Lecture Notes Ch. 9 Inventory PDF

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LECTURE NOTES: Inventory (Ch. 9)

Ch. 9: INVENTORY

At what value is inventory recorded on the balance sheet?  At initial recognition, inventory is recorded at: Historical cost, using a cost flow assumption such as LIFO, FIFO, Avg Cost, etc.  After initial recognition, a company may have to abandon the historical cost principle and write-down the value of its inventory. The two methods of recording an inventory write-down depend on which inventory costing method the company uses: o For companies using FIFO, average cost, or anything else other than LIFO or the retail inventory method: Inventory is stated at the Lower of Cost and Net Realizable Value (LCNRV) o For companies using LIFO or the retail inventory method:

Inventory is stated at the Lower of Cost or Market (LCM) Over time, inventory may lose value (obsoletion, perishables expire). Need to write inventory down when this occurs. Same thing, just the mechanics are slightly different

EXAMPLE 1: CASTLE BRANDS FINANCIAL STATEMENTS BALANCE SHEET (in part) March 31 2016 Inventories— net of allowance for obsolete and slow moving inventory of $331,008 and $267,557, respectively

27,233,322

___ 2015 21,068,241

NOTE 1 — SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (in part) Inventories — Inventories are comprised of distilled spirits, bulk wine, dry good raw materials (bottles, labels, corks and caps), packaging and finished goods, and are valued at the lower of cost or market, using the weighted average cost method. The Company assesses the valuation of its inventories and reduces the carrying value of those inventories that are obsolete or in excess of the Company’s forecasted usage to their estimated net realizable value. The Company estimates the net realizable value of such inventories based on analysesAnd assumptions including, but not limited to, historical usage, expected future demand and market requirements. A change to the carrying value of inventories is recorded in cost of goods sold. See Note 3. 1

LECTURE NOTES: Inventory (Ch. 9)

What is the logic for writing inventory down to net realizable value (or LCM)? In other words, why does this rule exist? To avoid reporting inventory at an amount greater than the benefits it can provide when sold. When should a company write-down its inventory? In the period the loss occurs – when the value of inventory drops below cost.

How do you determine the lower of cost and net realizable value (NRV)???? Compare the historical cost of inventory with “NRV,” where NRV is equal to… NRV = Estimated selling price – costs to complete/dispose/sell (“selling costs” or “disposal costs”) If historical cost is the lower value: (remains lower than NRV) Do nothing. Keep inventory at cost.

If NRV is the lower value: Journal entry is needed to write inventory down to NRV

Performing the Lower of Cost and NRV Test For financial reporting, companies can apply this test: (1) on an item-by-item (individual item) basis, each type of inventory (cost v. NRV) (2) on a categorical basis (i.e., apply the test to each category of inventory), or (i.e. product lines) (3) on a total inventory basis. (all types combined) Each approach is acceptable, but should be applied consistently from one period to the next. Some approaches will result in higher inventory value.

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LECTURE NOTES: Inventory (Ch. 9)

EXAMPLE 2.1: The Horton Company has five inventory items on hand at the end of 2016. The year-end unit costs (determined by applying the FIFO method), current unit sales prices, and the number of units on hand for each item as of December 31, 2016 are presented below. Selling costs are estimated to be 20% of the sales price. Item

Historical Cost

A B C D E

$ 70 100 75 80 85

Sales Price

Selling Costs

$ 100 120 85 95 110

$20 24 17 19 22

Number of Units on Hand

1,000 800 900 700 500

REQUIRED: Use the Lower of Cost and NRV rule on an individual item basis to determine the value of inventory that should be reported on the December 31, 2016 balance sheet. On the next page, repeat this analysis on a categorical basis, assuming that products A-B and CE represent inventory categories. Lastly, perform the analysis on a total inventory basis.

Individual Item Test *You need to figure out your Lower of Cost and NRV for each item (remember to extend!).

