Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Inventories: Additional Issues 9 9-2 Learning Objective Understand and apply the lower-of-cost- or-market rule used to value inventories. 9-3 Lower of Cost or Market (LCM) GAAP requires that inventories be carried at cost or current market value, whichever is lower. GAAP requires that inventories be carried at cost or current market value, whichever is lower. LCM is a departure from historical cost LCM is a departure from historical cost and is a conservative accounting and is a conservative accounting method. method. LCM is a departure from historical cost LCM is a departure from historical cost and is a conservative accounting and is a conservative accounting method. method. 9-4 Determining Market Value Net Realizable Value (Ceiling) Net Realizable Value less Normal Profit (Floor) Market value is NOT Market value is NOT necessarily the necessarily the amount for which amount for which inventory can be inventory can be sold. sold. Accounting Accounting Research Bulletin Research Bulletin No. 43 defines No. 43 defines “market value” in “market value” in terms of current terms of current replacement cost. replacement cost. Market value is NOT Market value is NOT necessarily the necessarily the amount for which amount for which inventory can be inventory can be sold. sold. Accounting Accounting Research Bulletin Research Bulletin No. 43 defines No. 43 defines “market value” in “market value” in terms of current terms of current replacement cost. replacement cost. 9-5 Determining Market Value Net Realizable Value (Ceiling) Net Realizable Value less Normal Profit (Floor) Net Realizable Value (NRV) is the estimated selling price less cost of completion and disposal. Net Realizable Value (NRV) is the estimated selling price less cost of completion and disposal. Replacement Cost Replacement Cost The definition of The definition of market market value value varies varies internationally. In many internationally. In many countries, for example countries, for example New Zealand market value New Zealand market value is defined as NRV. is defined as NRV. The definition of The definition of market market value value varies varies internationally. In many internationally. In many countries, for example countries, for example New Zealand market value New Zealand market value is defined as NRV. is defined as NRV. 9-6 Determining Market Value Net Realizable Value less Normal Profit (Floor) Net Realizable Value (Ceiling) If replacement cost > Ceiling, then Ceiling = Market Value Replacement Cost Replacement Cost If replacement cost < Floor, then Floor = Market Value 9-7 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 current replacement cost = $21.50 selling price = $30 selling price = $30 cost to complete and dispose = $4 cost to complete and dispose = $4 normal profit margin of = $5 normal profit margin of = $5 How would we value this item in the Balance Sheet? 9-8 Lower of Cost or Market Net Realizable Value (Ceiling) Net Realizable Value less Normal Profit (Floor) Replacement Cost =$21.50 Replacement Cost =$21.50 Which one do we use? 9-9 Market value = $21.50 Market value = $21.50 Cost = $20.00 Cost = $20.00 Should the inventory be Should the inventory be recorded at cost or market? recorded at cost or market? Market value = $21.50 Market value = $21.50 Cost = $20.00 Cost = $20.00 Should the inventory be Should the inventory be recorded at cost or market? recorded at cost or market? Market value = $21.50 Market value = $21.50 Cost = $20.00 Cost = $20.00 Since Cost < Market, the LCM Since Cost < Market, the LCM rule would dictate that inventory rule would dictate that inventory be recorded at Cost. be recorded at Cost. Market value = $21.50 Market value = $21.50 Cost = $20.00 Cost = $20.00 Since Cost < Market, the LCM Since Cost < Market, the LCM rule would dictate that inventory rule would dictate that inventory be recorded at Cost. be recorded at Cost. Lower of Cost or Market Net Realizable Value (Ceiling) Net Realizable Value less Normal Profit (Floor) Replacement Cost =$21.50 Replacement Cost =$21.50 In this case, market value will In this case, market value will be $21.50 because the be $21.50 because the replacement cost is between the replacement cost is between the ceiling and the floor. ceiling and the floor. In this case, market value will In this case, market value will be $21.50 because the be $21.50 because the replacement cost is between the replacement cost is between the ceiling and the floor. ceiling and the floor. 9-10 Lower of Cost or Market An inventory item is currently carried at An inventory item is currently carried at historical cost of $95.00 per unit. At the historical cost of $95.00 per unit. At the Balance Sheet date we gather the Balance Sheet date we gather the following per unit information: following per unit information: current replacement cost = $80.00 current replacement cost = $80.00 NRV = $100.00 NRV = $100.00 NRV reduced by normal profit = $85.00 NRV reduced by normal profit = $85.00 How would we value the item on our How would we value the item on our Balance Sheet? Balance Sheet? An inventory item is currently carried at An inventory item is currently carried at historical cost of $95.00 per unit. At the historical cost of $95.00 per unit. At the Balance Sheet date we gather the Balance Sheet date we gather the following per unit information: following per unit information: current replacement cost = $80.00 current replacement cost = $80.00 NRV = $100.00 NRV = $100.00 NRV reduced by normal profit = $85.00 NRV reduced by normal profit = $85.00 How would we value the item on our How would we value the item on our Balance Sheet? Balance Sheet? [...]