CHAPTER 9

INVENTORIES:ADDITIONAL ISSUES

Sommers – ACCT 3311

Retail Inventory Method

Explain the retail inventory method of estimating ending inventory.

Inventory Notation

BeginningBalance

Cost of Goods Available for Sale

Cost of Goods Sold

EndingBalance

Purchases

? ?

Introduction to Conventional Retail Method

Smith-Kline Company maintains inventory records at selling prices as well as at cost. For 2011, the records indicate the following data:

Cost Retail

Beginning inventory $ 80 $ 125

Purchases 671 1,006

Freight-in on purchases 30

Purchase returns 1 2

Net markups 4

Net markdowns 8

Net sales 916

Use the conventional retail method to approximate cost of ending inventory.

Introduction to Conventional Retail Method

Cost Retail

Beginning inventory $ 80 $ 125

Purchases 671 1,006

Freight-in on purchases 30

Purchase returns (1) (2)

Net markups 4

Goods available for sale 780 1,133

Cost-to-retail percentages:

Conventional cost ratio: $780 / $1,133 = 68.84%

Deduct: Net sales (916)

Net markdowns (8)

Ending inventory at retail $ 209

Ending inv at cost ($209 x 68.84%) $144

Example 4: Conventional Retail Method

Sparrow Company uses the retail inventory method to estimate ending inventory and cost of goods sold. Data for 2011 are as follows:

Cost RetailBeginning inventory $ 90,000 $180,000Purchases 355,000 580,000Freight-in 9,000Purchase returns 7,000 11,000Net markups 16,000Net markdowns 12,000Normal spoilage 3,000Abnormal spoilage 4,800 8,000Sales 540,000Sales returns 10,000

The company records sales net of employee discounts. Discounts for 2011 totaled $4,000. Estimate Sparrow’s ending inventory and cost of goods sold for the year using the conventional retail inventory method

Example 4: Conventional

  Cost RetailBeginning inventory Plus: Purchases

Freight-in Less:Purchase returns Plus: Net markups Less: Abnormal spoilage

Cost-to-retail percentage:Less:Net markdownsGoods available for sale

Normal spoilage Sales: Net sales Employee discounts

Estimated ending inventory at retail Estimated ending inventory at cost

Estimated cost of goods sold

Inventory Disclosures (CVS from MD&A)

Inventory

Our inventory is stated at the lower of cost or market on a first-in, first-out basis using the retail method of accounting to determine cost of sales and inventory in our CVS/pharmacy stores, weighted average cost to determine cost of sales and inventory in our mail service and specialty pharmacies and the cost method of accounting on a first-in, first-out basis to determine inventory in our distribution centers. Under the retail method, inventory is stated at cost, which is determined by applying a cost-to-retail ratio to the ending retail value of our inventory. Since the retail value of our inventory is adjusted on a regular basis to reflect current market conditions, our carrying value should approximate the lower of cost or market. In addition, we reduce the value of our ending inventory for estimated inventory losses that have occurred during the interim period between physical inventory counts.

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.

Example 5: LIFO Retail Inventory

Crosby Company owns a chain of hardware stores throughout the state. The company 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 three months ending March 31, 2011:

Cost Retail

Beginning inventory $ 160,000 $ 280,000

Net purchases 607,760 840,000

Net markups 20,000

Net markdowns 4,000

Net sales 800,000

Estimate the LIFO cost of ending inventory and cost of goods sold for the three months ending March 31, 2011. Assume stable retail prices during the period.

Example 5: Continued

  Cost RetailBeginning inventory Plus: Net purchases

Net markups Less:Net markdowns Goods available for sale (excl. beg. Inventory)Cost-to-retail percentage:Goods available for sale (incl. beg. Inventory)Less:Net sales Estimated ending inventory at retail Estimated ending inventory at cost: Retail CostBeginning inventoryCurrent period’s layer Total Estimated cost of goods sold

Inventory Disclosures (Walmart from MD&A)

Inventories

The Company values inventories at the lower of cost or market as determined primarily by the retail method of accounting, using the last-in, first-out (“LIFO”) method for substantially all of the Walmart U.S. segment’s merchandise inventories. The retail method of accounting results in inventory being valued at the lower of cost or market since permanent markdowns are currently taken as a reduction of the retail value of inventory. The Sam’s Club segment’s merchandise is valued based on the weighted-average cost using the LIFO method. Inventories for the Walmart International operations are primarily valued by the retail method of accounting and are stated using the first-in, first-out (“FIFO”) method. At January 31, 2011 and 2010, our inventories valued at LIFO approximated those inventories as if they were valued at FIFO.

