FAR 1 Chapter 9
Explain the (a) lower of cost or net realizable value (LCNRV) approach and the (b) lower of cost or market (LCM) approach to valuing inventory
GAAP generally requires the use of historical cost to value assets, but a departure from cost is necessary when the utility of an asset is no longer as great as its cost. The utility or benefits from inventory result from the ultimate sale of the goods. This utility could be reduced below cost due to deterioration, obsolescence, or changes in price levels. To avoid reporting inventory at an amount greater than the benefits it can provide, the lower of cost or net realizable value (LCNRV) approach to valuing inventory was developed for companies that use FIFO, average cost, or any method other than LIFO and the retail inventory method. For companies that use the retail inventory method, the lower of cost or market (LCM) approach is used. Market equals replacement cost, except that market should not (a) be greater than NRV (ceiling) or (b) be less than NRV minus an approximately normal profit margin (floor). Both LCNRV and LCM result in the recognition of losses when the value of inventory declines below its cost, rather than in the period in which the goods are ultimately sold.
Describe the alternative approaches for recording inventory write-downs
If inventory write-downs are commonplace for a company, losses usually are included in cost of goods sold. However, when a write-down is substantial and unusual, GAAP requires that the loss be expressly disclosed. This could be accomplished with a disclosure note or, instead of including the loss in cost of goods sold, by reporting the loss in a separate line in the income statement, usually among operating expenses. Even with separate line item reporting, a disclosure note still would be appropriate.
Define purchase commitments. What is the advantage(s) of these agreements to buyers?
Purchase commitments are contracts that obligate the company to purchase a specified amount of merchandise or raw materials at specified prices on or before specified dates. These agreements are entered into primarily to secure the acquisition of needed inventory and to protect against increases in purchase price.
Explain how purchase commitments are recorded for the lower of contract price or market price
Purchases made pursuant to a purchase commitment are recorded at the lower of contract price or market price on the date the contract is executed. A loss is recognized if the market price is less than the contract price. For purchase commitments outstanding at year-end, a loss is recognized if the market price at year-end is less than the contract price.
Explain the difference between the retail inventory method using LIFO and the dollar-value LIFO retail method
The dollar-value LIFO retail method eliminates the stable price assumption of regular retail LIFO. In effect, it combines dollar-value LIFO (Chapter 8) with LIFO retail. Before comparing beginning and ending inventory at retail prices, ending inventory is deflated to base year retail using the current year's retail price index. After identifying the layers in ending inventory with the years they were created, in addition to converting retail prices to cost using the cost-to-retail percentage, the dollar-value LIFO method requires that each layer first be converted from base year retail to layer year retail using the year's retail price index.
The Rider Company uses the gross profit method to estimate ending inventory and cost of goods sold. The cost percentage is determined based on historical data. What factors could cause the estimate of ending inventory to be overstated?
The key to obtaining accurate estimates when using the gross profit method is the reliability of the cost percentage. If the cost percentage is too low, cost of goods sold will be understated and ending inventory overstated. Cost percentages usually are based on relationships of past years, which aren't necessarily representative of the current relationship. Failure to consider theft or spoilage also could cause an overstatement of ending inventory.
Both the gross profit method and the retail inventory method provide a way to estimate ending inventory. What is the main difference between the two estimation techniques?
The main difference between the gross profit method and the retail inventory method is in the determination of the cost percentage used to convert sales at selling prices to sales at cost. The retail inventory method uses a cost percentage, called the cost-to-retail percentage, which is based on a current relationship between cost and selling price. The gross profit method relies on past data to reflect the current cost percentage.
When a company changes its inventory method to LIFO, an exception is made for the way accounting changes usually are reported. Explain the difference in the accounting treatment of a change to the LIFO inventory method from other inventory method changes
When a company changes to the LIFO inventory method from any other method, it usually is impossible to calculate the income effect on prior years. To do so would require assumptions as to when specific LIFO inventory layers were created in years prior to the change. As a result, a company changing to LIFO usually does not report the change retrospectively. Instead, the LIFO method simply is used from that point on. The base year inventory for all future LIFO determinations is the beginning inventory in the year the LIFO method is adopted.
