CHAPTER 9

INVENTORIES:ADDITIONAL VALUATION ISSUES

Sommers – ACCT 3311

LCM Approach

Lower-of-cost-or-market approach to valuing inventory

GAAP generally require the use of historical cost to value assets, but a departure from cost is necessary when the utility of an asset is no longer as great as its cost. The utility or benefits from inventory result from the ultimate sale of the goods. This utility could be reduced below cost due to deterioration, obsolescence, or changes in price levels. To avoid reporting inventory at an amount greater than the benefits it can provide, the lower-of-cost-or-market approach to valuing inventory was developed. This approach results in the recognition of losses when the value of inventory declines below its cost, rather than in the period in which the goods are ultimately sold.

Discussion Question

Q9-2 Explain the rationale for the ceiling and floor in the lower-of-cost-or-market method of valuing inventories.

Determining Market Value

CeilingNRV

ReplacementCost

NRV – NPFloor

DesignatedMarket

CostNot More Than

Not Less Than

Or

Step 1Determine Designated Market

Step 2Compare Designated Market with Cost

Lower of CostOr Market

Example 1: LCM

Tatum Company has four products in its inventory. Information about the Dec 31, 2011, inventory is as follows:

The normal gross profit percentage is 25% of cost.

Determine the balance sheet inventory carrying value at Dec 31, 2011, assuming the LCM rule is applied to individual products.

ProductTotal Cost

TotalReplacement

Cost

Total NetRealizable

Value101 $ 120,000 $ 110,000 $ 100,000102 90,000 85,000 110,000103 60,000 40,000 50,000104 30,000 28,000 50,000

Example 1: Continued

Product RCCeiling 

NRVFloor 

NRV-NPDesignated

Market  

CostInventory

Value101 $110,000 $100,000 $70,000102103104

 

Applying Lower of Cost or Market

Lower of cost or market can be applied 3 different ways.

1. Apply LCM to each individual item in inventory.

2. Apply LCM to each class of inventory.

3. Apply LCM to the entire inventory as a group.

Example 2: LCM applications

Almaden Hardware Store sells two distinct types of products, tools and paint products. Information pertaining to its 2011 year-end inventory is as follows:

Determine balance sheet inventory carrying value at year-end, assuming the LCM rule is applied to individual products, then product type, and then total inventory.

Inventory, by Product Type Quantity

Per Unit Cost

Designated Market

Tools:

Hammers 100 $5.00 $5.50

Saws 200 10.00 9.00

Screwdrivers 300 2.00 2.60

Paint products:

1-Gallon cans 500 6.00 5.00

Paint brushes 100 4.00 4.50

Inventory, by Product Type Cost

Designated Market

Individual LCM

TypeLCM

Total Inventory

LCM

Tools:

Hammers $500 $550

Saws 2,000 1,800

Screwdrivers 600 780

Total tools: 3,100 3,130

Paint products:

1-Gallon cans $3,000 2,500

Paint brushes 400 450

Total paint: 3,400 2,950

Total: $6,500 $6,080

Example 2: Continued

Expense recorded when loss in utility occurs. Profit on sale recognized at the point of sale.

Inventory valued at cost in one year and at market in the next year.

Net income in year of loss is lower. Net income in subsequent period may be higher than normal if expected reductions in sales price do not materialize.

LCM uses a “normal profit” in determining inventory values, which is a subjective measure.

Some Deficiencies:

Evaluation of LCM Rule

(1) a controlled market with a quoted price applicable to all quantities, and

(2) no significant costs of disposal (rare metals and agricultural products)

or

(3) too difficult to obtain cost figures (meatpacking).

Permitted by GAAP under the following conditions:

Valuation at Net Realizable Value

► Generally seller retains title to the merchandise.

► Buyer recognizes no asset or liability.

► If material, the buyer should disclose contract details in

footnote.

► If the contract price is greater than the market price, and

the buyer expects that losses will occur when the

purchase is effected, the buyer should recognize a

liability and a corresponding loss in the period during

which such declines in market prices take place.

Purchase Commitments

Purchase Commitments

• Purchase commitments are contracts that obligate a company to purchase a specified amount of merchandise or raw materials at specified prices on or before specified dates.

In July 2011, the Lassiter Company. signed two purchase commitments. The first requires Lassiter to purchase inventory for $500,000 by

November 15, 2011. The inventory is purchased on November 14, and paid for on December 15. On the date of acquisition, the inventory had a market value of $425,000.

The second requires Lassiter to purchase inventory for $600,000 by February 15, 2012. On December 31, 2011, the market value of the inventory items was $540,000. On February 15, 2012, the market value of the inventory items was $510,000.

Lassiter uses the perpetual inventory system and is a calendar year-end company.