Item

NRV

Historical Cost

LCNRV

A

100 – 20 = 80

70

$70 x 1000 units = $70,000

B

120 – 24 = 96

100

$96 x 800 units = $76,800

C

85 – 17 = 68

75

$68 x 900 = $61,200

D

95 – 19 = 76

80

$76 x 700 = $53,200

E

110 – 22 = 88

85

$85 x 500 = $42,500

Total

$303,700 3

LECTURE NOTES: Inventory (Ch. 9)

EXAMPLE 2.2: Lower of cost and NRV applied at higher levels of aggregation (categorical and total inventory): The Lower of cost and NRV analysis on a categorical or total inventory basis is identical to the individual item basis, with two exceptions: 1.) Both NRV and Cost for each item must be extended by the number of units on hand 2.) You must determine the total NRV and the total Cost for the category as a whole before determining the Lower of Cost and NRV.

Categorical and Total Inventory Test Item

NRV

Historical Cost

A

80 x 1000 = 80,000 70 x 1000 = 70,000

B

96 x 80 = 76,800

Total (A+B) Categor y

C

150,000

68 x 900 = 61,200

75 x 900 = 67,500

D

76 x 700 = 53,200 80 x 700 = 56,000

E

88 x 500 = 44,000 85 x 500 = 42,500

Total

315,200

Lower of Cost and NRV (Total)

100 x 800 = 80,000

156,800

Total (C+D+E) 158,400 Categor y

Lower of Cost and NRV (Categorical)

150,000

166,000

158,400

316,000

308,400

315,200

Categorical Total Total: Assume all inventory makes up one giant category Why does applying Lower of Cost and NRV to groups of inventory (or total inventory) result in a higher inventory valuation? When we group items together, decrease in 4

LECTURE NOTES: Inventory (Ch. 9)

NRV of some items are offset by increase in NRV of other items. The more inventory is aggregated the higher the value becomes.

Once you have the Lower of Cost and NRV determination, what do you do with it? Companies perform these calculations to determine the appropriate inventory value to carry on the balance sheet: historical cost or NRV. If NRV is chosen as the lower value in your analyses, it means that it was lower than the historical cost of the inventory. Thus, you must WRITE DOWN your inventory (currently being carried at historical cost) to NRV. Journal Entry Amount = Historical Cost – LCNRV (difference between the two costs) If COST is chosen as the lower value: No journal entry because inventory is already stated at historical cost There are two ways to write down inventory to “market”: 1. Direct Method: Record the loss of value directly in COGS Dr. COGS CR. Inventory or Allowance for Inventory 2. Indirect Method: Treats the loss as special or unusual by recording it in a separate loss account. Dr. Loss on inventory write-down Cr. Inventory or Allowance for Inventory

The Direct Method treats the write-down of inventory as a common place event (lumped in with COGS), while the Indirect Method treats inventory write-downs as a more unusual operating expense that warrants its own line-item on the income statement.

Under U.S. GAAP, this write-down is considered permanent. If the inventory recovers its value prior to its sale, U.S. GAAP does not allow the item to be written back up. ***US GAAP-IFRS DIFFERENCE***

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LECTURE NOTES: Inventory (Ch. 9)

Under IFRS write-down must be reversed if new information suggests inventory is no longer impaired.

Refer back to Example 2: What journal entry would Horton’s need to make following its lower of cost and NRV analysis, assuming that Horton’s applies it on an individual item basis and uses the direct method to record write-downs? Historical Cost 316,000 LCNRV 303,700 12,300 Dr. Cogs 12,300 Cr. Inventory or Allowance for inventory **know for exam

12,300

What is the journal entry if Horton’s applies lower of cost and NRV on a categorical basis and uses the indirect method to record write-downs? Historical Cost 316,000 LCNRV 308,400 7,600 Dr. Loss on inventory write-down 7,600 Cr. Inventory or Allowance for inventory 7,600 Refer back to Castle Brands’ financial statements from Example 1… When Castle Brands records inventory write-downs, does it reduce the value of inventory directly or use an allowance account? Uses “allowance for obsolete and slow moving inventory” Does Castle Brands use the direct or indirect method to record inventory write-downs? Direct method – “recorded in COGS” What journal entry do you think Castle Brands made during the year ended 3/31/16 to write its inventory down to the lower of cost and NRV (assuming that the company did not write-off any of its allowance account due to disposal of obsolete inventory)? Allowance for Inventory 267,557 63,451( journal entry amount)

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LECTURE NOTES: Inventory (Ch. 9)

Dr. COGS Cr. Allowance for obsolete and slow moving inventory

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LECTURE NOTES: Inventory (Ch. 9)

