Class 5 Lower Cost or Market Lower of

Class 5 Lower Cost or Market

Lower of Cost or Market (LCM) 1 GAAP requires that inventories be carried at cost or current market value, whichever is lower. LCM is a departure from historical cost and is a conservative accounting method. 1 FASC 330 -10 -35 -1

Determining Market Value • Market value is NOT necessarily the amount for which inventory can be sold. • FASC 330 -10 -35 -3 defines “market value” in terms of current replacement cost. Net Realizable Value (nrv) Net Realizable Value less Normal Profit (nrv-np)

Determining Market Value Net Realizable Value (NRV) is the estimated selling price less cost of completion and disposal. Net Realizable Value (nrv) Replacement Cost FASC 330 -10 -35 -5 “when the evidence The definition of market indicates that cost will be recovered with an value varies Netnormal Realizable Value approximately profit upon sale in the internationally. In many ordinary course of business, loss shall less Normalno. Profit countries market value isbe recognized even though replacement or (nrv-np) reproduction costs are lower. ” defined as NRV.

Determining Market Value If replacement cost > nrv, then nrv = Market Value Net Realizable Value (nrv) Replacement Cost If replacement cost < nrv-np, then nrv-np = Market Value Net Realizable Value less Normal Profit (nrv-np)

Lower of Cost or Market • An item in inventory is currently carried at historical cost of $20 per unit. At year-end we gather the following per unit information: – – current replacement cost = $21. 50 selling price = $30 cost to complete and dispose = $4 normal profit margin of = $5 • How would we value this item in the Balance Sheet?

Lower of Cost or Market Net Realizable Value (nrv) Replacement Cost =$21. 50 Which one do we use? Net Realizable Value less Normal Profit (nrv-np)

Lower of Cost or Market In this case, market value will be $21. 50 because the replacement cost is between the nrv and the nrv-np. Net Realizable Value (nrv) Replacement Cost =$21. 50 Market value = $21. 50 Cost = $20. 00 Since Should Costthe < Market, inventory thebe LCM rule recorded would dictate at costthat or market? inventory be recorded at Cost. Net Realizable Value less Normal Profit (nrv-np)

Lower of Cost or Market An inventory item is currently carried at historical cost of $95. 00 per unit. At the Balance Sheet date we gather the following per unit information: current replacement cost = $80. 00 NRV = $100. 00 NRV reduced by normal profit = $85. 00 How would we value the item on our Balance Sheet?

Lower of Cost or Market Net Realizable Value (nrv) = $100 ? Which one do we use as market value? ? Replacement Cost =$80 ? Net Realizable Value less Normal Profit (nrv-np) = $85

Lower of Cost or Market Net Realizable Value (nrv) = $100 Should the inventory be carried at Market Value or Cost? Replacement Cost =$80 Market = $85 < Cost = $95 Net Realizable Value less Normal Profit (nrv-np) = $85 Our inventory item will be written down to the Market Value $85.

Applying Lower of Cost or Market Lower of cost or market can be applied 3 different ways. 1. 3. Apply 2. Apply LCM to each the toentire each individual class inventory item of as in inventory. a group.

9 -13 Adjusting Cost to Market 1. Record the loss as a separate item in the income statement Loss on write-down of inventory Inventory 2. XX XX Record the loss as part of cost of goods sold. Cost of goods sold Inventory XX XX

BE 9 -1 • Ross Electronics has one product in its ending inventory. Per unit data consist of the following: cost, $20; replacement cost, $18; selling price, $30; disposal costs, $4. The normal profit margin is 30% of selling price. What unit value should Ross use when applying the LCM rule to ending inventory?

BE 9 -1 • • Cost = $20 NRV = $30 - 4 = $26 NRV – NP = $26 – (30% x $30) = $17 RC = $18 • The designated market is the middle value of NRV, NRV-NP, and RC, which is $18. Since this is lower than the cost of $20, the unit value is $18.

BE 9 -2 • SLR Corporation has 1, 000 units of each of its two products in its year-end inventory. Per unit data for each of the products are as follows: Determine the balance sheet carrying value of SLR’s inventory assuming that the LCM rule is applied to individual products. What is the before-tax income effect of the LCM adjustment?

