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Chapter 9

Inventories: AdditionalIssues

Reporting—Lower of Cost and Net Realizable Value

• Inventory must be reported at the lower of cost and net realizable value

LO9-1

Company benefitsInventory Sold

Salability impaired• Deterioration• Obsolescence• Changes in price levels

• Avoids reporting inventory at an amount greater than the benefits it can provide

• Losses are recognized in the period the value of inventory declines below its cost

Advantages

Determining Net Realizable Value

LO9-1

• Net Realizable Value (NRV): • Estimated selling price of the product reduced by

reasonably predictable costs of completion, disposal, and transportation

• Net amount a company expects to realize from the sale of the inventory

Example:If the selling price of Product A is $10 per unit, and the company estimates that sales commissions and shipping costs average approximately 10% of selling price:

NRV = ($10 − [10% × $10]) = $9

Illustration: Lower of Cost and Net Realizable Value (NRV)

LO9-1

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:

Item CostA 50$ 100$ 15$ B 100 120 30 C 80 85 10 D 90 100 15 E 95 120 24

Item Cost NRVA 50$ 85$ 50B 100 90 90C 80 75 75D 90 85 85E 95 96 95

Selling Price Estimated Costs to Sell

Inventory Value

$100 - $15

<>>><

Illustration: Lower of Cost and Net Realizable Value—Application at Different Levels of Aggregation

LO9-1

Item Cost

Net Realizable

Value

By Individual

ItemsBy Product

LineBy Total

InventoryA 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$

Lower of Cost and NRV

Concept Check √

The following information pertains to one item of inventory of the Dodge Company:

Per unitCost $270Replacement cost 225Selling price 292Costs to sell 52

Applying the lower of cost and net realizable value rule, this item should be valued at:a. $225. b. $240. c. $270. d. $292.

NRV of $240 ($292 - 52) is lower than cost of $270

Adjusting Cost to Net Realizable Value

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

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

Journal EntriesCost of goods sold................ xx Inventory...............………. xxORLoss on write-down of inventory ……………. xx Inventory......................... xx

Inventory Estimation Techniques

LO9-2

Inventory Estimation Techniques

Gross Profit MethodUses a cost of goods sold

estimate and cost of goods available for sale to obtain an estimate of ending inventory

Retail Inventory MethodUses the cost-to-retail percentage

based on a current relationship between cost and selling price

The Gross Profit Method

LO9-2

• Situations where this technique is valuable:• In determining cost of inventory that has been lost,

destroyed, or stolen• 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

• It is not acceptable for the preparation of annual financial statements

(Gross Margin Method)

The Gross Profit Method (continued)

LO9-2

Relationship between ending inventory and COGS

Ending

Inventory

Cost of Goods Sold

Cost of Goods

Available for Sale

Beginning inventory + Net purchases

Ending Inventory

Cost of Goods

Available for Sale

Cost of Goods Sold

Can be estimated from available information

The Gross Profit Method (continued)

LO9-2

Usual Method of Calculation

Beginning inventory(from the accounting records)+ Net purchases(from the accounting records)Goods available for sale− Cost of goods sold(estimated)Ending inventory(estimated)

Beginning inventory(from the accounting records)+ Net purchases(from the accounting records)Goods available for sale− Ending inventory(from a physical count)Cost of goods sold

Gross Profit Method of Calculation

Illustration: Gross Profit MethodLO9-2

Beginning inventory (from records)Plus: Net purchases (from records)

Goods available for saleLess: Cost of goods sold:

Net salesLess: Estimated gross profit of 40%

Estimated cost of goods soldEstimated ending inventory

$ 600,0001,500,0002,100,000

$2,000,000(800,000)

(1,200,000)$ 900,000

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 ratio in each of the previous three years has been very close to 40%.

