ 27,000 $ Net purchases for May 180,000 Goods available for sale 207,000 Cost ratio: (207,000 ÷ 345,000) = 60% Sales for May x
Ending inventory at retail $ Ending inventory at cost McGraw­Hill/Irwin
Slide 9­27 Slide 9­26 Retail Inventory Method Example $ Approximating Average Cost Retail 45,000 300,000 345,000 © 2004 The McGraw­Hill Companies, Inc.
Estimate inventory at June 30.
Estimate inventory at June 30. © 2004 The McGraw­Hill Companies, Inc.
Cost Inventory, June 1 $ 21,000 $ Plus: Net Purchases 200,000 200,000 Net Markups Less: Net Markdowns Goods available for sale 221,000 221,000 Cost ratio: (221,000 ÷ 343,000) = (221,000 ÷ 343,000) = 64.43% Less: Sales for June x
Ending inventory at retail $ Ending inventory at cost $ 27,705 ? McGraw­Hill/Irwin
Retail 35,000 304,000 8,000 (4,000) 343,000 Retail Inventory Method Average Cost Example Cost Inventory, June 1 $ 21,000 $ Plus: Net Purchases 200,000 Net Markups Less: Net Markdowns Goods available for sale 221,000 Cost ratio: (221,000 ÷ 343,000) = 64.43% Less: Sales for June Ending inventory at retail $ Ending inventory at cost (300,000) 43,000 ?
Retail Inventory Method Average LCM Approximating Average LCM Cost­to­ Retail % =
Beginning Inventory + Net Purchases Retail Value of (Beginning Inventory + Net Purchases + Net Markups) Net Markdowns are Net Markdowns are excluded in the excluded in the computation of the computation of the Cost­to­Retail % Cost­to­Retail % (300,000) 43,000 © 2004 The McGraw­Hill Companies, Inc.
Retail 35,000 304,000 8,000 (4,000) 343,000 © 2004 The McGraw­Hill Companies, Inc.
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Slide 9­30 Retail Inventory Method Average Cost Example © 2004 The McGraw­Hill Companies, Inc.
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Slide 9­28 Beginning inventory at cost $21,000 (at retail Beginning inventory at cost $21,000 (at retail $35,000), net purchases at cost $200,000 (at $35,000), net purchases at cost $200,000 (at retail $304,000), net markups $8,000, net retail $304,000), net markups $8,000, net markdowns $4,000, and net sales for June markdowns $4,000, and net sales for June $300,000. $300,000. Retail Value of (Beginning Inventory + Net Purchases + Net Markups ­ Net Markdowns) The primary difference The primary difference between this and our earlier, between this and our earlier, simplified example, is the simplified example, is the inclusion of markups and inclusion of markups and markdowns in the computation markdowns in the computation of the Cost­to­Retail %. of the Cost­to­Retail %. 21,000 ? Webb, Inc. uses the average cost retail method to Webb, Inc. uses the average cost retail method to estimate inventory at the end of June. The estimate inventory at the end of June. The controller gathers the following information: controller gathers the following information: Slide 9­29 Beginning Inventory + Net Purchases =
(310,000) 35,000 Retail Inventory Method Average Cost Example McGraw­Hill/Irwin
Cost­to­ Retail % McGraw­Hill/Irwin
© 2004 The McGraw­Hill Companies, Inc.
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Slide 9­31 Slide 9­32 Retail Inventory Method Average LCM Example Webb, Inc. uses the average cost retail method to Webb, Inc. uses the average cost retail method to estimate inventory at the end of June. The estimate inventory at the end of June. The controller gathers the following information: controller gathers the following information: Beginning inventory at cost $21,000 (at retail Beginning inventory at cost $21,000 (at retail $35,000), net purchases at cost $200,000 (at $35,000), net purchases at cost $200,000 (at retail $304,000), net markups $8,000, net retail $304,000), net markups $8,000, net markdowns $4,000, and net sales for June markdowns $4,000, and net sales for June $300,000. $300,000. Let’s estimate inventory at June 30.
Let’s estimate inventory at June 30. © 2004 The McGraw­Hill Companies, Inc.
McGraw­Hill/Irwin
Slide 9­33 $ Le ss: Net Markdowns Goods Available for Sale Cost ratio: (221,000 ÷ 347,000) = 63.69% Le ss: Sales for June Ending inventory at retail Ending inventory at cost $ Le ss: Net Markdowns Goods Available for Sale Cost ratio: (221,000 ÷ 347,000) = 63.69% Le ss: Sales for June Ending inventory at retail Ending inventory at cost McGraw­Hill/Irwin
Cost Retail 21,000 $ 35,000 200,000 304,000 8,000 347,000 (4,000) 221,000 343,000 x
$ Cost Retail 21,000 $ 35,000 200,000 304,000 8,000 347,000 (4,000) 221,000 343,000 $ (300,000) 43,000 ?
© 2004 The McGraw­Hill Companies, Inc.
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 cost­to­retail percentage for beginning inventory and for adjusted net purchases for the period.
