ACC 313 Chapter 8

Knight, Creighton University

lower-of-cost-or-market (LCM)

inventory is stated at either the lowest of its cost (determined by inventory valuation method) or its market value (replacement cost)

cost

the cost of an inventory item as determined by the inventory valuation method being used

what is the market for LIFO and the retail inventory method?

the replacement cost of an inventory item

ceiling of market price

the market cannot be higher than the net realizable value of an inventory item

(ceiling = NRV)

computation of net realizable value (NRV)

selling price - cost to put inventory item in a saleable condition

floor of market price

the market cannot be lower than NRV less the normal markup for an inventory item

(floor = NRV - markup)

what if the replacement cost of an item is greater than its ceiling?

the market is the ceiling

what is the replacement cost of an item is less than its floor?

the market is the floor

the market is always the middle number between…

replacement cost, the ceiling, and the floor

what is the market for FIFO, average cost, and specific identification?

an item’s NRV

(NRV = selling price - cost to put inventory item in a saleable condition)

how can LCM be applied to inventory?

• item-by-item → most conservative approach

• by inventory groups

• by total inventory → least conservative approach

entry to record inventory at market when it is below cost:

Db. loss from inventory price decline

Cr. merchandise inventory [inventory units on hand x (cost - market)]

how is “loss from inventory price decline” reported?

on the income statement in “other income-other expense”

what happens to the cost of inventory when it is written down to “market”?

the “market” becomes the new cost (carrying value); cannot be written back up if it ever recovers in value

what is the theoretical justification for the LCM rule?

conservatism

are companies required to apply the LCM rule to inventory?

yes, even if a company believes a price decline is temporary

what problem in reporting arises if inventory is written down to “market” and later sold at a sales price that has not been reduced?

artificially high gross profit → can mislead investors and creditors

who is an exception to the LCM rule?

industries that record revenue on its inventory before it’s sold → inventory is recorded at NRV and is not required to be reported at LCM (ex. agriculture, mining)

why are inventory estimation methods needed?

1. for companies that maintain periodic inventory systems

2. needed for interim or end-of-fiscal-year statements

3. needed in case of casualty losses, insurance claims, or recording income statement losses

4. estimation is compared with physical count (internal control purposes)

what are the inventory estimation methods?

• gross profit method

• conventional retail method

gross profit method

an inventory estimation method based on the relationship of gross profit to sales; used only with a periodic inventory system

conventional retail method

an inventory estimation method where a cost percentage is used; converts ending inventory at retail to ending inventory at cost; used only with a periodic inventory system

lower-of-average-cost-or-market approach - conventional retail method

ending inventory @ retail x (goods available for sale [@ cost] / goods available for sale adjusted for net markups [@ retail])

average cost approach - conventional retail method

ending inventory @ retail x (goods available for sale [@ cost] / goods available for sale adjusted for net markups and markdowns [@ retail])

conventional retail method vs. gross profit method

• all information used in gross profit method is given → relatively easy estimation method

• conventional retail method requires special information that isn’t available to companies unless thy use the retail method for inventory valuation

• conventional retail method is more expensive to maintain but is more accurate

when is it acceptable to use the conventional retail estimation method?

at interim dates and at the end of a fiscal accounting period

when is it acceptable to use the gross profit estimation method?

only at interim dates

what are some companies that value inventory at NRV?

• precious metal mining companies

• meat-packing companies

• agricultural firms

theoretical reasons for inventory valuation at NRV

• if there is an active market and set price → determining NRV is not difficult

• a buyer doesn’t need to be found since there is a constant market → revenue is “realizable”

• since revenue is “realizable”, it is “earned” snd should be recorded, even if a sale is not yet made

practical reasons for inventory valuation at NRV

• determining the value of ending inventory is too complicated for some industries

• ease of NRV computation overrules any theoretical negatives (materiality)

relative sales value method

done when a group of varying units is acquired at a single lump-sum price; the cost of the acquisition is allocated to the varying units based on their relative sales values

steps of the relative sales value method

1. # of units x sales price = total sales price

2. compute each sales price as a % of the total sales price

3. % of total sales price x total acquisition cost = amount of acquisition cost allocated

4. amount of acquisition cost allocated / # of units = cost per unit

gross profit as a % of sales

most likely a % of net sales; the most common way of stating gross profit percentage

gross profit as a % of costs

reported as a % of “cost of goods sold”

equation to change gross profit as a % of sales to gross profit as a % of costs

stated % / (100% - stated %)

equation to change gross profit as a % of costs to gross profit as a % of sales

stated % / (100% + stated %)

merchandise inventory turnover

computation: COGS / (average merchandise inventory)

measured in: times

measures: operating efficiency

days in merchandise inventory

computation: 365 / merchandise inventory turnover

measured in: days

measures: operating eficiency

what are the disclosure requirements of merchandise inventory?

• inventory methods being used

• breakdown of inventory items (WIP, FGI, raw materials)

• unusual or significant financing arrangements

• inventories may be disclosed on a current value or constant-dollar basis (no longer required)

what are unusual or significant financing arrangements for merchandise inventory? (these must be disclosed)

• related party transactions

• product financing arrangements

• firm purchase commitments

• involuntary liquidation of LIFO

• pledging of inventory as collateral