Intermediate Accounting - Chap009 potx

Determining Market ValueNet Realizable Value Ceiling Net Realizable Value less Normal Profit Floor Net Realizable Value NRV is the estimated selling price less cost of completion

Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved

Learning Objective

Understand and apply the or-market rule used to value inventories.

lower-of-cost-Lower of Cost or Market (LCM)

GAAP requires that inventories be

carried at cost or current market

value, whichever is lower.

GAAP requires that inventories be

carried at cost or current market

value, whichever is lower.

LCM is a departure from historical cost

and is a conservative accounting

method.

LCM is a departure from historical cost

and is a conservative accounting

method.

Determining Market Value

Net Realizable Value ( Ceiling )

Net Realizable Value less Normal Profit

Determining Market Value

Net Realizable Value ( Ceiling )

Net Realizable Value less Normal Profit

( Floor )

Net Realizable Value (NRV) is

the estimated selling price

less cost of completion and

disposal.

Net Realizable Value (NRV) is

the estimated selling price

less cost of completion and

is defined as NRV.

The definition of market

value varies internationally In many countries, for example New Zealand market value

is defined as NRV.

Determining Market Value

Net Realizable Value less Normal Profit

( Floor )

Net Realizable Value ( Ceiling )

Lower of Cost or Market

 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

normal profit margin of = $5

 How would we value this item in the

Balance Sheet?

Lower of Cost or Market

Net Realizable Value ( Ceiling )

Net Realizable Value less Normal

Profit ( Floor )

Replacement Cost =$21.50

Replacement Cost =$21.50

Which one do

we use?

Net Realizable Value less Normal

Profit ( Floor )

Replacement Cost =$21.50

Replacement Cost =$21.50

In this case, market value will

be $21.50 because the replacement cost is between the

ceiling and the floor.

In this case, market value will

be $21.50 because the replacement cost is between the

ceiling and the floor.

Lower of Cost or Market

An inventory item is currently carried at

historical cost of $95.00 per unit At the

Balance Sheet date we gather the following per unit information:

current replacement cost = $80.00

NRV = $100.00 NRV reduced by normal profit = $85.00

How would we value the item on our

Balance Sheet?

An inventory item is currently carried at

historical cost of $95.00 per unit At the

Balance Sheet date we gather the

following per unit information:

current replacement cost = $80.00

NRV = $100.00 NRV reduced by normal profit = $85.00

How would we value the item on our

Balance Sheet?

Lower of Cost or Market

Net Realizable Value less Normal Profit

( Floor ) = $85

Net Realizable Value ( Ceiling ) = $100

Replacement Cost =$80

Replacement Cost =$80

Which one do

we use as market value?

Lower of Cost or Market

Should the inventory be carried at

Market Value or Cost?

Should the inventory be carried at

Market Value or Cost?

Market = $85 < Cost = $95

Our inventory item will be written down

to the Market Value $85.

Market = $85 < Cost = $95

Our inventory item will be written down

to the Market Value $85.

Net Realizable Value less Normal Profit

( Floor ) = $85

Net Realizable Value ( Ceiling ) = $100

Replacement Cost =$80

Replacement Cost =$80

1 Apply LCM to each individual item in

inventory

1 Apply LCM to each individual item in

inventory

2 Apply LCM to each class of inventory

2 Apply LCM to each 3 Apply LCM to the entire class inventory as a of inventory

group

3 Apply LCM to the entire inventory as a

group

Applying Lower of Cost or Market

Lower of cost or market can be applied 3

different ways

Adjusting Cost to Market - Options

 Record the Loss as a Separate Item in

the Income Statement

Adjust inventory directly or by using an

Learning Objective

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

Inventory Estimation Techniques

Estimate instead of taking

physical inventory

Less costly

Less time consuming

Two popular methods are

Gross Profit Method

Retail Inventory Method

Gross Profit Method

Useful when

Useful when

Auditors are testing

the overall reasonableness of client inventories.

Preparing budgets and forecasts.

Preparing budgets and forecasts.

NOTE: The Gross Profit Method is not acceptable

for use in annual financial statements.

NOTE: The Gross Profit Method is not acceptable

for use in annual financial statements.

Gross Profit Method

This method assumes that the historical

gross margin rate is reasonably

constant in the short run.

This method assumes that the historical

gross margin rate is reasonably

constant in the short run.

We need to know

Steps to the Gross Profit Method

1. Estimate Historical Gross Margin %

2. Sales x (1 - Estimated Gross Margin %) =

Estimated COGS

3. Beg Inventory + Net Purchases = Cost of

Goods Available for Sale (COGAS)

4. COGAS - Estimated COGS = Estimated

Cost of Ending Inventory

1. Estimate Historical Gross Margin %

2. Sales x (1 - Estimated Gross Margin %) =

Estimated COGS

3. Beg Inventory + Net Purchases = Cost of

Goods Available for Sale (COGAS)

4. COGAS - Estimated COGS = Estimated

Cost of Ending Inventory

Gross Profit Method

Matrix, Inc uses the gross profit method to

estimate end of month inventory At the end

of May, the controller has the following data:

•Net sales for May = $1,213,000

•Net purchases for May = $728,300

•Inventory at May 1 = $237,400

•Gross margin = 43% of sales

Estimate Inventory at May 31.

Matrix, Inc uses the gross profit method to

estimate end of month inventory At the end

of May, the controller has the following data:

•Net sales for May = $1,213,000

•Net purchases for May = $728,300

•Inventory at May 1 = $237,400

•Gross margin = 43% of sales

Estimate Inventory at May 31.

