Class 5 Lower Cost or Market

Lower of Cost or Market (LCM) GAAP requires that inventories be carried at cost or current market value, whichever is lower. 1 LCM is a departure from historical cost and is a conservative accounting method. Generally accepted accounting principles, known as GAAP, require that inventories be carried on the balance sheet at lower-of-cost-or-market. Lower-of-cost-or-market represents a departure from the historical cost concept, but is considered a conservative accounting measure. We will refer to lower-of-cost- or-market by using the term LCM. 1 FASC 330-10-35-1

Determining Market Value Market value is NOT necessarily the amount for which inventory can be sold. FASC 330-10-35-3 defines “market value” in terms of current replacement cost. Net Realizable Value (nrv) The first step in applying LCM is to determine market value. Market value is considered replacement cost, as long as replacement cost falls between the nrv and the nrv-np. The nrv is a shorthand way of referring to the net realizable value of the inventory item. The nrv-np is shorthand for net realizable value reduced by the normal profit. Net Realizable Value less Normal Profit (nrv-np)

Determining Market Value Net Realizable Value (NRV) is the estimated selling price less cost of completion and disposal. Net Realizable Value (nrv) Replacement Cost The definition of market value varies internationally. In many countries market value is defined as NRV. Net realizable value is the estimated selling price per unit of the item, less the cost to complete and dispose of that item. The nrv-np is merely the net realizable value less the normal profit on a particular item. The International Accounting Standards Board’s International Accounting Standard 2 defines market as net realizable value, the policy used in New Zealand. FASC 330-10-35-5 “when the evidence indicates that cost will be recovered with an approximately normal profit upon sale in the ordinary course of business, no loss shall be recognized even though replacement or reproduction costs are lower.” Net Realizable Value less Normal Profit (nrv-np)

Determining Market Value Net Realizable Value (nrv) If replacement cost > nrv, then nrv = Market Value Replacement Cost If replacement cost < nrv-np, then nrv-np = Market Value If replacement cost is greater than the nrv, then market becomes nrv. If replacement cost is less than the nrv-np, then nrv-np becomes market value. As long as replacement cost falls between the nrv and the nrv-np, it will be considered market value. Net Realizable Value less Normal Profit (nrv-np)

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 selling price = $30 cost to complete and dispose = $4 normal profit margin of = $5 How would we value this item in the Balance Sheet? Let’s look at an example to demonstrate application of the lower of cost or market concept. Here we have an inventory item that has the historical cost of $20. Its replacement cost is $21.50. The normal selling price of the inventory item is $30, and it will cost four dollars to complete and dispose of the item in its current condition. The normal profit margin on this item is five dollars. Let’s begin by determining market value.

Net Realizable Value less Normal Profit (nrv-np) Lower of Cost or Market Net Realizable Value (nrv) Replacement Cost =$21.50 Which one do we use? We assume the market value will be replacement cost, as long as it falls between the nrv-np and the nrv. The nrv is the selling price, $30, less the cost to complete and sell, four dollars, or $26. The nrv-np is the nrv of $26, less normal profit of five dollars, or $21. Net Realizable Value less Normal Profit (nrv-np)

Lower of Cost or Market Net Realizable Value (nrv) Replacement In this case, market value will be $21.50 because the replacement cost is between the nrv and the nrv-np. Net Realizable Value (nrv) Replacement Cost =$21.50 Market value = $21.50 Cost = $20.00 Since Cost < Market, the LCM rule would dictate that inventory be recorded at Cost. Market value = $21.50 Cost = $20.00 Should the inventory be recorded at cost or market? In this case, the replacement cost of $21.50 falls between the nrv-np and the nrv, so replacement cost becomes market. We compare market of $21.50 to cost of $20, and we see that cost is below market. So we will value this item in inventory at its historical cost of $20. Remember, we always value the item at lower-of-cost-or-market. Net Realizable Value less Normal Profit (nrv-np)

Lower of Cost or Market An inventory item is currently carried at historical cost of $95.00 per unit. At the Balance Sheet date we gather the following per unit information: current replacement cost = $80.00 NRV = $100.00 NRV reduced by normal profit = $85.00 How would we value the item on our Balance Sheet? Read through this example and jot down the values, then we’ll see how this item will be valued on the balance sheet.

Lower of Cost or Market Net Realizable Value (nrv) = $100 ? Which one do we use as market value? Replacement Cost =$80 ? The nrv is $100, replacement cost is $80, and the nrv-np is $85. Which of these three values would you select as market value? ? Net Realizable Value less Normal Profit (nrv-np) = $85

Lower of Cost or Market Market = $85 < Cost = $95 Net Realizable Value (nrv) = $100 Should the inventory be carried at Market Value or Cost? Replacement Cost =$80 Replacement cost of $80 is less than the nrv-np. So we will select the nrv-np of $85 as market value. The cost of the item in inventory is $95 and market is $85, so we will write down this item of inventory to $85. The inventory item will be carried at market on the balance sheet. Market = $85 < Cost = $95 Our inventory item will be written down to the Market Value $85. Net Realizable Value less Normal Profit (nrv-np) = $85

Applying Lower of Cost or Market Lower of cost or market can be applied 3 different ways. Part I We can apply lower-of-cost-or-market in one of three different ways. First, we can apply it to individual items of inventory, Part II. or we can apply it to groups of similar items in inventory, Part III or finally, we can apply it to the entire inventory. 3. Apply LCM to the entire inventory as a group. 2. Apply LCM to each class of inventory. 1. Apply LCM to each individual item in inventory.

