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 Ceiling NRV Replacement Cost NRV – NP Floor Designated Market Cost Not More Than Not Less Than Or Step 1 Determine Designated Market Step 2 Compare Designated Market with Cost Lower of Cost Or 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. Product Total Cost Total Replacement Cost Total Net Realizable Value 101$ 120,000$ 110,000$ 100,000 10290,00085,000110,000 10360,00040,00050,000 10430,00028,00050,000
Example 1: Continued ProductRC Ceiling NRV Floor NRV-NP Designated Market Cost Inventory Value 101$110,000$100,000$70,000 102 103 104
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 TypeQuantity Per Unit Cost Designated Market Tools: Hammers100$5.00$5.50 Saws20010.009.00 Screwdrivers3002.002.60 Paint products: 1-Gallon cans5006.005.00 Paint brushes1004.004.50
Inventory, by Product TypeCost Designated Market Individual LCM Type LCM Total Inventory LCM Tools: Hammers$500$550 Saws2,0001,800 Screwdrivers600780 Total tools:3,1003,130 Paint products: 1-Gallon cans$3,0002,500 Paint brushes400450 Total paint:3,4002,950 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 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, 2011 Inventory (market price)425,000 Loss on purchase commitment 75,000 Accounts payable 500,000 December 15, 2011 Accounts payable500,000 Cash 500,000 Multi-period commitment December 31, 2011 Unrealized loss on commitment 60,000 Est liab on purch commitment 60,000 February 15, 2012 Inventory (market price)510,000 Loss on purchase commitment 30,000 Est 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 $58,500. The following information for the month of November was available from company records: Purchases$ 110,000 Freight-in 3,000 Sales 180,000 Sales returns 5,000 Purchases 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
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 UnitReplacementSelling ProductQuantityCost Cost Price A1,000$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 ProductNRV per unitNRV-NP per unit A$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
LCM Practice Decker Company has five products in its inventory. Information about the December 31, 2011, inventory follows. Unit Unit UnitReplacementSelling ProductQuantityCost Cost Price A1,000$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.