What if a Company Uses LIFO or the Retail Inventory Method? In this case, we will use the "lower of cost or market" (LCM) rule. Rather than comparing cost to NRV, we'll compare cost to a "market" value. The market value will be the value that falls in the MIDDLE out of the following three alternatives: 1.) Replacement cost (always given) 2.) Net Realizable Value (you already know how to calculate this!) 3.) NRV less a normal profit margin (NP) (NP = some percentage of the selling price)

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LECTURE NOTES: Inventory (Ch. 9)

EXAMPLE 3.1: The Norton Company has five inventory items on hand at the end of 2016. The year-end unit costs (determined by applying the LIFO method), current unit selling prices, and estimated disposal (selling) costs for each of the items are presented below. The normal profit margin for each of the products is 20% of the selling price. Item

Historical Cost

A B C D E

Replacement Cost

$ 50 100 80 90 95

$ 55 90 70 37 92

Selling Price

$100 120 85 100 110

Estimated Disposal Costs

Normal Profit

$15 20 20 24 24

REQUIRED: Use the lower of cost or market rule on an individual item basis to determine the proper value for balance sheet reporting purposes for the inventory at December 31, 2016. Assume that the company has 1,000 units of each product on hand. Individual Item Test: Figure out your LCM for each item (remember to extend!). Ceiling (NRV)

Floor (NRV – NP)

Replacement Cost

Designated Market

(historical) Cost

D

76

56

37

56

90

56*1,000 = 56,000

E

86

64

92

86

95

86*1,000 = 86,000

Item

LCM

A

B

C

Total

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LECTURE NOTES: Inventory (Ch. 9)

EXAMPLE 3.2: LCM Application at higher levels of aggregation Now let's calculate the LCM on a categorical and total inventory basis.

Item

Designated Market

Historical Cost

LCM Categorical Basis

LCM Total Inventory Basis

A

B Total (A+B) Category

C

D

56*1,000 = 56,000

90*1,000 = 90,000

E

86*1,000 = 86,000

95*1,000 = 95,000

Total (C+D+E) Category Total

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LECTURE NOTES: Inventory (Ch. 9)

Lower of cost and NRV is a new rule adopted by the FASB in July 2015. It just became effective (i.e., companies must now start using this new rule) in 2017. The CPA exam starts testing the new standard 6 months later (i.e., mid-2017).

The Process of Changing an Accounting Standard (Brief Overview) What are some reasons the FASB decides to change a standard?

The Process (with lower of cost and NRV as an example): 1.) Issue an exposure draft (rough draft of standard) (Issued July 15, 2014) a. Posted to the FASB’s website http://www.fasb.org/jsp/FASB/Page/SectionPage&cid=1176157086783 2.) Get input from the public (comment letters) (Due Sept. 30, 2014) http://www.fasb.org/jsp/FASB/CommentLetter_C/CommentLetterPage&cid =1218220137090&project_id=2014-210 3.) Issue the final standard (and update the Codification) or drop the project (ASU No. 2015-11 Inventory (Topic 330) was issued in July 2015) http://www.fasb.org/jsp/FASB/Page/SectionPage&cid=1176156316498 4.) Standard becomes effective (i.e., companies start applying the new standard) (Becomes effective December 15, 2016) 5.) Appears on the CPA exam six months later (CPA exam started testing the lower of cost and NRV in June/July 2017)

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LECTURE NOTES: Inventory (Ch. 9)

INVENTORY COST FLOW ASSUMPTIONS REVISITED Inventory is initially stated at historical cost (and adjusted to NRV later if necessary). For historical cost to be exact, the company would have to track the exact cost associated with each item of inventory (i.e., specific identification). For many companies, this is not feasible, so they use a cost flow assumption. Recall the cost flow assumptions you learned in ACC 400:  Average Cost  First-In-First-Out (FIFO)  Last-In-First-Out (LIFO) We are going to cover two additional cost flow assumptions. The first is… DOLLAR-VALUE LIFO The primary benefit of using Dollar-Value LIFO rather than regular LIFO is…

What is LIFO liquidation and why is it a problem?  Recall that when using the LIFO assumption, the most recently purchased items (i.e., “last in”) are the first ones assumed to be sold (i.e., “first out”). If prices are increasing, then this means that LIFO will result in higher COGS and lower ending inventory compared to other methods. Managers choose this method if they want higher COGS and lower inventory.  LIFO liquidation is when:

This results in old, low-cost items being pushed into COGS, which means COGS is: ________________ than it would have been if not for the LIFO liquidation.