Purchase Commitments

Single-period commitment

November 14, 2011Inventory (market price) 425,000Loss on purchase commitment 75,000

Accounts payable 500,000

December 15, 2011Accounts payable 500,000

Cash 500,000

Multi-period commitment

December 31, 2011Unrealized loss on commitment 60,000

Est liab on purch commitment 60,000

February 15, 2012Inventory (market price) 510,000Loss on purchase commitment 30,000Est liab on purch commitment 60,000

Cash 600,000

Inventory Estimation Techniques

Estimate instead of taking physical inventory • Less costly • Less time consuming• Sometimes only option!

Two popular methods are . . .• Gross Profit Method• Retail Inventory Method (next time)

Relies on Three Assumptions:(1) Beginning inventory plus purchases equal total goods to be

accounted for.

(2) Goods not sold must be on hand.

(3) The sales, reduced to cost, deducted from the sum of the

opening inventory plus purchases, equal ending inventory.

Gross Profit Method

The gross profit method estimates cost of goods sold, which is then subtracted from cost of goods available for sale to obtain an estimate of ending inventory. The estimate of cost of goods sold is found by multiplying sales by the historical ratio of cost to selling prices. The cost percentage is the reciprocal of the gross profit ratio.

Example 3: Gross Profit Method

Royal Gorge Company uses the gross profit method to estimate ending inventory and cost of goods sold when preparing monthly financial statements required by its bank. Inventory on hand at the end of October was $58,500. The following information for the month of November was available from company records:

Purchases $ 110,000Freight-in 3,000Sales 180,000Sales returns 5,000Purchases returns 4,000

In addition, the controller is aware of $8,000 of inventory that was stolen during November from one of the company’s warehouses.

Calculate the estimated inventory at the end of November, assuming a gross profit ratio of 40%.

Example 3: Continued

Disadvantages:

(1) Provides an estimate of ending inventory.

(2) Uses past percentages in calculation.

(3) A blanket gross profit rate may not be representative.

(4) Normally unacceptable for financial reporting purposes.

GAAP requires a physical inventory as additional

verification.

Evaluation of Gross Profit Method

A method used by retailers, to value inventory without a

physical count, by converting retail prices to cost.

(1) Total cost and retail value of goods purchased.

(2) Total cost and retail value of the goods available for

sale.

(3) Sales for the period.

Requires retailers to keep:

Methods Conventional Method LIFO Dollar-value LIFO

Retail Inventory Method

Retail Inventory Method

Explain the retail inventory method of estimating ending inventory.

The retail inventory method first determines the amount of ending inventory at retail by subtracting sales for the period from goods available for sale at retail. Ending inventory at retail is then converted to cost by multiplying it by the cost-to-retail percentage.

The Retail Inventory Method

This method was developed for retail operations like department stores.• Uses both the retail value and cost of items for sale to calculate a

cost-to-retail percentage.

Objective: Convert ending inventory at retail to ending inventory at cost.

Terminology:• Initial markup - Original amount of markup from cost to selling price.• Additional markup - Increase in selling price subsequent to initial

markup.• Markup cancellation - Elimination of an additional markup.• Markdown - Reduction in selling price below the original selling

price.• Markdown cancellation - Elimination of a markdown.

LCM Practice

Decker Company has five products in its inventory. Information about the December 31, 2011, inventory follows.

Unit Unit Unit Replacement Selling

Product Quantity Cost Cost Price

A 1,000 $10 $12 $16

B 800 15 11 18

C 600 3 2 8

D 200 7 4 6

E 600 14 12 13

The selling cost for each product consists of a 15 percent sales commission. The normal profit percentage for each product is 40 percent of the selling price.

Determine the balance sheet inventory carrying value at December 31, 2011, assuming the LCM rule is applied to individual products.

LCM Practice

Product NRV per unit NRV-NP per unitA $16 - (15% x $16) = $13.60 $13.60 - (40% x $16) = $7.20

  (1) (2) (3) (4) (5)      

Product(units)

     

RC

 Ceiling   

NRV

 Floor   

NRV-NP

 Designated

Market Value[Middle value

of (1), (2) & (3)]

    

Cost

 Inventory

Value[Lower of

(4) and (5)]             

A (1,000) $12,000 $13,600 $7,200 $12,000 $10,000 $10,000

LCM Practice

Decker Company has five products in its inventory. Information about the December 31, 2011, inventory follows.

Unit Unit Unit Replacement Selling

Product Quantity Cost Cost Price

A 1,000 $10 $12 $16

B 800 15 11 18

C 600 3 2 8

D 200 7 4 6

E 600 14 12 13

The selling cost for each product consists of a 15 percent sales commission. The normal profit percentage for each product is 40 percent of the selling price.

Determine the balance sheet inventory carrying value at December 31, 2011, assuming the LCM rule is applied to the entire inventory.

LCM Practice