ACC 304- Chapter 9: Additional Inventory Issues

Why does GAAP require that companies evaluate their unsold inventory at the end of each reporting period

Because stuff happens after we make/buy inventory that means that the company will sell inventory for less than the cost

• Inventory damage

• Physical deterioration

• Obsolescence

• Changes in price levels

2 approaches to inventory write down

1. Lower of cost OR net realizable value (LCNRV)

2. Lower of cost OR market value (LCM)

What companies use the “Lower cost OR net realizable value” methord

Those that use FIFO, average cost or specific identification methods for inventory valuation.

What companies use the “Lower cost OR market” methord

Companies that use LIFO or the retail inventory method

Financial statement effects of inventory write downs- LCNRV and LCM

a. reduce reported inventory

b. reduce net income

When does LCNRV apply

When the usefuleness/value of inventory drops below what you orginally paid

How to calculate NRV

Selling price - completion costs - disposal/selling costs

When do you record a loss for LCNRV

NRV is below the historical cost

How does LCNRV work

1. Compare cost and NRV

2. Choose the lower of the two

3. E/I (cost) - E/I (LCNRV) = adjusttment to LCNRV

JE for LCNRV- loss method

Dr. Loss due to decline on inventory

Cr. Allowance to reduce inventory to mkt

JE for LCNRV- COGS method

Dr. COGS

Cr. Allowance to reduce inventory to mkt/ Inventory

What is lower cost or market (LCM)

goods are valued at cost or at the cost to replace, whichever is lower, used by companies who use LIFO or retail inventory

When is it used

when inventories experience a decline in future utility

What costs does LCM deal with

Historical cost

• Replacement cost

• Net Realizable Value (ceiling)

• NRV less Normal Markup (floor)

• Designated Market Value

Historical cost

Original purchase price using one of the historical cost-

based methods (LIFO, FIFO, etc)

Replacement cost

The estimated amount that a company would have to pay to make or buy new units to replace the existing units

Net Realizable Value: Ceiling

Estimated selling price - any cost of completion and

costs of disposal

NRV - Normal profit margin

• = Floor

• Limits the inventory reduction so that inventory is not

  less than net realizable value minus and allowance for an

  approximately normal profit margin.

Designated market value

• Replacement cost, not to exceed NRV or be less than

NRV-NPM

• Middle value

Decline in Replacement cost usually equals _____

decline in selling price.

If reduction in RC fails to indicate reduction in utility, then two additional valuation limitations are used:

Ceiling - net realizable value

Floor - net realizable value - normal profit margin.

What is the point of a ceiling/NRV

prevents overstatement of the value of obsolete, damaged, or shopworn inventories.

What is the point of a floor/ (NRV- NPM)

deters understatement of inventory and overstatement of the loss in the current period.

Deficiencies of LCM

1. Timing - Losses recorded early, gains recorded late

2. Valuation- Switches between cost & market inconsistently

3. Net income - Distorts income across periods

4. Subjectivity - "Normal profit" is a judgment call (LCM only)

What is VALUATION BASIS: RELATIVE SALES VALUE

This method is a way to estimate inventory costs. It is used when a company has a lump sum purchase Basket purchase.

How to find relative sales value

1. Find the total purchase price (given)

2. Determine the selling price (SP) of each unit

or group and give the total weighted selling

price

3. Calculate the ratio: (SP for each group)/ (total

weighted SP)=RSV

4. Apply the RSV to the purchase price to

determine the allocated cost of each unit or

group

5. Use sales price and cost from #4 to calculate

other items:

• Gross Margin, Ending Inventory, etc.

When do you write down/ calculate before-tax income for LCM/LCNRV, what is the JE

What the cost is higher

1. Cost- NRV (LCNRV or whatever the middle value was for LCM)

2. Multiply by amt of unit

DR. COGS

CR. Inventory

How to caclulate NRV

Estimated selling price - cost of completion and disposal

Why do we have to estimate inventory

• To confirm expectations

• To estimate interim inventory under a periodic system

• To estimate casualty losses when no records

exist (fire, hurricane, etc).

Steps for Inventory estimation with gross profit %

1. Determine gross profit percentage

• If given markup % - convert to GP %.

2. Determine estimated (or actual) sales

3. Determine estimated cost of goods sold.

4. Determine estimated goods available for sale.

5. Determine estimated ending inventory

When do you calculate Gross profit %? How do you calculate it?

1. If you are given the markup percentage

2. Calculation: Markup/ 100% + markup = GP %

Retail Inventory Method

A method used by retailers, to estimate inventory without a physical count, by converting retail prices to cost.

(1) Total cost and retail value of goods purchased.

(2) Total cost and retail value of the goods available for

sale.

(3) Sales for the period.

What methods use the retail inventory method

Methods

o Conventional Method

o Cost Method

o LIFO

o Dollar-value LIFO

Why should i use the retail inventory method

1) Estimate income without counting

2) Catch theft and losses

3) Manage stock

(4)Insurance purposes

Conventional retail method

• Include markups and markup cancellations in cost ratio

calculation

• Do not include markdowns

Cost Retail Inventory Method

Includes markups and markdowns in cost ratio calculation.