(300,000) 43,000 27,387 ? Slide 9­35 McGraw­Hill/Irwin
Slide 9­36 The LIFO Retail Method LIFO Cost­ =
to­Retail % $ The LIFO Retail Method © 2004 The McGraw­Hill Companies, Inc.
McGraw­Hill/Irwin
Inventory, June 1 Plus: Net Purchases Net Markups Slide 9­34 Retail Inventory Method Average LCM Example Inventory, June 1 Plus: Net Purchases Net Markups Retail Inventory Method Average LCM Example Net Purchases Retail Value of (Net Purchases + Net Markups­Net Markdowns) Beginning inventory has its own Beginning inventory has its own cost­to­retail percentage. cost­to­retail percentage. © 2004 The McGraw­Hill Companies, Inc.
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; n Net purchases at cost $200,000, at retail $304,000; n Net markups $8,000; n Net markdowns $4,000; n Net sales for June $300,000. n Estimate ending inventory.
McGraw­Hill/Irwin
© 2004 The McGraw­Hill Companies, Inc.
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Slide 9­37 Slide 9­38 The LIFO Retail Method Example Current Period LIFO Cost ratio: Inventory, June 1 (60%) $ (200,000 ÷ 308,000) = 64.94% Plus: Net Purchases Retail Net Markups Beginning Inventory 35,000 x Less: Net Markdowns $ Current Period's Layer 8,000 x Goods Available (Less Beg. Inv.) Total $ 43,000 Goods Available (Incl. Beg. Inv.) * $21,000 ÷ $35,000 = 60% LIFO Cost ratio: ** rounded
Requires a composite ratio (200,000 ÷ 308,000) = 64.94% Less: Sales for June Ending inventory at retail Ending inventory at cost $ Others Issues of Retail Method Cost Retail 21,000 $ 35,000 200,000 304,000 Cost 8,000 60%* = 21,000 (4,000) 64.94% = 5,195 ** 200,000 308,000 26,195 221,000 343,000 $ Purchase returns and purchase discounts. Freight­in. Employee discounts. Spoilage, breakage, and theft.
(300,000) 43,000 ? 26,195 © 2004 The McGraw­Hill Companies, Inc.
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Slide 9­39 McGraw­Hill/Irwin
Slide 9­40 Dollar­Value LIFO Retail We need to eliminate the effect of any price changes before we compare the ending inventory with the beginning inventory.
© 2004 The McGraw­Hill Companies, Inc.
Dollar­Value LIFO Retail Example Use the data from Webb Inc. to estimate the LIFO Use the data from Webb Inc. to estimate the LIFO ending inventory. ending inventory. n n Beginning inventory at cost $21,000, at retail Beginning inventory at cost $21,000, at retail $35,000; $35,000; n n Net purchases at cost $200,000, at retail $304,000; Net purchases at cost $200,000, at retail $304,000; n n Net markups $8,000; Net markdowns $4,000; Net markups $8,000; Net markdowns $4,000; n n Net sales for June $300,000. Net sales for June $300,000. Price index at June 1 is 100 and at June 30 the index Price index at June 1 is 100 and at June 30 the index is 102. Estimate ending inventory.
is 102. Estimate ending inventory. © 2004 The McGraw­Hill Companies, Inc.
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Slide 9­41 Dollar­Value LIFO Retail Example Ending Inventory at Year­end Retail Prices $ 43,000 (Determined earlier) © 2004 The McGraw­Hill Companies, Inc.
Slide 9­42 Changes in Inventory Method Step 1 Ending Inve ntory at Ba se Year Retail Prices $ 43,000 ÷ 1.02 = $ 42,157 Step 2 Inventory Layers at Base Year Retail Prices $ 42,157 35,000 x 1.00 x 60.00% = 7,157 x 1.02 x 64.94% = Total Ending Inventory at Dollar Value LIFO Retail Cost
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Step 3 Inventory Layers Converted to LIFO Cost $ $ 21,000.00 4,740.71 Changes not involving LIFO n Report the cumulative effect of the change, net of tax, on the current income statement. Changes to LIFO from other methods n Usually impossible to determine the cumulative effect. Changes from LIFO to other methods n Retroactively restate financial statements for each year reported.
25,740.71 © 2004 The McGraw­Hill Companies, Inc.
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Slide 9­43 Slide 9­44 Inventory Errors Inventory Errors Overstatement of ending inventory Overstatement of beginning inventory n Understates cost of goods sold and n Overstates cost of goods sold and n Overstates pretax income. n Understates pretax income. Understatement of ending inventory Understatement of beginning inventory n Overstates cost of goods sold and n Understates pretax income.
n Understates cost of goods sold and n Overstates pretax income.
McGraw­Hill/Irwin
© 2004 The McGraw­Hill Companies, Inc.
Slide 9­45 McGraw­Hill/Irwin
© 2004 The McGraw­Hill Companies, Inc.
Slide 9­46 Inventory Errors End of Chapter 9
Overstatement of purchases n Overstates cost of goods sold and n Understates pretax income. Understatement of purchases n Understates cost of goods sold and n Overstates pretax income.
McGraw­Hill/Irwin
© 2004 The McGraw­Hill Companies, Inc.
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© 2004 The McGraw­Hill Companies, Inc.