× 40%

Concept Check √

The records of Oregon Timber, Inc., revealed the following information related to inventory destroyed in a fire:

Inventory, beginning of period $ 900,000Purchases to date of fire 480,000Net sales to date of fire 1,350,000Gross profit ratio 30%

The estimated amount of inventory destroyed by the fire is:a. $975,000. b. $ 30,000. c. $435,000. d. All of these answer choices are incorrect.

$900,000 (beginning inventory) + $480,000 (purchases) - $945,000 (estimated cost of sales: $1,350,000 x 70%) = $435,000

The Gross Profit Method: A Word of Caution

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• The key to obtaining good estimates is the reliability of the gross profit ratio

• The accuracy of the estimate can be improved by grouping inventory into pools of products that have similar gross profit relationships

• The company’s cost flow assumption should be implicitly considered when estimating the gross profit ratio

• Suspected theft or spoilage would require an adjustment to estimates obtained using the gross profit method

The Retail Inventory Method

LO9-3

• Relies on the relationship between cost and selling price to estimate ending inventory and cost of goods sold

• Used by high-volume retailers selling many different items at low unit prices

• More accurate than gross profit method because it’s based on the current cost-to-retail percentage

Goods available for sale at costGoods available for sale at retail

Cost-to-retail percentage =

Amount of ending inventory (at retail)

Sales (at retail)

= Goods available for sale (at retail)

Illustration: Retail Method

LO9-3

Beginning inventoryPlus: Net purchasesGoods available for saleCost-to-retail percentage:

Less: Net salesEstimated ending inventory at retailEstimated ending inventory at costEstimated cost of goods sold

$ 60,000287,200

$347,200

(99,200)

Cost Retail$100,000

460,000$560,000

(400,000)$160,000

$248,000

$347,200 $560,000= 62%62%

Goods available for sale − ending inventory = COGS(at cost) (at cost)

Illustration: Terminology Used in Applying the Retail Method

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• Original amount of markup from cost to selling priceInitial markup:

• Increase in selling price subsequent to initial markupAdditional markup:

• Elimination of an additional markupMarkup cancellation:

• Reduction in selling price below the original selling price

Markdown:

• Elimination of a markdownMarkdown cancellation:

Illustration: Retail Inventory Method TerminologyLO9-3

• When applying the retail inventory method, net markups and net markdowns must be included in the determination of ending inventory at retail

Cost Flow Methods

LO9-3

• Cost-to-retail percentage is based on the weighted averages of the costs and retail amounts for all goods available for sale

Average Cost

• To approximate the lower of average cost and net realizable value, markdowns are not included in the calculation of the cost-to-retail percentage

Conventional Retail

Method

• If inventory at retail increases during the year a new layer is added

• Beginning inventory is excluded from the calculation of the cost-to-retail percentage

• Assume that retail prices of goods remained stable during the period

LIFO Retail Method

Illustration: The Retail Inventory Method—Various Cost Flow Methods

LO9-3

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:

Beginning inventory $99,200305,280

Cost Retail$160,000

470,000Net markupsNet purchases

Net markdownsNet sales

10,0008,000

434,000

Illustration: Retail Method—Average Cost

LO9-3

Beginning inventoryPlus: Net purchases

Goods available for saleCost-to-retail percentage:

Less: Net salesEstimated ending inventory at retailEstimated ending inventory at costEstimated cost of goods sold

$ 99,200305,280

(126,720)

Cost Retail$160,000

470,000

$632,000

(434,000)$198,000

$277,760

= 64%

Net markupsLess: Net markdowns

10,000(8,000)

$404,480$404,480 $632,00064%

Concept Check √

The Bowden Company uses the retail inventory method. The following information is available for the year ended December 31, 2016:

Cost RetailInventory 1/1/16 $ 780,000 $ 1,300,000Net purchases for the year 2,804,000 3,670,000Net markups 150,000Net markdowns 90,000Net sales 3,690,000

Applying the average cost retail inventory method, Bowden's inventory at December 31, 2016, is estimated at:a. $954,784. b. $790,318. c. $938,000. d. $810,700.

