FIN Chapter 9 - Inventories Additional Issues Reporting –...

Info iconThis preview shows page 1. Sign up to view the full content.

View Full Document Right Arrow Icon
This is the end of the preview. Sign up to access the rest of the document.

Unformatted text preview: Inventories: Additional Issues Reporting – Lower of Cost or Market Inventory valuation starts with historical costs Then allocation between COGS and EI is Then estimated using one of the cost flow assumptions (specific identification, average cost, FIFO or LIFO) But inventory value is subject to an additional But constraint: Lower of Cost or Market (LCM) constraint: – If Cost > Market Value, then some portion of the cost If is unlikely to be recovered and the inventory value is impaired. impaired. – LCM is required by GAAP Determining Market Value Start with replacement cost – The cost to replace the item by purchase or The manufacture manufacture – However ARB No. 43 states that we must However apply a ceiling and floor to replacement cost. apply Ceiling: the replacement cost cannot exceed the Ceiling: net realizable value net – NRV = Selling Price less costs of completion and NRV disposal (selling costs) disposal Floor: the replacement cost must be higher than Floor: NRV less a normal profit margin NRV Determining Market Value Must compare the ceiling, replacement cost, and Must floor to determine the “Designated Market” value floor – Means pick the number that is the middle of those Means three values three – Then must compare the designated market to Then historical cost historical The inventory should be valued at the lower of The designated market or historical cost designated IFRS requires that designated market is NRV Theoretical Merits Accountants claim that LCM promotes Accountants conservatism at expense of consistency conservatism Applying Lower of Cost or Market Can be applied to individual items, Can inventory pools, or the entire inventory as a whole whole – Most common to apply to individual items Applying to larger groups generally results Applying in highest inventory valuation. in Adjusting Cost to Market Once the amount of any write-down is determined, can Once use one of two common methods: use Dr. Loss on Reduction to LCM Cr. Inventory OR Dr. COGS Cr. Inventory Most companies choose second method because F/S Most users won’t know about their bad purchase decision. users – However, reporting loss within COGS distorts relationship However, between sales and COGS between Once inventory is written, it is not allowed to be written Once back up back – Increased profits will show up in gross profit when item is sold E9­3, p. 458 Work in class Inventory Estimation Techniques Need to use when inventory is destroyed Need and physical count of goods is impossible. and Also can be used to estimate ending Also inventory in between physical counts. inventory The Gross Profit Method (Gross Margin Method) Is not allowed for the preparation of annual F/S, Is annual but is useful for calculating ending inventory in interim reports. interim COGS + Ending Inventory = Cost of Goods COGS Available for Sale Available Beginning Inventory + Net Purchases = Cost of Beginning Goods Available for Sale Goods Normally we can count ending inventory and Normally subtract it from COGAS to compute COGS. subtract – However, here we do not know either EI or COGS. We begin by estimating COGS: Estimated Gross Profit = Gross Profit % Estimated multiplied by Net Sales multiplied Net Sales $XXXX Less: Estimated Gross Profit (XXXX) Estimated COGS $XXXX We can then use the Estimated COGS in the traditional Inventory formula: Beginning Inventory + Purchases Cost of Goods Available for Sale − Estimated COGS Estimated = Estimated Ending Inventory $XXXX XXXX $XXXX XXXX $XXXX A Word of Caution If your gross profit percentage is unreliable, so too will be If your estimates of COGS and Ending Inventory. your Note: Sometimes the gross profit is stated as a Note: percentage of cost rather than a percentage of sales. percentage GP% on Cost = [(Gross Profit/Sales)/(COGS/Sales)] GP% on Cost = [(Gross Profit/Sales)*(Sales/COGS)] GP% on Cost = Gross Profit/COGS GP% on Sales = GP% on Cost / (1 + GP% on Cost) E9­8, p. 459 Work in class The Retail Inventory Method Another estimation technique but more accurate than Another Gross Profit Method Gross Beginning Inventory + Net Purchases = Cost of Goods Beginning Available for Sale Available Uses the Cost-to-Retail percentage based on a current Uses relationship between cost and selling price relationship Uses current selling prices (retail information) Can be used for both financial reporting and income tax Can purposes purposes Need to know the Goods