Professional Documents
Culture Documents
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Learning Objectives
1. 2. Describe and apply the lower-of-cost-or-net realizable value rule. Explain when companies value inventories at net realizable value.
3.
Explain when companies use the relative sales value method to value inventories.
Discuss accounting issues related to purchase commitments.
4.
5.
6.
7.
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Lower-of-Costor-Market
Ceiling and floor How LCM works Application of LCM Market Use of an allowance Multiple periods Evaluation of rule
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Valuation Bases
Net realizable value Relative sales value Purchase commitments
Lower-of-Cost-or-Market
A company abandons the historical cost principle when
the future utility (revenue-producing ability) of the asset drops below its original cost.
Market = Replacement Cost Lower of Cost or Replacement Cost Loss should be recorded when loss occurs, not in the period of sale.
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Lower-of-Cost-or-Market
Illustration 9-1
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LO 1
Lower-of-Cost-or-Market
Ceiling and Floor
Why use Replacement Cost (RC) for Market?
Decline in the RC usually = decline in selling price. RC allows a consistent rate of gross profit. If reduction in RC fails to indicate reduction in utility, then two additional valuation limitations are used:
Ceiling - net realizable value and Floor - net realizable value less a normal profit margin.
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Lower-of-Cost-or-Market
Net realizable value (NRV) is the is the estimated selling
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Lower-of-Cost-or-Market
Illustration 9-3
Ceiling = NRV
Not >
Cost
Market
Replacement Cost
Not <
GAAP LCM
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Lower-of-Cost-or-Market
Limitations
Ceiling prevents overstatement of the value of obsolete, damaged, or shopworn inventories. Floor deters understatement of inventory and overstatement of the loss in the current period.
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Lower-of-Cost-or-Market
How LCM Works (Individual Items)
Illustration 9-5
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Lower-of-Cost-or-Market
Methods of Applying LCM
Illustration 9-6
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Lower-of-Cost-or-Market
Recording Market Instead of Cost
Ending inventory (cost)
Ending inventory (market) Adjustment to LCM Loss Method
$ 82,000
70,000 $ 12,000
12,000
12,000
COGS Method
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12,000
12,000
Lower-of-Cost-or-Market
Balance Sheet Presentation
Loss Method Current assets: Cash Accounts receivable Inventory Less: inventory allowance Prepaids Total current assets $ 100,000 350,000 770,000 (12,000) 20,000 1,175,000 20,000 1,175,000 $ 100,000 350,000 (758,000) COGS Method
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Lower-of-Cost-or-Market
Income Statement Presentation
Loss Method Sales Cost of goods sold Gross profit Operating expenses: Selling General and administrative Total operating expenses Other revenue and (expense): Loss on inventory Interest income Total other Income from operations Income tax expense Net income
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COGS Method $ 300,000 132,000 168,000 45,000 20,000 65,000 5,000 5,000 108,000 32,400 $ 75,600
300,000 120,000 180,000 45,000 20,000 65,000 (12,000) 5,000 (7,000) 108,000 32,400
75,600
LO 1
Lower-of-Cost-or-Market
P9-1: Remmers Company manufactures desks. The company attempts to obtain a 20% gross margin on selling price. At December 31, 2012, the following finished desks appear in the companys inventory.
The 2012 catalog was in effect through November 2012, and the 2013 catalog is effective as of December 1, 2012. Instructions: At what amount should each of the four desks appear in the companys December 31, 2012, inventory, assuming that the company has adopted a lower-of-FIFO-cost-or-market approach for valuation of inventories on an individual-item basis?