Ending inventory at retail: $1,340,000 [$1,300,000 (beginning inventory) + $3,670,000 (net purchases) + $150,000 (net markups) - $90,000 (net markdowns) - $3,690,000 (net sales)]. Cost ratio = 71.2525% [$780,000 (beginning inventory) + $2,804,000 (net purchases)] [$1,300,000 (beginning inventory) + $3,670,000 (net purchases) + $150,000 (net markups) - $90,000 (net markdowns]. Ending inventory at cost: $1,340,000 x 71.2525% = $954,784

Illustration: Retail Method—Conventional

LO9-3

Beginning inventoryPlus: Net purchases

$ 99,200305,280

Cost Retail$160,000

470,000 Net markups

Less: Net markdowns10,000(8,000)

63.2%

Goods available for sale

Cost-to-retail percentage:

Less: Net salesEstimated ending inventory at retailEstimated ending inventory at costEstimated cost of goods sold

(125,136)

$632,000(434,000)$198,000

$279,344

= 63.2%

$404,480$404,480 $632,000Less: Net markdowns (8,000)

$640,000$640,000

Concept Check √

The Bowden Company uses the retail inventory method. The following information is available for the year ended December 31, 2016:

Cost RetailInventory 1/1/16 $ 780,000 $ 1,300,000Net purchases for the year 2,804,000 3,670,000Net markups 150,000Net markdowns 90,000Net sales 3,690,000

Applying the conventional retail inventory method, Bowden's inventory at December 31, 2016, is estimated at:a. $954,784. b. $790,318. c. $938,000. d. $810,700.

Ending inventory at retail: $1,340,000 [$1,300,000 (beginning inventory) + $3,670,000 (net purchases) + $150,000 (net markups) - $90,000 (net markdowns) - $3,690,000 (net sales)]. Cost ratio = 70% [$780,000 (beginning inventory) + $2,804,000 (net purchases)] [$1,300,000 (beginning inventory) + $3,670,000 (net purchases) + $150,000 (net markups)]. Ending inventory at cost: $1,340,000 x 70% = $938,000

Illustration: LIFO Retail MethodLO9-4

Beginning inventoryPlus: Net purchases

Goods available for sale (including beginning inventory)Beginning inventory cost-to-retail percentage:

Less: Net salesEstimated ending inventory at retailEstimated ending inventory at cost

$99,200305,280

Cost Retail$160,000

470,000

$632,000

(434,000)$198,000

= 62%

Net markupsLess: Net markdowns

10,000(8,000)

$404,480

July cost-to-retail percentage: = 64.68%

Goods available for sale (excluding beginning inventory) $472,000$305,280

$99,200 $160,000

CostRetailBeginning inventoryCurrent period’s layer

Estimated cost of goods soldTotal

$160,00038,000

==

××

$198,000

$99,20024,578

$123,778 (123,778)$280,702

$305,280 $472,000

62%

64.68%

$198,000 – 160,000

Illustration: Recap of Other Retail Method Elements

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Dollar-Value LIFO Retail

• Each layer year carries its unique retail price index and its unique cost-to-retail percentage

Beginning InventoryEnding Inventoryexceeds

New LIFO layer added or Increase in retail prices

LO9-5

$ $

Illustration: The Dollar-Value LIFO Retail Method

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Beginning inventoryPlus: Net purchases

Goods available for sale (including beginning inventory)Beginning inventory cost-to-retail percentage:

Less: Net salesEstimated ending inventory at retailEstimated ending inventory at cost (see next slide)

$99,200305,280

Cost Retail$160,000

470,000

$632,000

(434,000)$198,000

Net markupsLess: Net markdowns

10,000(8,000)

$404,480

Cost-to-retail percentage:

Goods available for sale (excluding beginning inventory) $472,000$305,280

$99,200 $160,000

Estimated cost of goods sold(113,430)$291,050

$305,280

62%

64.68%

Illustration: The Dollar-Value LIFO Retail Inventory Method (continued)

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Ending Inventory at

Year-End Retail Prices

Step 1Ending Inventory

at Base Year Retail Prices

Step 2Inventory Layers at

Base Year Retail Prices

Step 3Inventory Layers

Converted to Cost

$198,000 $198,0001.10

= $180,000 $180,000

160,000 (base)20,000 (2016)

XX

1.001.10

XX

.62.6468

==

$99,200

14,230

$113,430

(determined)

Total ending inventory at dollar-value LIFO retail cost

$180,000 – 160,000

Change in retail prices over the year of 10%: An increase in the retail price index from 1 to 1.10.

Cost-to-retail percentage

Illustration: The Dollar-Value LIFO Retail Inventory Method (continued)

LO9-5

$226,200 $226,2001.16

= $195,000 $195,000160,000 (base)20,000 (2016)

XX

1.001.10

XX

.62.6468

==

$ 99,200

14,230

$124,392

(assumed)

Total ending inventory at dollar-value LIFO retail cost15,000 (2017) X 1.16 X .63 = 10,962

Ending Inventory at

Year-End Retail Prices

Step 1Ending Inventory

at Base Year Retail Prices

Step 2Inventory Layers at

Base Year Retail Prices

Step 3Inventory Layers

Converted to Cost

An increase in the retail price index from 1 to 1.16.

Illustration: The Dollar-Value LIFO Retail Inventory Method

LO9-5

$204,160 $204,1601.16

= $176,000 $176,000160,000 (base)16,000 (2016)

XX

1.001.10

XX

.62.6468

==

$ 99,200

11,384

$110,584

(assumed)

Total ending inventory at dollar-value LIFO retail cost

Ending Inventory at

Year-End Retail Prices

Step 1Ending Inventory

at Base Year Retail Prices

Step 2Inventory Layers at

Base Year Retail Prices

Step 3Inventory Layers

Converted to Cost

Concept Check √

On January 1, 2016, the Bowden Corporation adopted the dollar-value LIFO retail inventory method. Beginning inventory at cost and at retail were $60,000 and $94,000, respectively. Purchases during the year at cost and at retail were $201,500 and $310,000, respectively. There were no markdowns or markups during the year. 2016 net sales totaled $300,000. The retail price index at the end of 2016 was 1.04.Ending inventory at dollar-value LIFO cost is: a. $ 65,000. b. $ 67,600. c. $ 64,056. d. $100,000.

Cost to retail percentage for 2016: $201,500 ÷ $310,000 = 65%. Ending inventory at retail = $104,000 ($94,000 + 310,000 – 300,000). $104,000 ÷ 1.04 = $100,000. $100,000 – 94,000 = $6,000 x 1.04 x .65 = $4,056 (2016 layer) + 60,000 (base layer) = $64,056

Change in Inventory MethodLO9-6

Change in Inventory Method

Step 1:Revising comparative

statements

Step 2:Affected accounts are adjusted

Step 3:Disclosure provides additional

Information

The LIFO method is used from the point the change is adopted and that period’s beginning balance is considered as the base year inventory

Change to the LIFO Method

Most Inventory Changes:

Retrospective Treatment

Change in Inventory Method (continued)

Autogeek, Inc., a wholesale distributor of auto parts, began business in 2013. Inventory reported in the 2015 year-end balance sheet, determined using the average cost method, was $123,000. In 2016, the company decided to change its inventory method to FIFO.If the company had used the FIFO method in 2015, ending inventory would have been $146,000. Ignoring income taxes, what steps should Autogeek take to report this change?