Available for Sale at both their Need cost and retail prices cost Cost-to-Retail % = Goods Available for Sale at Cost / Cost-to-Retail Goods Available for Sale at Retail Goods Compute the Estimated Ending Inventory at Retail Prices as: Cost of Goods Available for Sale at Retail Prices $XXXX Less Net Sales (XXXX) (XXXX) Estimated Ending Inventory at Retail Prices $XXXX Then can convert Estimated EI at Retail to Estimated EI Then at Cost: at – Estimated EI at Cost = Estimated EI at Retail multiplied by the Estimated Cost-to-Retail % Cost-to-Retail Then can compute Estimated COGS as follows: Cost of Goods Available for Sale at Cost $XXXX Less Estimated EI at Cost (XXXX) (XXXX) Estimated COGS $XXXX Example Cost $30,000 30,000 $60,000 Retail $50,000 40,000 $90,000 65,000 $25,000 $16,675 Inventory, January 1 Purchases in January Goods available for sale Cost percentage ($60,000/$90,000) = 66.7% Deduct sales for January Inventory, January 31, at retail Inventory, January 31, at estimated cost ($25,000 x 66.7%) This example was based on an average cost assumption since beginning inventory and purchases are lumped together to compute one cost percentage. Cost Flow Methods Can incorporate various cost flow Can assumptions into the Retail Inventory Method Method Example FIFO and LIFO assumptions can be incorporated as follows: Cost $30,000 30,000 $60,000 Retail $50,000 40,000 $90,000 Inventory, January 1 Purchases in January Goods available for sale Cost percentage: Beginning inventory ($30,000/$50,000) = 60% Purchases ($30,000/$40,000) = 75% Deduct sales for January Inventory, January 31, at retail Inventory, January 31, at estimated cost FIFO ($25,000 x 75%) LIFO ($25,000 x 60%) 65,000 $25,000 $18,750 $15,000 With a FIFO assumption, the retail inventory is converted to cost using the cost percentage applicable to the most recently acquired goods (purchases). With a LIFO assumption, the retail-to-cost conversion for ending inventory is done using the old cost percentage (beginning inventory). Can even make it more complicated by incorporating LIFO layers, changing prices, etc. - this is referred to as the dollar-value LIFO retail method. Retail Terminology Initial markup = original amount of markup from cost to Initial selling price selling Additional markup = increase in selling price subsequent Additional to initial markup to Markup cancellation = elimination of an additional Markup markup markup Markdown = reduction in selling price below the original Markdown selling price selling Markdown cancellation = elimination of a markdown Net markups and net markdowns are included in the Net retail numbers to determine ending inventory at retail. retail Approximating Average Cost To approximate average cost, the cost-to-retail To % is determined for all goods available for sale. is Goods Available for Sale at Retail is computed Goods as: as: Beginning Inventory at Retail Plus Net Purchases at Retail Plus Net Markups Less Net Markdowns Goods Available for Sale at Retail $XXXX XXXX XXXX (XXXX) $XXXX This will change the cost-to-retail % but rest of This computations are the same. computations Approximating Average LCM – The Conventional Retail Method Treats Net Markdowns differently from Average Cost Treats method: method: Goods Available for Sale at Retail is computed as: Beginning Inventory at Retail Plus Net Purchases at Retail Plus Net Markups Denominator in Cost-to-Retail % Less Net Markdowns Goods Available for Sales at Retail $XXXX XXXX XXXX $XXXX (XXXX) $XXXX Rest of computations are same as original Retail Rest Inventory Method. Inventory Assume the previous information, and in addition we had retail price markups of $30,000 and markdowns of $20,000 during the month of January. The markups and markdowns are incorporated into the retail inventory estimate as follows: Average Cost Lower of Cost or Market Cost Retail Cost Retail Inventory, January 1 $30,000 $50,000 $30,000 $50,000 Purchases in January 30,000 40,000 30,000 40,000 $60,000 $90,000 $60,000 $90,000 Markups 30,000 30,000 Markdowns (20,000) $100,000 $120,000 Cost percentage: Average cost ($60,000/$100,000) = 60% Lower of cost or market ($60,000/$120,000) = 50% Markdowns Goods available for sale Deduct sales for January Inventory, January 31, at retail Inventory, January 31, at estimated cost: Average cost ($35,000 x 60%) = Lower of cost or market ($35,000 x 50%) = (20,000) $100,000 65,000 $35,000 $100,000 65,000 $35,000 $21,000 $17,500 Notes: Subtracting the markdown before calculation of the cost percentage is equivalent to assuming that the markdowns result from a change in pricing strategy. Under this assumption, all markups and markdowns should be reflected in the computation