BE 9 -2 * Selling price less disposal costs. ** NRV less normal profit margin

BE 9 -2 • Cost LCM • Product 1 (1, 000 u) $50, 000 • Product 2 (1, 000 u) 30, 000 26, 000 • Cost $80, 000 • LCM value $76, 000 • Before-tax income will be lower by $4, 000, the amount of the required inventory writedown.

9 -19 U. S. GAAP vs. IFRS International and U. S. standards for valuing inventory at the lower of cost or market are slightly different. • • Inventory is valued at the lower of cost or market with market selected from replacement cost, net realizable value or NRV reduced by the normal profit margin. Designated market is compared to historical cost to determine LCM. The LCM rule can be applied to individual items, logical inventory categories, or the entire inventory. Reversals are not permitted. • • • Inventory is valued at the lower or cost of market and net realizable value. The assessment usually is applied to individual items, although using logical inventory categories is allowed under certain circumstances. If an inventory write-down is no longer appropriate, it must be reversed.

9 -20 Inventory Estimation Techniques Estimate 1. 2. instead of taking physical inventory Less costly Less time-consuming Two popular methods of estimating ending inventory are the. . . 1. 2. Gross profit method Retail inventory method

9 -21 Gross Profit Method Estimating inventory and COGS for interim reports. Auditors in testing the overall reasonableness of client inventories. Useful when. . . Determining the cost of inventory lost, destroyed, or stolen. Preparing budgets and forecasts. NOTE: The gross profit method is not acceptable for use in annual financial statements.

9 -22 Gross Profit Method This method assumes that the historical gross margin ratio is reasonably constant in the short-run. Beginning Inventory Plus: Net purchases Goods available for sale Less: Cost of goods sold Ending inventory (from accounting records) (calculated) (estimated) Estimate the Gross Profit Ratio

9 -23 Gross Profit Method Matrix Inc. uses the gross profit method to estimate end of month inventory. At the end of May, the controller has the following data: 1. 2. 3. 4. Net sales for May = $1, 213, 000 Net purchases for May = $728, 300 Inventory at May 1 = $237, 400 Estimated gross profit ratio = 43% of sales Estimate Inventory at May 31.

9 -24 Gross Profit Method NOTE: The key to successfully applying this method is a reliable gross profit ratio.

9 -25 The Retail Inventory Method This method was developed for retail operations like department stores. Uses both the retail value and cost of items for sale to calculate a cost to retail percentage. Objective: Convert ending inventory at retail to ending inventory at cost.

9 -26 The Retail Inventory Method Retail Terminology Term Initial markup Additional markup Markup cancellation Markdown cancellation Meaning Original amount of markup from cost to selling price. Increase in selling price subsequent to initial markup. Elimination of an additional markup. Reduction in selling price below the original selling price. Elimination of a markdown.

9 -27 Retail Terminology An Example of the Terminology

9 -28 The Retail Inventory Method Beginning inventory at retail and cost. Sales for the period. We need to know. . . Net purchases at retail and cost. Adjustments to the original retail price.

9 -29 The Retail Inventory Method Matrix Inc. uses the retail method to estimate inventory at the end of each month. For the month of May the controller gathers the following information: 1) Beginning inventory at cost $27, 000 (at retail $45, 000) 2) Net purchases at cost $180, 000 (at retail $300, 000) 3) Net sales for May $310, 000 Estimate the inventory at May 31.

9 -30 The Retail Inventory Method

9 -31 The Retail Inventory Method × x

Retail Inventory Method Markups and Markdowns Matrix Inc. uses the retail method to estimate inventory at the end of July. The controller gathers the following information: • Beginning inventory at cost $21, 000 (at retail $35, 000) • Net purchases at cost $200, 000 (at retail $304, 000) • Net markups $8, 000 • Net markdowns $4, 000 • Net sales for July $300, 000 Estimate inventory at July 31. 9 -32

Conventional Retail Method: Markups and Markdowns 9 -33

Conventional Retail Method: Markups and Markdowns 9 -34

Conventional Retail Method: Markups and Markdowns 9 -35

Conventional Retail Method: Markups and Markdowns $43, 000 × 63. 69% = $27, 387 9 -36

9 -37 Changes in Inventory Method Recall that most voluntary changes in accounting principles are reported retrospectively This means reporting all previous periods’ financial statements as though the new method had been used in all prior periods. Changes in inventory methods, other than a change to LIFO, are treated retrospectively.