Journal Entry CreditDebitInventory 23,000

23,000Retained earnings

$146,000 – $123,000

Illustration: Disclosure of Change in Inventory Method—CVS Caremark Corporation

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Illustration: Change in Inventory Method Disclosure—Seneca Foods Corporation

LO9-6

Nature and justification of change

Illustration: Change in Inventory Method Disclosure—Seneca Foods Corporation (continued)

LO9-6

Why retrospective application was impracticable

Illustration: Change in Inventory Method Disclosure—Seneca Foods Corporation (continued)

LO9-6

The effect of change

Concept Check √

In 2016, the Beldre Company switched its inventory method from average cost to FIFO. Inventories at the end of 2015 were reported in the balance sheet at $55 million. If the FIFO method had been used, 2015 ending inventory would have been $50 million. The company's tax rate is 40%. The adjustment to 2016’s beginning retained earnings would be:a. Zero. b. A $5 million decrease. c. A $3 million decrease. d. A $3 million increase.

2015 cost of goods sold would have been higher by $5 million, reducing pretax income by $5 million. Of that, taxes would have been reduced by $2 million, leaving a $3 million decrease in net income.

Inventory ErrorsLO9-7

Error Types Error TreatmentsError in same accounting period

• Original erroneous entry should be reversed• Appropriate entry recorded

Error discovered in subsequent accounting period

• Previous year financial statement should be retrospectively restated

• Incorrect account balances are corrected by journal entry

• Correction of retained earnings is reported as a prior period adjustment to the beginning balance in the statement of shareholders’ equity

• Disclosure note describing the nature and impact of error

Inventory errors Over or understatement of ending inventory or purchases

(1) Mistake in physical count or pricing

(2) Cutoff errors

Illustration: Visualizing the Effect of Inventory Errors

LO9-7

Illustration: Inventory Error CorrectionLO9-7

Illustration: Inventory Error Correction (continued)

LO9-7

The Barton Company uses a periodic inventory system. At the end of 2015, a mathematical error caused an $800,000 overstatement of ending inventory. Ending inventories for 2016 and 2017 are correctly determined.

Journal Entry CreditDebitRetained earnings 800,000

800,000Inventory

When the Inventory Error is Discovered the Following Year

This journal entry, ignoring income taxes, corrects the error:

Illustration: Inventory Error Correction (continued)

LO9-7

When the Inventory Error is Discovered Two Years Later• No correcting entry required as the error has self-corrected• A disclosure note in the company’s annual report should

describe the nature of the error and its impact on each year’s:• Net income—overstated by $800,000 in 2015; understated

by $800,000 in 2016 (ignoring income taxes)• Earnings per share

The Barton Company uses a periodic inventory system. At the end of 2015, a mathematical error caused an $800,000 overstatement of ending inventory. Ending inventories for 2016 and 2017 are correctly determined.

Concept Check √

Hightower Co. uses a periodic inventory system. Beginning inventory on January 1, 2016 was overstated by $49,000, and ending inventory on December 31, 2016 was understated by $79,000. These errors were not discovered until 2017. As a result, Hightower's cost of goods sold for 2016 was:

a. Understated by $128,000. b. Overstated by $30,000. c. Overstated by $128,000. d. Understated by $30,000.

$49,000 + 79,000 = $128,000 overstatement of cost of goods sold

Differences between U.S. GAAP and IFRS

LO9-8

U.S. GAAP IFRS

Lower of cost and net realizable value

Reversals are not permitted If circumstances indicate that an inventory write-down is no longer appropriate, it must be reversed

Can be applied to individual items, logical inventory categories, or the entire inventory

Usually applied to individual items, although using logical inventory categories is allowed under certain circumstances

Purchase commitments

• Contracts that obligate a company to purchase a specified amount of merchandise or raw materials at specified prices on or before specified dates

• Protects the buyer against increases in purchase price and provides a supply of product

• Recorded at the lower of contract price or market price on the date the contract is executed

Illustration: Purchase CommitmentsAPPENDIX 9

In July 2016, the Lassiter Company signed two purchase commitments. The first requires Lassiter to purchase inventory for $500,000 by November 15, 2016. The second requires the company to purchase inventory for $600,000 by February 15, 2017. Lassiter’s fiscal year-end is December 31. The company uses a perpetual inventory system.