Identify any differences between U.S. GAAP and IFRS when applying the lower of cost or net realizable value rule to inventory valuation
When applying the lower of cost or net realizable value (LCNRV) rule for valuing inventory according to IFRS, if circumstances reveal that an inventory write-down is no longer appropriate, it must be reversed. Reversals are not permitted under U.S. GAAP. Also, under U.S. GAAP, the LCNRV rule can be applied to individual items, inventory categories, or the entire inventory. Using the international standard, the assessment usually is applied to individual items, although using inventory categories is allowed under certain circumstances.
Explain how to estimate the average cost of inventory when using the retail inventory method
When using the retail method to estimate average cost, the cost-to-retail percentage is determined by dividing total cost of goods available for sale by total goods available for sale at retail. By including beginning inventory in the calculation of the cost-to-retail percentage, the percentage reflects the average cost/retail relationship for all inventories, not just the portion acquired in the current period.
It is discovered in 2018 that ending inventory in 2016 was understated. What is the effect of the understatement
2016: Cost of goods sold:overstated Net income: understated Ending retained earnings: understated 2017: Net purchases:no effect Cost of goods sold:understated Net income:overstated Ending retained earnings correct
Describe the accounting treatment for a change in inventory method using LIFO and the dollar-value LIFO retail method
Changes in inventory methods, other than a change to the LIFO method, are reported retrospectively. This means reporting all previous periods' financial statements as if the new inventory method had been used in all prior periods.
markdown cancellation
Elimination of a markdown.
markup cancellation
Elimination of an additional markup.
Discuss the treatment of freight-in, net markups, normal spoilage, and employee discounts in the application of the retail inventory method
Freight-in is added to purchases in the cost column. Net markups are added in the retail column before the calculation of the cost-to-retail percentage. Normal spoilage is deducted in the retail column after the calculation of the cost-to-retail percentage. If sales are recorded net of employee discounts, the discounts are deducted in the retail column.
Explain the accounting treatment of material inventory errors discovered in an accounting period subsequent to the period in which the error is made
If a material inventory error is discovered in an accounting period subsequent to the period in which the error is made, any previous years' financial statements that were incorrect as a result of the error are retrospectively restated to reflect the correction. And, of course, any account balances that are incorrect as a result of the error are corrected by journal entry. If retained earnings is one of the incorrect accounts, the correction is reported as a prior period adjustment to the beginning balance in the statement of shareholders' equity. In addition, a disclosure note is needed to describe the nature of the error and the impact of its correction on income from continuing operations, net income, and earnings per share.
additional markup
Increase in selling price subsequent to initial markup.
initial markup
Original amount of markup from cost to selling price.
markdown
Reduction in selling price below the original selling price.
What are the various levels of aggression to which the LCNRV and LCM approaches can be applied?
The LCNRV and LCM determination can be made based on individual inventory items, on categories of inventory, or on the entire inventory.
Explain the gross profit method of estimating ending inventory
The gross profit method estimates cost of goods sold, which is then subtracted from cost of goods available for sale to obtain an estimate of ending inventory. The estimate of cost of goods sold is found by multiplying sales by the historical ratio of cost to selling prices. The cost percentage is the complement of the gross profit ratio (1 - GP%).
What is the conventional retail method?
The lower of cost or market (LCM) retail variation combined with the average cost method is called the conventional retail method. The LCM rule is incorporated into the retail inventory estimation procedure by excluding markdowns from the calculation of the cost-to-retail percentage.
Explain the retail inventory method of estimating ending inventory
The retail inventory method first determines the amount of ending inventory at retail by subtracting sales for the period from goods available for sale at retail. Ending inventory at retail is then converted to cost by multiplying it by the cost-to-retail percentage.
Explain the LIFO retail inventory method
When applying LIFO, if inventory increases during the year, none of the beginning inventory is assumed sold. Ending inventory includes the beginning inventory plus the current year's layer. To determine layers, we compare ending inventory at retail to beginning inventory at retail and assume that no more than one inventory layer is added if inventory increases. Each layer carries its own cost-to-retail percentage that is used to convert each layer from retail to cost.