Inventory Disclosures (Walmart from MD&A)Inventories (Continued)

Under the retail method, inventory is stated at cost, which is determined by applying a cost-to-retail ratio to each merchandise grouping’s retail value. The FIFO cost-to-retail ratio is based on the initial margin of beginning inventory plus the fiscal year purchase activity. The cost-to-retail ratio for measuring any LIFO reserves is based on the initial margin of the fiscal year purchase activity less the impact of any markdowns. The retail method requires management to make certain judgments and estimates that may significantly impact the ending inventory valuation at cost, as well as the amount of gross profit recognized. Judgments made include recording markdowns used to sell through inventory and shrinkage. When management determines the salability of inventory has diminished, markdowns for clearance activity and the related cost impact are recorded at the time the price change decision is made. Factors considered in the determination of markdowns include current and anticipated demand, customer preferences and age of merchandise, as well as seasonal and fashion trends. Changes in weather patterns and customer preferences related to fashion trends could cause material changes in the amount and timing of markdowns from year to year.

Dollar-Value LIFO Retail

• We need to eliminate the effect of any price changes before we compare the ending inventory with the beginning inventory.

Example 6: Dollar-Value LIFO Retail Method

Smith-Kline Company maintains inventory records at selling prices as well as at cost. For 2011, the records indicate the following data: Cost Retail

Beginning inventory $ 80 $ 125Purchases 671 1,006Freight-in on purchases 30Purchase returns 1 2Net markups 4Net markdowns 8Net sales 916

Assuming the price level increased from 1.00 at January 1 to 1.10 at December 31, 2011, use the dollar-value LIFO retail method to approximate cost of ending inventory and cost of goods sold.

Example 6: Continued

  Cost RetailBeginning inventory Plus: Purchases

Freight-in Net markups

Less: Purchase returns Net markdowns

Goods available for sale (exclud beg inv) Goods available for sale (includ beg inv) Base layer cost-to-retail %:2011 layer cost-to-retail %:Less: Net sales Estimated ending inv at current year retail prices

Example 6: Continued

Cost of goods available for sale (including beginning inventory)

Less estimated ending inventory at cost

Estimated cost of goods sold

Ending Inventory at

Year-end Retail Prices

Step 1: Ending Inventory at Base Year Retail Prices

Step 2: Inventory Layers at Base Year

Retail Prices

Step 3: Inventory

Layers Converted to

Cost

Widely used for the following reasons:

(1) To permit the computation of net income without a physical count of inventory.

(2) Control measure in determining inventory shortages.

(3) Regulating quantities of merchandise on hand.

(4) Insurance information.

Some companies refine the retail method by computing inventory separately by departments or class of merchandise with similar gross profits.

Evaluation of Retail Inventory Method

RELEVANT FACTS - Similarities

IFRS and GAAP account for inventory acquisitions at historical cost and evaluate inventory for lower-of-cost-or-market subsequent to acquisition.

Who owns the goods—goods in transit, consigned goods, special sales agreements—as well as the costs to include in inventory are essentially accounted for the same under IFRS and GAAP.

IFRS

RELEVANT FACTS - Differences

The requirements for accounting for and reporting inventories are more principles-based under IFRS. That is, GAAP provides more detailed guidelines in inventory accounting.

A major difference between IFRS and GAAP relates to the LIFO cost flow assumption. GAAP permits the use of LIFO for inventory valuation. IFRS prohibits its use. FIFO and average-cost are the only two acceptable cost flow assumptions permitted under IFRS. Both sets of standards permit specific identification where appropriate.

In the lower-of-cost-or-market test for inventory valuation, IFRS defines market as net realizable value. GAAP, on the other hand, defines market as replacement cost subject to the constraints of net realizable value (the ceiling) and net realizable value less a normal markup (the floor). IFRS does not use a ceiling or a floor to determine market.

IFRS

RELEVANT FACTS - Differences

Under GAAP, if inventory is written down under the lower-of-cost-or-market valuation, the new basis is now considered its cost. As a result, the inventory may not be written back up to its original cost in a subsequent period. Under IFRS, the write-down may be reversed in a subsequent period up to the amount of the previous write-down. Both the write-down and any subsequent reversal should be reported on the income statement.

IFRS requires both biological assets and agricultural produce at the point of harvest to be reported at net realizable value. GAAP does not require companies to account for all biological assets in the same way. Furthermore, these assets generally are not reported at net realizable value. Disclosure requirements also differ between the two sets of standards.

IFRS

LIFO to FIFO Conversion – Dow Chemical

LIFO FIFO