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Lower-of-Cost-or-Market
Finished Desks A Inventory cost $ 470 Est. cost to manufacture 460 Commissions and disposal costs 50 Catalog selling price 500
Ceiling = 450
(500 50)
Not >
Cost = 470
Market = 450
Not <
Floor = 350
(450-(500 x 20%))
LCM = 450
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Lower-of-Cost-or-Market
Finished Desks B Inventory cost $ 450 Est. cost to manufacture 430 Commissions and disposal costs 60 Catalog selling price 540
Ceiling = 480
(540 60)
Not >
Cost = 450
Market = 430
Not <
Floor = 372
(480-(540 x 20%))
LCM = 430
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Lower-of-Cost-or-Market
Finished Desks C Inventory cost $ 830 Est. cost to manufacture 610 Commissions and disposal costs 80 Catalog selling price 900
Ceiling = 820
(900 80)
Not >
Cost = 830
Market = 640
Not <
Floor = 640
(820-(900 x 20%))
LCM = 640
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Lower-of-Cost-or-Market
Finished Desks D Inventory cost $ 960 Est. cost to manufacture 1,000 Commissions and disposal costs 130 Catalog selling price 1,200
Ceiling = 1,070
(1,200 130)
Not >
Cost = 960
Market = 1,000
Not <
Floor = 830
(1,070-(1,200 x 20%))
LCM = 960
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Lower-of-Cost-or-Market
Use of an AllowanceMultiple Periods
In general, accountants leave the allowance account on the books. They merely adjust the balance at the next year-end to agree with the discrepancy between cost and the lower-ofcost-or-market at that balance sheet date.
Illustration 9-10
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Lower-of-Cost-or-Market
Evaluation of LCM Rule
Some Deficiencies:
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.
LO 1 Describe and apply the lower-of-cost-or-market rule.
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Valuation Bases
Valuation at Net Realizable Value
Permitted by GAAP under the following conditions:
(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).
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Valuation Bases
Valuation Using Relative Sales Value
Used when buying varying units in a single lump-sum purchase.
E9-7: Larsen Realty Corporation purchased a tract of unimproved land for $55,000. This land was improved and subdivided into building lots at an additional cost of $30,000. These building lots were all of the same size but owing to differences in location were offered for sale at different prices as follows. Operating expenses allocated to this project total $18,200.
No. of Group 1 2 3 Lots 9 15 19 $ Price per Lot 3,000 4,000 2,000 Lots Unsold at Year-End 5 7 2
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LO 3 Explain when companies use the relative sales value method to value inventories.
Valuation Bases
E9-7 (Relative Sales Value Method):
No. of x Price Lots per Lot 9 15 19 $ 3,000 4,000 2,000 $
=
$
x
$
=
$
Group 1 2 3
Group 1 2 3
=
$
Calculation of Net Income Sales $ 78,000 Cost of good sold Gross profit Expenses Net income $ 53,040 24,960 18,200 6,760
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LO 3 Explain when companies use the relative sales value method to value inventories.
Valuation Bases
Purchase CommitmentsA Special Problem
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.
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Valuation Bases
Illustration: St. Regis Paper Co. signed timber-cutting contracts to be executed in 2013 at a price of $10,000,000. Assume further that the market price of the timber cutting rights on December 31, 2012, dropped to $7,000,000. St. Regis would make the following entry on December 31, 2012. Unrealized Holding Gain or LossIncome 3,000,000
3,000,000
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Valuation Bases
Illustration: When St. Regis cuts the timber at a cost of $10 million, it would make the following entry. Purchases (Inventory) Purchase Commitment Liability Cash 7,000,000 3,000,000 10,000,000
Assume the government permitted St. Regis to reduce its contract price and therefore its commitment by $1,000,000. Purchase Commitment Liability 1,000,000 1,000,000
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inventory.
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Instructions: (a) Compute the estimated inventory at May 31, assuming that the gross profit is 25% of sales. (b) Compute the estimated inventory at May 31, assuming that the gross profit is 25% of cost.
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LO 5
160,000 640,000
= 20% of sales
verification.
