5. Valuing Inventory at LCM/NRV and Analyzing Inventory Errors

What does LCM stand for?

lower cost or market

What does NRV stand for?

net realizable value

What happens after companies apply one of four costing methods?

Inventory is reviewed to ensure it is reported at the lower of cost or market (LCM) or the lower of cost or net realizable value (LCNRV)

When inventory value is lower than inventory cost we must…

adjust the inventory balance downward.

When inventory value is higher than inventory cost…

no adjustment is made.

When inventory value (market) is lower than inventory cost, we must adjust the inventory balance downward. When inventory value is higher than inventory cost, no adjustment is made. If the company is using LIFO what is this process referred to as?

As reporting inventory at the lower of cost or market.

What is market value?

The replacement cost of inventory.

To determine whether inventory value is lower than inventory cost, we look at…

each individual inventory item separately.

With the increasing use of technology and inventory tracking, companies increasingly evaluate,,,

each item separately. This method yields the lowest inventory.

Review example at end of the section Computing the Lower of Cost or Market

When a company uses FIFO, Weighted Average, or Specific Identification, and when inventory value is lower than inventory cost what happens?

We adjust the inventory balance downward by reporting inventory at the lower of cost or net realizable value.

How to you calculate net realizable value (NRV)?

net realizable value = sales price - selling costs

Review

Similar to LCM, we look at each individual inventory item separately to determine whether inventory value is lower than inventory cost. However, instead of comparing Cost to "Market", we compare cost to "NRV".

Is FIFO or LIFO popular among publicly traded companies?

FIFO

Is FIFO or LIFO popular among smaller companies?

LIFO

When is inventory adjusted downward?

when total "LCM applied to items" (or "LCNRV Applied to Items") is less than the total cost of inventory

Review example under Adjusting Inventory Section

Review Need-To-Know 6-3

What does an inventory error cause misstatements in?

Cost of goods sold, gross profit, net income, current assets, and equity. It also causes misstatements in the next period's statements because ending inventory of one period is the beginning inventory of the next.

What is the equation for cost of goods sold?

Cost of goods sold = Beginning inventory + net purchases - ending inventory

When the ending inventory is understated is cost of goods sold and net income overstated or understated?

cost of goods sold is overstated, net income is understated

Review: This makes sense because the formula for net income = gross profit - expenses. The formula for gross profit = net sales - cost of goods sold. So if cost of goods sold is overstated, then gross profit is a smaller number and so is net income since gross profit is used in the calculation for net income.

When the ending inventory is understated why is cost of goods sold overstated?

Since the ending inventory is smaller than it should be this can be seen as selling more goods so cost of goods sold is overstated.

When the ending inventory is understated why is net income understated?

Since the ending inventory is smaller this can be seen as selling more goods so cost of goods sold is overstated (higher number). Net income is calculated by doing sales - cost of goods sold - expenses so the higher the cost of goods sold the lower the net income. So net income is understated.

Understated ending inventory for Year 1 becomes what in Year 2?

an understated beginning inventory for Year 2.

If the beginning inventory is understated, is cost of goods sold understated or overstated and why?

Cost of goods sold is understated because we are starting with a smaller amount.

If the beginning inventory is understated, is net income understated or overstated and why?

Net income is overstated because a lower cost of goods sold yields a higher income.

When the ending inventory is overstated is cost of goods sold and net income overstated or understated?

cost of goods sold is understated, net income is overstated

When the ending inventory is overstated why is the cost of goods sold understated and net income overstated?

Cost of goods sold is understated because there is more ending inventory so less goods are sold. A lower cost of goods sold yields a higher income.

If the beginning inventory is overstated is cost of goods sold and net income overstated or understated?

Cost of goods sold is overstated and net income is understated.

When the beginning inventory is overstated why is cost of goods sold overstated?

Cost of goods sold is overstated because we are beginning with a larger amount.

When the beginning inventory is overstated why is net income understated?

An overstated beginning inventory means a higher cost of goods sold. A higher cost of goods sold means a lower net income.

Review Inventory Error Example under Financial Statement Effects of Inventory Errors.

Understating ending inventory understates… (balance sheet)

both current and total assets.

An understatement in ending inventory also yields an understatement in… (balance sheet)

equity because of the understatement in net income.

How does an overstatement in ending inventory affect assets and equity?

It causes an overstatement in assets and in equity.

Review Need-To-Know 6-4