... 9-3 1 Retail Inventory Method - Average Cost 9-3 2 Retail Inventory Method - Average Cost x 9-3 3 Learning Objective Explain how the retail inventory method can be made to approximate the lower-of-cost-or-market rule 9-3 4 Retail Inventory Method - Average LCM Approximating Average LCM Net Markdowns are Net Markdowns are excluded in the excluded in the computation of the computation of the Cost-to-Retail... 9-2 7 Retail Inventory Method 9-2 8 Retail Inventory Method x 9-2 9 Approximating Average Cost The primary difference The primary difference between this and our earlier, between this and our earlier, simplified example, is the simplified example, is the inclusion of markups and inclusion of markups and markdowns in the computation markdowns in the computation of the Cost-to-Retail % of the Cost-to-Retail... 9-2 5 Steps to the Retail Inventory Method 1 2 3 4 Determine cost and retail value of goods sold Calculate the cost-to-retail % Retail value of goods available for sale sales = ending inventory at retail Cost-to-retail % x Ending inventory at retail = Estimated ending inventory at cost 9-2 6 Retail Inventory Method Matrix, Inc uses the retail method to estimate Matrix, Inc uses the retail method to estimate... rate Net purchases for Net purchases for the period the period 9-1 9 Steps to the Gross Profit Method 1 2 3 4 Estimate Historical Gross Margin % Sales x (1 - Estimated Gross Margin %) = Estimated COGS Beg Inventory + Net Purchases = Cost of Goods Available for Sale (COGAS) COGAS - Estimated COGS = Estimated Cost of Ending Inventory 9-2 0 Gross Profit Method Matrix, Inc uses the gross profit method to... Inventory Method - Average LCM Approximating Average LCM Net Markdowns are Net Markdowns are excluded in the excluded in the computation of the computation of the Cost-to-Retail % Cost-to-Retail % 9-3 5 Retail Inventory Method - Average LCM Matrix, Inc uses the average cost retail method Matrix, Inc uses the average cost retail method to estimate inventory at the end of June The to estimate inventory at... $85 9-1 3 Applying Lower of Cost or Market Lower of cost or market can be applied 3 different ways 3 Apply LCM to the entire inventory as a 1 Apply LCM to the entire 3.Apply LCM to each classinventory as a 1 Apply LCM to each individual item in Apply LCM to each individual item in 2 Apply LCM to each class of inventory 2 inventory of inventory group inventory group 9-1 4 Adjusting Cost to Market - Options... Inventory at May 31 Estimate Inventory at May 31 9-2 1 Gross Profit Method NOTE: The key to successfully applying this NOTE: The key to successfully applying this method is a reliable Gross Margin Percentage method is a reliable Gross Margin Percentage 9-2 2 Learning Objective Estimate ending inventory and cost of goods sold using the retail inventory method, 9-2 3 Retail Inventory Method This method was... inventory directly or by using an allowance account 9-1 5 Learning Objective Estimate ending inventory and cost of goods sold using the gross profit method 9-1 6 Inventory Estimation Techniques Estimate instead of taking physical inventory Less costly Less time consuming Two popular methods are Gross Profit Method Retail Inventory Method 9-1 7 Gross Profit Method Auditors are testing Auditors... the simplified example, is the inclusion of markups and inclusion of markups and markdowns in the computation markdowns in the computation of the Cost-to-Retail % of the Cost-to-Retail % 9-3 0 Retail Inventory Method - Average Cost Matrix, Inc uses the average cost retail method Matrix, Inc uses the average cost retail method to estimate inventory at the end of June The to estimate inventory at the end... 9-1 1 Lower of Cost or Market Net Realizable Value (Ceiling) = $100 ? Which one do Which one do we use as we use as market value? market value? ? Replacement Replacement Cost =$80 Cost =$80 ? Net Realizable Value less Normal Profit (Floor) = $85 9-1 2 Lower of Cost or Market Net Realizable Value (Ceiling) = $100 Should the inventory . McGraw-Hill Companies, Inc. All rights reserved. Inventories: Additional Issues 9 9-2 Learning Objective Understand and apply the lower-of-cost- or-market rule used to value inventories. 9-3 Lower. conservative accounting and is a conservative accounting method. method. LCM is a departure from historical cost LCM is a departure from historical cost and is a conservative accounting and. . know . . . 9-1 9 Steps to the Gross Profit Method 1. 1. Estimate Historical Gross Margin %. Estimate Historical Gross Margin %. 2. 2. Sales x (1 - Estimated Gross Margin %) = Sales x (1 - Estimated