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Instructions: Prepare a schedule computing estimate retail inventory using the following methods:
Beg. inventory, Oct. 1 Purchases Freight in Purchase returns Additional markups Markup cancellations Markdowns (net) Normal spoilage Sales
(1) Conventional
(2) Cost
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Beg. inventory Purchases Freight in Purchase returns Markups, net Current year additions Goods available for sale Markdowns, net Normal spoilage Sales Ending inventory at retail Ending inventory at Cost: $ 96,400 x 67.00% =
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= 67.00%
64,588
Beg. inventory Purchases Freight in Purchase returns Markdowns, net Markups, net Current year additions Goods available for sale Normal spoilage Sales Ending inventory at retail Ending inventory at Cost: $ 96,400 x 67.49% =
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283,000 335,000
=
67.49%
65,056
Freight costs
Purchase returns Purchase discounts and allowances Transfers-in Normal spoilage
Abnormal shortages
Employee discounts
LO 6 Determine ending inventory by applying the retail inventory method.
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Illustration 9-23
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LO 6
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LO 7
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APPENDIX
9A
Tax advantages. Results in a better matching of costs and revenues. The use of LIFO retail is made under two assumptions: 1. stable prices and 2. fluctuating prices.
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APPENDIX
9A
percentage.
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APPENDIX
9A
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APPENDIX
9A
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APPENDIX
9A
Assume that the ending inventory for 2013 at retail is $50,000. Notice that the 2012 layer is reduced from $11,000 to $5,000.
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APPENDIX
9A
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APPENDIX
9A
Illustration: Assume that the beginning inventory had a retail market value of $10,000 and the ending inventory had a retail market value of $15,000. Assume further that the price level has risen from 100 to 125. It is inappropriate to suggest that a real increase in inventory of $5,000 has occurred. Instead, the company must deflate the ending inventory at retail.
Illustration 9A-4
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APPENDIX
9A
Illustration: Assume that the current 2010 price index is 112 (prior year 100) and that the inventory ($56,000) has remained unchanged.
Dollar-Value LIFO Retail Method Fluctuating Prices
Illustration 9A-5
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LO 8
APPENDIX
9A
Hernandez must restate layers of a particular year to the prices in effect in the year when the layer was added.
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APPENDIX
9A
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APPENDIX
9A
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LO 8
APPENDIX
9A
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APPENDIX
9A
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APPENDIX
9A
Illustration 9A-10
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LO 8
APPENDIX
9A
Hakeman Clothing can then quickly approximate the ending inventory for 2012 under the LIFO retail method.
Illustration 9A-11
The difference of $500 ($11,250 - $10,750) between the LIFO retail method and the conventional retail method is the amount by which the company must adjust beginning inventory for 2013.
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RELEVANT FACTS
Goods in transit, consigned goods, special sales agreementsas well as the costs to include in inventory are essentially accounted for the same under IFRS and GAAP. GAAP permits the use of LIFO for inventory valuation. IFRS prohibits its use. FIFO and average cost are the only two acceptable cost flow assumptions permitted under IFRS. Both sets of standards permit specific identification where appropriate. In the lower-of-cost-or-market test for inventory valuation, IFRS defines market as net realizable value. GAAP defines market as replacement cost subject to the constraints of net realizable value (the ceiling) and net realizable value less a normal markup (the floor). IFRS does not use a ceiling or a floor to determine market.
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RELEVANT FACTS
Under GAAP, if inventory is written down under the lower-of-cost-ormarket valuation, the new basis is now considered its cost. As a result, the inventory may not be written back up to its original cost in a subsequent period. Under IFRS, the write-down may be reversed in a subsequent period up to the amount of the previous write-down. Both the write-down and any subsequent reversal should be reported on the income statement. IFRS requires both biological assets and agricultural produce at the point of harvest to be reported to net realizable value. GAAP does not require companies to account for all biological assets in the same way. Furthermore, these assets generally are not reported at net realizable value. Disclosure requirements also differ between the two sets of standards.
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d. guidelines are more principles based under IFRS than they are under GAAP.
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Copyright
Copyright 2012 John Wiley & Sons, Inc. All rights reserved.
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