Chapter 9: Inventories: Additional Issues

How does GAAP require companies to report inventory? Why?

- At the lower of cost and net realizable value - It avoids reporting inventory at an amount greater than the benefits it can provide - Causes losses to be recognized in the period the value of inventory declines below its cost rather than in the period in which the goods ultimately are sold

Cost Flow Assumptions

- Average Cost - Conventional Retail Method - LIFO Retail Method

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

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 inventory

LIFO 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

Errors made in the same accounting period

- original entry should be reversed - appropriate entry recorded

Errors discovered in the 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 stockholders' equity - disclosure note describing the nature and impact of error

Journal Entry for changing inventory method Example: 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?

146,000 - 123,000 = 23,000 Inventory 23,000 Retained Earnings 23,000

The following information pertains to one item of inventory of the Dodge Company: Per unit Cost $270 Replacement cost 225 Selling price 292 Costs 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.

292 - 52 = $240 240 < 270 b. $240

Conventional Retail Method

Any markdowns are excluded from the cost-to-retail percentage. Markdowns are still accounted for but after the percentage has been calculated.

The Bowden Company uses the retail inventory method. The following information is available for the year ended December 31, 2016: Cost Retail Inventory 1/1/16 $ 780,000 $ 1,300,000 Net purchases for the year 2,804,000 3,670,000 Net markups 150,000 Net markdowns 90,000 Net sales 3,690,000 Applying the LIFO retail inventory method, Bowden's inventory at December 31, 2016, is estimated at?

Beginning Inventory $780,000 $1,300,000 Plus: Purchases 2,804,000 3,670,000 Net Markups 150,000 Net Markdowns (90,000) GAFS excluding Beg. Inv. 2,804,000 3,730,000 GAFS including Beg. Inv. 3,584,000 5,030,000 Beg. Inv. Cost-to-Retail %: 60 % Current Period CTR %: 75.17 % Less: Net Sales (3,690,000) Est. End Inventory at Retail 1,340,000 Est. End Inventory at Cost *810,068* Est. COGS 2,773,932 Calculating Ending Inventory at Cost: Retail Cost Beginning Inventory: 1,300,000 x 60% = 780,000 Current Period's Layer: 40,000 x 75.17% = 30,068 Estimated End Inv: 1,340,000 810,068 Current Period's Layer = estimated ending inv - beginning inventory

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%. How much inventory was destroyed in the fire?

Beginning Inventory: 600,000 + Net purchases: 1,500,000 = Goods Available for Sale: 2,100,000 - Cost of Goods Sold: Net Sales: 2,000,000 - Estimate Gross Profit: (800,000) = Estimate COGS (1, 200,000) Estimated Ending Inventory: 900,000

If inventory write-down are commonplace for a company, losses usually are included in ______.

Cost of Goods Sold When a loss is substantial and unusual, GAAP requires that the loss be expressly disclosed COGS xx Inventory xx OR Loss on write-down of Inventory xx Inventory xx

Average Cost

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

Markdown Cancellation

Elimination of a markdown

Markup Cancellation

Elimination of an additional markup

Relationship between ending inventory and COGS

Ending inventory + Cost of Goods Sold = Cost of Goods Available for Sale Cost of Goods Available for Sale = Beginning Inventory + Net Purchases

Amount of ending inventory (at retail) =

Goods available for sale (at retail) - sales (at retail)

Cost-to-retail percentage =

Goods available for sale at cost / goods available for sale at retail

Inventory Estimation Techniques

Gross Profit Method Retail Inventory Method

What kind of companies use the retail inventory method?

High-volume retailers selling many different items at low unit prices

Dollar-Value LIFO Retail Method

If ending inventory exceeds beginning inventory then: - a new LIFO layer was added or - increase in retail price each layer year carries its unique retail price index and its unique cost-to-retail percentage

Additional Markup

Increase in selling price subsequent to initial markup

Purchase Commitment example: 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. When the market price is at least equal to the contract price

Inventory (contract price) 500,000 Cash (or accounts payable) 500,000

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. When market price is less than the contract price

Inventory (market price) 425,000 Loss on purchase commitment 75,000 Cash (or accounts payable) 500,000

Change in Inventory Methods

Most Inventory Changes: Retrospective Treatment: - revising comparative statements - affected accounts are adjusted - disclosure provides additional information Change to the LIFO Method - 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

Example of NRV: 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, what is the NRV?

NRV = ($10 - [10% of $10]) = $9

Gross Profit =

Net Sales - COGS

Inventory Errors

Over or understatement of ending inventory or purchases 1. mistakes in physical counting or pricing 2. cutoff errors

Markdown

Reduction in selling price below the original selling price

Gross Profit Method

Uses a cost of goods sold estimate and cost of goods available for sale to obtain an estimate of ending inventory Not acceptable according to GAAP for annual financial statements

Retail Inventory Method

Uses the cost-to-retail percentage based on a current relationship between cost and selling price

Usual Method of Calculation vs Gross Profit Method of Calculation

Usual Method: Beginning Inventory (from the accounting records) + Net Purchases (from records) = Goods Available for Sale - Ending Inventory (from a physical count) = Cost of Goods Sold Gross Profit Method: Beginning Inventory (from records) + Net Purchases (from records) = Goods Available for Sale - Cost of Goods Sold (estimated) = Ending Inventory (estimated)

The Bowden Company uses the retail inventory method. The following information is available for the year ended December 31, 2016: Cost Retail Inventory 1/1/16 $ 780,000 $ 1,300,000 Net purchases for the year 2,804,000 3,670,000 Net markups 150,000 Net markdowns 90,000 Net 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.

a. $954,784 Beginning Inventory 780,000 1,300,000 Plus: purchases 2,804,000 3,670,000 Mark ups 150,000 Less: Mark downs (90,000) Goods Avail. for Sale 3,584,000 5,030,000 Cost-to-retail % = 71.2525% Less: Net sales 3,690,000 Estimated End Inv @ Retail 1,340,000 Est. End Inv @ Cost $954,784

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.

c. $3 million decrease 50 mil - 55 mil = 5 mil decrease 5 mil x 40% = 2 mil increase (less taxes were taken out from the 5 mil decrease)

The records of Oregon Timber, Inc., revealed the following information related to inventory destroyed in a fire: Inventory, beginning of period $ 900,000 Purchases to date of fire 480,000 Net sales to date of fire 1,350,000 Gross 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.

c. $435,000 Explanation: $900,000 (beg inv) + $480,000 (purchases) - $945,000 (estimated cost of sales: $1,350,000 x 70%) = $435,000

The Bowden Company uses the retail inventory method. The following information is available for the year ended December 31, 2016: Cost Retail Inventory 1/1/16 $ 780,000 $ 1,300,000 Net purchases for the year 2,804,000 3,670,000 Net markups 150,000 Net markdowns 90,000 Net 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.

c. $938,000 Beginning Inventory $780,000 $1,300,000 Plus: Purchases 2,804,000 3,670,000 Net Markups 150,000 Cost-to-retail percentage: 70% Net Markdowns (90,000) Goods Avail. for Sale 3,584,000 5,030,000 Less: Net Sales (3,690,000) Est. End Inventory at Retail 1,340,000 Est. End Inventory at Cost *$938,000*

Initial Markup

original amount of markup from cost to selling price