Gross Profit Method

NOTE: The key to successfully applying this

method is a reliable Gross Margin Percentage.

NOTE: The key to successfully applying this

method is a reliable Gross Margin Percentage.

Learning Objective

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

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: Convert ending

inventory at retail to ending

inventory at cost.

Objective: Convert ending

inventory at retail to ending

inventory at cost.

Retail Inventory Method

We need to know

We need to know

Sales for the

period.

Sales for the

period.

Beginning inventory at retail

and cost.

Beginning inventory at retail

and cost.

Adjustments to the original retail price.

Adjustments to the original retail price.

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.

Retail Inventory Method

Matrix, Inc uses the retail method to estimate

inventory at the end of each month For the

month of May the controller gathers the following

Net sales for May $310,000.

Estimate the inventory at May 31.

Matrix, Inc uses the retail method to estimate

inventory at the end of each month For the

month of May the controller gathers the following

Net sales for May $310,000.

Estimate the inventory at May 31.

Retail Inventory Method

Retail Inventory Method

x

Approximating Average Cost

The primary difference between this and our earlier, simplified example, is the inclusion of markups and markdowns in the computation

of the Cost-to-Retail %.

The primary difference between this and our earlier, simplified example, is the inclusion of markups and markdowns in the computation

of the Cost-to-Retail %.

Retail Inventory Method - Average Cost

Matrix, Inc uses the average cost retail method

to estimate inventory at the end of June The

controller gathers the following information:

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 inventory at June 30.

Matrix, Inc uses the average cost retail method

to estimate inventory at the end of June The

controller gathers the following information:

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 inventory at June 30.

Retail Inventory Method - Average Cost

Retail Inventory Method - Average Cost

x

Learning Objective

Explain how the retail inventory method

can be made to approximate the lower-of-cost-or-market rule.

Retail Inventory Method - Average LCM

 Approximating Average LCM

Net Markdowns are excluded in the computation of the Cost-to-Retail %

Net Markdowns are excluded in the computation of the Cost-to-Retail %

Retail Inventory Method - Average LCM

Matrix, Inc uses the average cost retail method

to estimate inventory at the end of June The

controller gathers the following information:

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

Let’s estimate inventory at June 30.

Matrix, Inc uses the average cost retail method

to estimate inventory at the end of June The

controller gathers the following information:

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

Let’s estimate inventory at June 30.

Retail Inventory Method - Average LCM

Retail Inventory Method - Average LCM

x

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

The LIFO Retail Method

Beginning inventory has its own

cost-to-retail percentage.

The LIFO Retail Method

 Use the data from Matrix Inc to estimate

the LIFO ending inventory

1. Beginning inventory at cost $21,000, at retail

5. Net sales for June $300,000

Estimate ending inventory.

The LIFO Retail Method

Other Issues of Retail Method

Learning Objective

Determine ending inventory using the dollar-value LIFO retail inventory

method.

Dollar-Value LIFO Retail

We need to eliminate the effect of

any price changes before we compare the ending inventory

with the beginning inventory.

Dollar-Value LIFO Retail

Use the data from Matrix 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

Price index at June 1 is 100 and at June 30

the index is 102 Estimate ending inventory.

Use the data from Matrix 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

Price index at June 1 is 100 and at June 30

the index is 102 Estimate ending inventory.

Dollar-Value LIFO Retail

Changes in Inventory Method

Recall that most voluntary changes in accounting

principles are reported retrospectively This means

reporting all previous periods’ financial statements as

though the new method had been used in all prior

periods.

Changes in inventory methods,

other than a change to

other than a change to LIFO, LIFO, are

Change To The LIFO Method

When a company elects to change to to LIFO, it is usually

impossible to calculate the income effect on prior years

As a result, the company does not report the change

retrospectively Instead, the LIFO method is used from

the point of adoption forward.

A disclosure note is needed to explain (a) the

nature of the change; (b) the effect of the

change on current year’s income and

earnings per share, and (c) why retrospective

application was impracticable.

A disclosure note is needed to explain (a) the

nature of the change; (b) the effect of the

change on current year’s income and

earnings per share, and (c) why retrospective

application was impracticable.

Learning Objective

Explain the appropriate accounting treatment when an inventory error is

discovered.

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

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

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

Appendix 9

Purchase Commitments

Purchase Commitments

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.

In July 2006, Matrix, Inc signed two purchase commitments The

first requires Matrix to purchase raw materials for $100,000 by

December 1, 2006 On December 1, 2006, the raw materials

had a market value of $90,000 The second requires Matrix

to purchase inventory items for $200,000 by March 1, 2007.

On December 31, 2006, the market value of the inventory items

were $188,000 On March 1, 2007, the market value of the inventory

items were $186,000 Matrix uses the perpetual inventory system

and is a calendar year-end company.

Let’s make the journal entries for these commitments.

In July 2006, Matrix, Inc signed two purchase commitments The

first requires Matrix to purchase raw materials for $100,000 by

December 1, 2006 On December 1, 2006, the raw materials

had a market value of $90,000 The second requires Matrix

to purchase inventory items for $200,000 by March 1, 2007.

On December 31, 2006, the market value of the inventory items

were $188,000 On March 1, 2007, the market value of the inventory

items were $186,000 Matrix uses the perpetual inventory system

and is a calendar year-end company.

Let’s make the journal entries for these commitments.

Purchase Commitments

Single year commitment

Multi-year Commitment

End of Chapter 9