 LIFO liquidation is problematic for companies because:

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LECTURE NOTES: Inventory (Ch. 9)

Dollar-Value LIFO attempts to solve the LIFO liquidation issue by determining increases and decreases in the dollar-value for a POOL of goods (i.e., many similar products are grouped together), rather than specifically identifying the change in quantity for each product. Two benefits to using Dollar Value LIFO rather than regular LIFO: (1) It simplifies record-keeping because it doesn’t require tracking of individual units purchased. (2) It minimizes the probability of LIFO liquidations by aggregating different types of inventory into one pool.

How do you compute ending inventory using Dollar-Value LIFO? 1. Convert ending inventory valued at year-end costs to base-year cost.

Ending inventory at base-year cost =

where Price index = Note: the base-year price index is 1.0.

2. Identify the layers of inventory and the year in which each layer was created.

3. Adjust each layer from base-year cost back to its “current year” cost using the price index for the year the inventory layer was created.

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LECTURE NOTES: Inventory (Ch. 9)

EXAMPLE 4: DOLLAR VALUE LIFO PROBLEM Presented below is information for Jasmine Company, which began operations in 2010.

December 31, 2011 December 31, 2012 December 31, 2013 December 31, 2014 December 31, 2015 December 31, 2016

Ending Inventory (@ End of year prices) $80,000 115,500 108,000 123,500 159,500 90,000

Price Index 100% 105% 120% 130% 145% 150%

Required: 1. Compute the ending inventory for Jasmine for 2011 – 2016 using the Dollar-Value LIFO Method.

2.

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LECTURE NOTES: Inventory (Ch. 9)

Dollar Value LIFO Date of dollarvalue calculation

Inventory stated in current year costs

Price Index

Inventory stated in base-year costs

Increase (decrease)

Layers in Base-year costs

Layers adjusted back to current year costs

Dollar-Value LIFO Ending Inventory

12/31/2011

$80,000

1.00

$80,000

$80,000

$80,000

$80,000*1.0 = $80,000

$80,000

12/31/2012

115,500

108,000

12/31/2013

123,500

12/31/2014

12/31/2015

12/31/2016

159,500

90,000

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LECTURE NOTES: Inventory (Ch. 9)

RETAIL INVENTORY METHOD Method used by many retail companies (e.g., Target, Walmart, Home Depot) to estimate the value of ending inventory and COGS. Principal Benefit (and what makes it different than other cost flow assumptions):

There are several different ways that a company can apply the Retail Inventory Method. We will focus on the “Conventional Retail Method.” This is the most common variant of the Retail Method because it allows a company to approximate the lower of cost and NRV.

The Mechanics of the Retail Inventory Method Calculating ending inventory and COGS using the Retail Inventory Method is a bit complex, but it relies on several formulas with which you should already be familiar: Cost of Goods Available for Sale =

Net Purchases = COGS =

Ending Inventory =

All of the formulas above are based on cost (i.e., what the company paid). When using the Retail Inventory Method, some of these formulas are adjusted to reflect the retail value of these items (i.e., what they would sell for). For instance, the ending inventory formula above can be rewritten as follows: Ending Inventory (at retail) = Once we know ending inventory (at retail), all we need to do is adjust it to a cost basis, and we’re left with the value of ending inventory that should appear on the balance sheet. We can make this adjustment from retail to cost using the cost-to-retail percentage: Cost-to-Retail Percentage = 16

LECTURE NOTES: Inventory (Ch. 9)

EXAMPLE 5: CONVENTIONAL RETAIL METHOD (Illustration 9-10 from your book) Home Improvement Stores, Inc. uses a periodic inventory system and the conventional retail method to estimate ending inventory and cost of goods sold. The following data are available from the company’s records for the first quarter of 2016.

Cost Beginning inventory on 1/01/2016 $160,000 Net Purchases during Q1 Net Markups during Q1 10,000 Net Markdowns during Q1 8,000 Net Sales during Q1

Retail $99,200

305,280

470,000

434,000

Estimate ending inventory and cost of goods sold for the first quarter of 2016.

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