of the cost percentage. Subtracting markdowns after calculation of the cost percentage reflects the assumption that the markdowns are the result of a decline in the value of the inventory. As a results, markdowns do not affect the normal cost percentage, but are instead reflected as a direct decline in the recorded value of inventory. This assumption yields an estimate of inventory at lower of cost or market. Dollar­Value LIFO Retail Not responsible for knowing Most Inventory Changes Changes in inventory methods, other than a change to Changes LIFO, are accounted for retrospectively. LIFO, – First, must revise prior years’ financial statements if presented First, for comparative purposes. for – For the earliest year reported, beginning retained earnings would For be revised to reflect the cumulative income effect of the difference in methods for all prior years. difference – Record a journal entry to adjust inventory balances to correct Record levels under new method (retained earnings will be the other side of the entry). side – Must disclose the change (including the justification for the Must change) and the effect on current and all prior year’s income that is presented along with the associated EPS. is Change to LIFO Method Do not have enough information to create LIFO Do layers from previous years. layers Instead company just starts creating layers from Instead the point of adoption on. the Must disclose the change (including the Must justification for the change) and the effect on current year’s income and EPS. current If company has switched away from LIFO in the If past, it can’t switch back for at least five years for tax-purposes. for E9­21, p. 462 Work in class When the Inventory Error is Discovered the Following Year For material errors, previous years’ financial For statements must be retrospectively restated. statements Incorrect balances are corrected. A correction of retained earnings is reported as a correction prior period adjustment. prior Must disclose the impact of the error on income. When the Inventory Error is Discovered Subsequent to the Following Year Inventory and retained earnings will be Inventory correct since inventory errors reverse in second year following error. second However, previous years’ F/S must be However, retrospectively restated for COGS and net income amounts. income Error must be disclosed in footnotes along Error with impact on income numbers and EPS. with E9­22, p. 462 Work in class Earnings Quality Inventory write-downs are one of the most Inventory common ways to manage earnings. common Called taking a “big bath”. Purchase Commitments Purchase commitments protect the buyer Purchase against price increases and provide a supply of the product. supply Purchases are recorded at the lower of the Purchases contract price or market price on the date the contract is executed. the Material amounts of purchase Material commitments outstanding at year-end must be disclosed in a footnote. must Contract Period within Fiscal Year If market price >= contract price, then the If purchase is recorded at the contract price. purchase If market price < contract price, then the If purchase is recorded at the market price and a loss is recognized on the purchase commitment: loss Dr. Inventory (or Purchases) (market price) Dr. Dr. Loss on Purchase Commitment ((difference between contract and market price) between Cr. A/P or Cash (contract price) Contract Period Extends beyond Fiscal Year If market price at year-end < contract price, then If record an adjusting entry to recognize an estimated loss: estimated Dr. Estimated Loss on Purchase Commitment (contract Dr. price less market price at year-end) price Cr. Estimated Liability on Purchase Commitment Then to record the actual purchase if market Then price has not declined further since year-end: price Dr. Inventory or Purchases (accounting cost) Dr. Estimated Liability on Purchase Commitment Dr. (remove liability from adjusting entry at year-end) (remove Cr. Cash or A/P (contract price) Contract Period Extends beyond Fiscal Year If market price declines further subsequent If to year-end, then the entry at the purchase date is: date Dr. Inventory of Purchases (market price) Dr. Loss on Purchase Commitment Dr. (additional loss since end of the year) (additional Dr. Estimated Liability on Purchase Dr. Commitment (remove liability from adjusting entry at year-end) adjusting Cr. Cash or A/P (contract price) Apple’s MD&A E9­26, p. 463 Work in class ...
View Full Document

This note was uploaded on 04/08/2009 for the course ACG 3481 taught by Professor Dickinson during the Fall '08 term at University of Florida.

Ask a homework question - tutors are online