Chp 9: Inventories: Additional Issues

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Lower of Cost and Net Realizable value

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GAAP requires companies to report at inventory at lower of cost or NRV.

Benefit received from inventory results from the ultimate sale of inventory; Things that compromise the salability of inventory such as, deterioration, impair the benefit it provides.

Avoids reporting at amount greater than the benefits it can provide.

losses recognized in period when inventory declines in value, rather than when sold.

People argue that it's inconsistent because increases aren't recorded and causes losses that haven't actually occurred to be recognized.

Increases in inventory prior to sale not recognized because of potential premature revenue recognition.

LCM used to be required by GAAP to value inventory, but was intended as a guide rather than a literal rule.

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Gross Profit Method or Gross margin method(Inventory estimation technique)

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Useful in situations where estimates of inventory are desirable in a variety of ways:

1. In determining the cost of inventory that has been lost, destroyed, or stolen

2. In estimating inventory and COGS for interim reports, avoiding the expense of a physical inventory count.

3. In auditors' testing of the overall reasonableness of inventory amounts reported by clients

4. In budgeting and forecasting

Not acceptable for the preparation of annual financial statements(approximation of inventory).

First step in estimating inventory is to estimate COGS, which relies on historical relationship between net sales, cogs, and gross profit

Front 3

Cost-to-retail percentage

Back 3

based on a current relationship between cost and selling price; comparing of cost of goods AFS with goods AFS at current selling prices.

Cost of goods available for sale/goods available for sale at selling price

Front 4

Applying Lower of Cost and NRV

Back 4

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

Front 5

Adjusting cost to NRV

Back 5

If common place, include losses in COGS.


If significant and unusual, GAAP requires expressive disclosure, so consider including loss in separate line item such as "loss on write–down of inventory," or disclosing it in a disclosure note.



Reduced inventory because the new cost basis and can't be written back up.

Front 6

IFRS lower of cost and NRV

Back 6

Both IFRS and GAAP value inventory at lower of cost or NRV.


Differences:


1. IFRS allows reversal of write–downs, while GAAP doesn't.


2. Under GAAP, lower of cost and NRV can be applied to individual items, logical categories, or the entire inventory, whereas under IFRS, it is usually only applied to individual items; however, it is applied to logical categories under certain circumstances.

Front 7

Word of Caution(Gross Profit Method)

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


all available information should be used to make adjustments


Blanket ratio should not be applied in situations of different products having different markups.


Inventory should be grouped in pools of products with similar gross profit relationships, instead of applying gross profit ratio to entire inventory


Cost flow assumption should be considered


it doesn't consider possible theft or spoilage of inventory. which requires an adjustment.

Front 8

Markup on cost

Back 8

Gross profit stated as a percentage of cost instead of sales.

Gross Profit/Cost= Gross profit as% of cost

Gross profit as % of sales= Gross Profit as % of cost/1+Gross profit as % of cost

Front 9

Determining NRV

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NRV is estimated selling price of the product in the ordinary course of business less reasonably predictable costs of completion, disposal, and transportation, such as sales commission and shipping costs; net amount company expects to realize from the sale of inventory

Front 10

Applying Lower of Cost and Net Realizable(Determining NRV)

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Lower of cost and net realizable value can be applied to individual inventory items, to logical categories of inventory(major product lines), or to the entire inventory.

For income tax purposes, must be applied on an individual item basis.

Applying this to categories usually will cause a higher inventory valuation than if applied on a n item by item basis because the decreases the NRV of some items is offset by increases.

Front 11

Adjusting Cost to NRV(Determining NRV)

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-Commonplace inventory write-downs are included in COGS(losses).

-Substantial and unusual write-downs, are required by GAAP to be expressly disclosed:

1. Through a disclosure note

2. Reporting loss in separate line in the income statement , usually among operating expenses, instead of in COGS.

3. Disclosure note appropriate regardless

Regardless of approach to write-down inventory, reduced inventory value becomes new cost basis and cannot be written back up.

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The retail Inventory Method(Inventory estimation technique)

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1. Cost to retail percentage: More reliable than historical gross profit ratio

2. Retail information: records of inventory and purchases at cost and selling price

3. Estimates EI(retail) by subtracting sales(retail) from goods available for sale(retail).

4. Estimating EI(retail) is converted to cost by multiplying by the cost-to-retail percentage.

5. Like gross profit method used to estimate the cost of inventory lost, stolen, or destroyed; testing overall reasonableness of physical counts; forecasting and budgeting; as well as generating information for interim financial statements

6. Physical count of inventory still performed once a year, despite accuracy of method to detect theft, spoilage, and other irregularities.

Advantages:

1. Acceptable for external financial reporting

2. Allowed by IRS to determine COGS for income tax purposes.

3. Different cost flow methods can be explicitly incorporated into the estimation technique.

*Principle benefit similar to gross profit method is that physical count of inventory is not necessary to estimate EI and COGS.

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Retail Terminology(Retail Inventory method)

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· Initial Markup
· Additional Markup
· Markup Cancellation
· Markdown
· Markdown Cancellation

*Changes in the selling price must be included in the determination of ending inventory at retail

*Net markups and net markdowns included in the retail column to determine ending inventory at retail.

