Transcript
MGT 220 Chapter 9
Lower of Cost or Market
• The lower of cost or market (LCM) is an exception to the historical cost principle
• When the future potential of the asset is less than its original cost:– Re-state asset at cost to market
• The loss is charged against revenues of the period
Lower of Cost or Market
• LCM is justified for two reasons:– Current assets reported at a value
approximately equal to the amount of cash they can be converted to
– Matching principle: loss of utility reported in the period the loss occurred
• LCM falls in line with conservatism
Lower of Cost or Market
LCM conceptual deficiencies:
1. Inconsistent
2. Potentially produces aggressive income in subsequent periods
Lower of Cost or Market
When would the ‘market’ price be lower than the cost of the inventory?
What Is Market?• CICA Handbook, Section 3030 reflects the
desire to provide a more specific description of ‘market’
• Use of the terms:– Replacement cost– Net realizable value (NRV)– Net realizable value less a normal profit margin
• Net realizable value most commonly used– All three are acceptable methods– Method adopted must be disclosed
What Is Market?
• Replacement:Amount required to obtain an equivalent item
• NRV:Estimated selling price in the ordinary course of business less costs to complete and dispose of the item
• NRV less a normal profit margin:NRV (as defined above) less normal profit margin
Lower of Cost or Market
• The lower of cost or market may be applied on a(n):1. item-by-item basis (as in the example)
2. category basis
3. total inventory basis
• Whichever method is selected, it should be consistently applied
Application of LCM
Item Category CostMarket
1. Patio Furn. $10 $ 8
2. Patio Furn. $20 $24
3. Indoor Furn. $18 $18
4. Indoor Furn. $15 $14
$63 $64
Application of LCM
Item-By-Item
Item Cost Market LCM
1. $10 $8 $ 8
2. $20 $24 $20
3. $18 $18 $18
4. $15 $14 $14
$63 $64 $60
Application of LCM
By Category
Category Cost Market LCM
Patio Furn. $30 $32$30
Indoor Furn. $33 $32 $32
$63 $64$62
Application of LCM
Total Inventory
Cost Market LCM
$63 $64 $63
LCM-Decline in Value
If cost <= market then do nothing
If cost > market then make an adjusting journal entry
• Direct Method
• Allowance method (indirect method)
LCM-Decline in Value
Direct Method
Charge decline in value to CGS:
CGS $1,000
Inventory $1,000
LCM-Decline in Value
Allowance Method
Charge decline in value to a separate loss account:
Loss Due to Decline in
Market Value $1,000
Allowance to Reduce
Inventory to Market Value $1,000
Valuation Basis: Relative Sales Values
• Relative sales values is an appropriate basis when basket purchases are made
• Basket purchases involve a group of varying units
• The purchase price is paid as a lump sum amount
• The lump sum price is allocated to units on the basis of their relative sales values
Relative Sales Values: Example
• Intell Company buys three different lots (A, B and C) in a basket purchase, paying $300,000
• The lots were then sold as follows:A $ 75,000B $150,000 C $200,000
for a total of $425,000• Determine the allocated cost to A, B and C and the
gross profit for each lot
Relative Sales Values: Example
Lot Sales Value Allocated Cost Gross Profit
A $75,000 ($75,000/$425,000) X $300,000= $ 52,941 $ 22,059
B $150,000 ($150,000/$425,000) X $300,000= $105,882 $ 44,118
C $200,000 ($200,000/$425,000) X $300,000= $ 141,176 $ 58,824
Margin vs. Mark-up
Gross Margin
= Gross Profit/Selling Price = $15/75 = 20%
Markup
= Gross Profit/Cost = $15/60 = 25%
Gross Profit Method • The gross profit method is used to estimate ending
inventory (e.g., interim reporting, fire loss, testing reasonableness of cost from another method).
• The method is based on the assumptions that:
1.beginning inventory + net purchases= CGAS
2.CGAS – sales*(1-Gross margin %) = ending inventory
3.Goods not sold are in ending inventory
Gross Profit Method: Example
Given:• Beginning inventory (at cost): $ 60,000• Net Purchases (at cost) : $ 200,000• Sales (net) : $ 280,000• Gross Profit percentage on sales 30%
Estimate the ending inventory using the Gross Profit Method.
Gross Profit Method: Example
Beg. Inventory + Net Purchases - CGS = Estimated Ending Inventory
$60,000 + $200,000 - ($280,000X0.7) = Ending Inventory$60,000 + $200,000 - ($196,000) = $64,000
Cost of goods sold = Sales X (1 - 0.3)
Limitations of Gross Profit Method• Provides only an estimate; physical inventory
count still required• Uses past information (gross profit percentage) to
determine a current inventory value– A current gross profit percentage more relevant
• A ‘blanket’ gross profit percentage may be applied– Different product lines may have materially
different gross profit percentages, which produce more accurate estimates
• Not accepted for year-end financial reporting, appropriate for interim reporting (with disclosure)
Financial Statement Presentation
• The following items must be disclosed:
i. The basis of valuation.
ii. Any change in the basis of valuation and the effect of such a change on net income for the period.
• It is also desirable to disclose the amount of the major categories making up total inventory.
Inventory Ratios
a) Inventory turnover
= CGS/average inventory
b) # days inventory
= (average inventory/CGS) x 365
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