9 -38 Change to the LIFO Method When a company elects to change to LIFO, it is usually impossible to calculate the income effect on prior years. As a result, the company does not report the change retrospectively. Instead, the LIFO method is used from the point of adoption forward. A disclosure note is needed to explain (a) the nature of the change, (b) the effect of the change on current year’s income and earnings per share, and (c) why retrospective application was impracticable.

9 -39 Inventory Errors When analyzing inventory errors, it’s helpful to visualize the way cost of goods sold, net income, and retained earnings are determined.

9 -40 Inventory Errors ◦ ◦ Overstatement of ending inventory Understates cost of goods sold and Overstates pretax income. Understatement of ending inventory Overstates cost of goods sold and Understates pretax income.

9 -41 Inventory Errors Overstatement of beginning ◦ Overstates cost of goods sold and ◦ Understates pretax income. inventory Understatement of beginning ◦ Understates cost of goods sold and ◦ Overstates pretax income. inventory

9 -42 Inventory Errors When the Inventory Error is Discovered the Following Year If an error was made in 2013, but not discovered until 2014, the 2013 financial statements were incorrect as a result of the error. The error should be retrospectively restated to reflect the correct inventory amount, cost of goods sold, net income, and retained earnings when the comparative 2014 and 2013 financial statements are issued for 2014. When the Inventory Error is Discovered Subsequent to the Following Year If an error was made in 2013, but not discovered until 2015, all previous years’ financial statements that were incorrect as a result of the error also are retrospectively restated to reflect the correct inventory, cost of goods sold, retained earnings, and net income even though no correcting entry is needed in 2015. The error has self-corrected and no prior period adjustment is needed.

9 -43 BE 9 -6 Kiddie World uses a periodic inventory system and the retail inventory method to estimate ending inventory and cost of goods sold. The following data are available for the quarter ending September 30, 2013: Estimate ending inventory and cost of goods sold (average cost).

9 -44

9 -45 Brief Exercise 9 -14 In 2013, Winslow International, Inc. ’s controller discovered that ending inventories for 2011 and 2012 were overstated by $200, 000 and $500, 000, respectively. Determine the effect of the errors on retained earnings at January 1, 2013. (Ignore income taxes. )

9 -46 Brief Exercise 9 -14 This is a timing error. The 2011 error caused 2011 net income to be overstated, but since 2011 ending inventory is 2012 beginning inventory, 2012 net income was understated the same amount. So, the income statement was misstated for 2011 and 2012, but the balance sheet (retained earnings) was incorrect only for 2011. After that, no account balances are incorrect due to the 2011 error.

9 -47 BE 9 -14 Analysis: U = Understated O = Overstated 2011 Beginning inventory 2012 ® Plus: net purchases Less: ending inventory Cost of goods sold Revenues Less: cost of goods sold Less: other expenses Net income O U U O â Retained earnings Beginning inventory O Plus: net purchases Less: ending inventory Cost of goods sold O Revenues Less: cost of goods sold Less: other expenses Net income O U â O Retained earnings corrected

9 -48 BE 9 -14 However, the 2010 error has not yet self-corrected. Both retained earnings and inventory still are overstated as a result of the second error. Analysis: O = Overstated U = Understated 2012 ® Beginning inventory Plus: net purchases Less: ending inventory Cost of goods sold Revenues Less: cost of goods sold Less: other expenses Net income O U U O â Retained earnings O Retained earnings on January 1, 2011, in this case, would be overstated by $500, 000 (ignoring income taxes).

9 -49 Brief Exercise 9 -12 In 2013, Hopyard Lumber changed its inventory method from LIFO to FIFO. Inventory at the end of 2012 of $127, 000 would have been $145, 000 if FIFO had been used. Inventory at the end of 2013 is $162, 000 using the new FIFO method but would have been $151, 000 if the company had continued to use LIFO. Describe the steps Hopyard should take to report this change. What is the effect of the change on 2013 cost of goods sold?

9 -50 Brief Exercise 9 -12 Apply the FIFO method retrospectively; to all prior periods reported in the annual report; as if it always had used that method. 2013 cost of goods sold is $7, 000 higher than it would have been if the company did not switch to FIFO. This is because beginning inventory is $18, 000 higher ($145, 000 – 127, 000) and ending inventory is $11, 000 higher ($162, 000 – 151, 000). So gross profit will be $7, 000 higher.