Front 14

Initial Markup

Back 14

Original amount of markup from cost to selling price.

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Additional Markup

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Increase in selling price subsequent to initial markup.

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Markup cancellation

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Elimination of additional markup

Front 17

Markdown

Back 17

Reduction in selling price below the original selling price.

Front 18

Markdown Cancellation

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Elimination of markdown

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Net Markup

Back 19

Additional markup less markup cancellation

Front 20

Net Markdown

Back 20

Markdown less markdown cancellation

Front 21

Approximating Average cost

Back 21

Both net markups and net markdowns included in the determination of goods available for sale at retail.

Front 22

Conventional retail method: Approximating average lower of cost and NRV

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Markdowns excluded from the calculation of cost-to-retail percentage to approximate the lower of average cost and NRV.

Markdowns still subtracted from retail column, but only after the percentage is calculated.

Cost approximation of EI will always be less when markdowns exist.

Logic behind using this method is that a markdown is evidence of a reduction in the utility of inventory, such as through spoilage and overstocking.

Usually not used in combination with LIFO, but companies using LIFO don't ignore the lower of cost and NRV rule and write down any obsolete or slow-moving inventory that hasn't been marked down by year-end to NRV after the estimation of inventory using the retail method.

Could be applied to FIFO method.

Front 23

LIFO Retail Method

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We assume retail prices of goods remained stable during the period.

New layer is added(one per year) if inventory at retail increases.

Each layer carries its own cost-to-retail percentage.

Net markups and net markdowns included in calculation of current period's cost-to-retail percentage.

Front 24

Other issues pertaining to retail method

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Fundamental elements such as returns and allowances, discounts, freight, spoilage, and shortages can complicate retail method.

Front 25

Before calculating cost to retail percentage(Other issues pertaining to retail method)

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Freight in: Added in cost column

Purchase returns: Deducted in both the cost and retail column

Purchase discount taken(gross method used to record purchases): Deducted in cost column

Abnormal shortages(spoilage, breakage, theft): Deducted in both the cost and retail column

Abnormal shortages not anticipated and not implicit in determination of selling prices.

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After calculating the cost to retail percentage(other issues pertaining to retail method)

Back 26

Normal shortages(spoilage, breakage, theft): Deducted in the retail column

Employee Discounts: Added to net sales

Discounts added to net sales because subtracting discounts from sales would overstate inventory; sales discounts do not represent an adjustment in selling price.

Including normal shortages in cost-to-retail percentage would distort relationship between cost and retail.

Because shortage losses are anticipated, they are included implicitly in determination of selling prices.

Front 27

Dollar Value LIFO Retail Method

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Using the retail method to approximate LIFO.

Combines LIFO retail and dollar value LIFO.

Used to determine if there's been a real increase in quantity of goods in inventory by eliminating effect of any price changes before comparing EI to BI.

Step 1: Deflate ending inventory to base year retail prices

Step 2: Inventory layers at base year retail prices

Step 3: Inventory layers converted to cost

Front 28

Most Inventory Changes(change in inventory method)

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Changes in inventory methods, other than LIFO, are accounted for retrospectively(reporting all previous periods' financial statements as if the new method had been used in all previous periods)

Step 1: Revise comparative financial statements

Step 2: The affected accounts are adjusted

Step 3: A disclosure note provides additional information(provides justification for change) and indicates effect on:

a. items not reported on the face of the primary statements.

b. any per share amounts affected for the current period and prior periods

c. cumulative effect of the change on retained earnings or other components of equity as of the beginning of the earliest period presented.

Front 29

Change to the LIFO method(change in inventory method)

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Accounting records usually are inadequate for company changing to LIFO to report the change retrospectively, thus most companies report the change prospectively.

Disclosure is needed to explain:

a. nature of and justification for the change

b. the effect of the change on current year's income and EPS.

c. why retrospective application was impracticable.

Front 30

Additional consideration(change to LIFO method)

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Change in principle must be justified in that it results in financial information that properly portrays operating results and financial position.

For income tax purposes, must obtain consent from IRS and file a form when adopting LIFO inventory method.

Can't change back to LIFO until five tax returns have been filed.

Front 31

Inventory Errors

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1. Over- or understatement of inventory due to a mistake in physical count or a mistake in pricing inventory quantities

2. Over- or understatement of purchases which could be caused by cutoff errors

3. Financial statements restated retrospectively if material error discovered in subsequent period to the period the error was made.

4. Prior period adjustment to beginning balance of retained earnings

5. Disclosure note needed to describe nature of error and impact of correction on net income, income before extraordinary items, and EPS.

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When inventory error is discovered in the following year

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Financial statements retrospectively restated when those statements are reported again for comparative purposes

Prior period adjustment to retained earnings and correction to inventory account.

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When the inventory error is discovered two years later

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Financial statements retrospectively restated, but inventory and retained earnings would not require adjustment because the error has self-correct

Disclosure note should describe nature of the error and the impact of its correction on each year's net income, income before extraordinary items, and EPS.