Contract Period within Fiscal Year

Journal Entry CreditDebitInventory (contract price) 500,000

500,000Cash (or accounts payable)

When the market price is at least equal to the contract price

APPENDIX 9

In July 2016, the Lassiter Company signed two purchase commitments. The first requires Lassiter to purchase inventory for $500,000 by November 15, 2016. The market price is $425,000. The second requires the company to purchase inventory for $600,000 by February 15, 2017. Lassiter’s fiscal year-end is December 31. The company uses a perpetual inventory system.

Contract Period within Fiscal Year

Journal Entry CreditDebitInventory (market price) 425,000

75,000Cash (or accounts payable)

When the market price is less than the contract price

Loss on purchase commitment500,000

Illustration: Purchase Commitments (continued)

$500,000 − $425,000

APPENDIX 9

In July 2016, the Lassiter Company signed two purchase commitments. The first requires Lassiter to purchase inventory for $500,000 by November 15, 2016. The second requires the company to purchase inventory for $600,000 by February 15, 2017. The year-end market price of the inventory for Lassiter’s second purchase commitment is $540,000. Lassiter’s fiscal year-end is December 31. The company uses a perpetual inventory system.

Contract Period Extends beyond Fiscal Year

When the market price is at least equal to the contract price

Journal Entry – December 31, 2016 CreditDebitEstimated loss on purchase commitment 60,000

60,000Estimated liability on purchase commitment

Illustration: Purchase Commitments (continued)

$600,000 − $540,000

APPENDIX 9

In July 2016, the Lassiter Company signed two purchase commitments. The first requires Lassiter to purchase inventory for $500,000 by November 15, 2016. The second requires the company to purchase inventory for $600,000 by February 15, 2017. The year-end market price of the inventory for Lassiter’s second purchase commitment is $540,000. Lassiter’s fiscal year-end is December 31. The company uses a perpetual inventory system.

Contract Period Extends beyond Fiscal Year

Journal Entry CreditDebitInventory (accounting cost) 540,000

60,000Cash (or accounts payable)

Estimated liability on purchase commitment600,000

Illustration: Purchase Commitments (continued)

When market price is unchanged or increased from year-end price

APPENDIX 9

In July 2016, the Lassiter Company signed two purchase commitments. The first requires Lassiter to purchase inventory for $500,000 by November 15, 2016. The second requires the company to purchase inventory for $600,000 by February 15, 2017. The year-end market price of the inventory for Lassiter’s second purchase commitment is $540,000. Lassiter’s fiscal year-end is December 31. The market price of the inventory covered by the commitment further declines to $510,000. The company uses a perpetual inventory system.

Contract Period Extends beyond Fiscal Year

Journal Entry CreditDebitInventory (market price) 510,000

30,000

Cash (or accounts payable)

Loss on purchase commitment

600,00060,000Estimated liability on purchase commitment

Illustration: Purchase Commitments (continued)

When market price declines even further from year-end levels$540,000 − $510,000

Concept Check √

On August 15, 2016, Pesky Corporation signed a purchase commitment to purchase inventory for $300,000 on or before February 20, 2017. The company’s fiscal year-end is December 31. The contract was exercised on February 3, 2017, and the inventory was purchased for cash at the contract price. On the purchase date of February 3, the market price of the inventory was $315,000. The market price of the inventory on December 31, 2016, was $270,000. The company uses a perpetual inventory system.How much loss on purchase commitment will Pesky recognize in 2016?

a. $45,000. b. $30,000. c. $15,000. d. None.

$300,000 – 270,000 = $30,000 loss

End of Chapter 9