Adjusting Cost to Market Record the loss as a separate item in the income statement Loss on write-down of inventory XX Inventory XX Record the loss as part of cost of goods sold. Cost of goods sold XX Inventory XX When a company applies the LCM rule and a material write-down of inventory is required, the company has two choices of how to report the reduction. One way is to report the loss as a separate item in the income statement. An alternative is to include the loss as part of the cost of goods sold. If inventory write-downs are commonplace for a company, it usually will include the losses as part of cost of goods sold. However, a write-down loss that is substantial and unusual should be reported as a separate item among operating expenses.

BE 9-1 Ross Electronics has one product in its ending inventory. Per unit data consist of the following: cost, $20; replacement cost, $18; selling price, $30; disposal costs, $4. The normal profit margin is 30% of selling price. What unit value should Ross use when applying the LCM rule to ending inventory?

BE 9-1 Cost = $20 NRV = $30 - 4 = $26 NRV – NP = $26 – (30% x $30) = $17 RC = $18 The designated market is the middle value of NRV, NRV-NP, and RC, which is $18. Since this is lower than the cost of $20, the unit value is $18.

BE9-2 SLR Corporation has 1,000 units of each of its two products in its year-end inventory. Per unit data for each of the products are as follows: Determine the balance sheet carrying value of SLR’s inventory assuming that the LCM rule is applied to individual products. What is the before-tax income effect of the LCM adjustment?

BE9-2 * Selling price less disposal costs. ** NRV less normal profit margin

BE9-2 Cost LCM Product 1 (1,000u) $50,000 $50,000 LCM value $76,000 Before-tax income will be lower by $4,000, the amount of the required inventory write-down.

U. S. GAAP vs. IFRS International and U.S. standards for valuing inventory at the lower of cost or market are slightly different. Inventory is valued at the lower of cost or market with market selected from replacement cost, net realizable value or NRV reduced by the normal profit margin. Designated market is compared to historical cost to determine LCM. The LCM rule can be applied to individual items, logical inventory categories, or the entire inventory. Reversals are not permitted. Inventory is valued at the lower or cost of market and net realizable value. The assessment usually is applied to individual items, although using logical inventory categories is allowed under certain circumstances. If an inventory write-down is no longer appropriate, it must be reversed. International and U.S. standards for valuing inventory at the lower-of-cost-or-market are slightly different. From the perspective of the FASB, Inventory is valued at the lower of cost or market with market selected from replacement cost, net realizable value or NRV reduced by the normal profit margin. Designated market is compared to historical cost to determine LCM. Under U.S. GAAP, the LCM rule can be applied to individual items, logical inventory categories, or the entire inventory. If an inventory write-down is not longer appropriate, it must be reversed. However, according to international standards: IAS No. 2, states that inventory is valued at the lower of cost or market and net realizable value. The assessment usually is applied to individual items, although using logical inventory categories is allowed under certain circumstances. If an inventory write-down is no longer appropriate, it must be reversed.

Inventory Estimation Techniques Estimate instead of taking physical inventory Less costly Less time-consuming Two popular methods of estimating ending inventory are the . . . Gross profit method Retail inventory method Most companies estimate their inventories at interim periods. In some cases, when inventory is extremely large and spread out over a wide geographical area, inventory estimation may be used to determine year-end inventory. It may be impossible or impractical to physically count such inventories. Inventory estimation is less costly than a physical count and less time-consuming. The two most popular methods of inventory estimation are known as the gross profit method and the retail inventory method.

Gross Profit Method Estimating inventory and COGS for interim reports. Auditors in testing the overall reasonableness of client inventories. Useful when . . . Determining the cost of inventory lost, destroyed, or stolen. Preparing budgets and forecasts. Companies can use the gross profit method when preparing interim reports, and auditors often use it to determine the reasonableness of ending inventory. The gross profit method can be used by insurance companies to estimate lost, destroyed, or stolen inventory. We can use the gross profit method in the budgeting process. It is important to remember that the gross profit method is not acceptable for use in the annual report distributed to external users. NOTE: The gross profit method is not acceptable for use in annual financial statements.

Estimate the Gross Profit Ratio Gross Profit Method This method assumes that the historical gross margin ratio is reasonably constant in the short-run. Beginning Inventory   (from accounting records) Plus: Net purchases Goods available for sale (calculated) Less: Cost of goods sold (estimated) Ending inventory Before we can use the gross profit method, there is some information we need to know. First, we need an estimate of the gross profit ratio, often relying on the historical gross profit ratio. Then we need to know the beginning inventory and net purchases that can be obtained from the existing accounting records. In addition, we need to determine net sales from the accounting records. Once we have determined these amounts we can use the gross profit method to estimate ending inventory and cost of goods sold. Estimate the Gross Profit Ratio

Estimate Inventory at May 31. Gross Profit Method Matrix Inc. uses the gross profit method to estimate end of month inventory. At the end of May, the controller has the following data: Net sales for May = $1,213,000 Net purchases for May = $728,300 Inventory at May 1 = $237,400 Estimated gross profit ratio = 43% of sales Estimate Inventory at May 31. Matrix is interested in estimating its ending inventory at May 31 using the gross profit method. The controller has provided us with certain information. Perhaps the most critical amount in the process is the estimation of the company’s gross profit ratio. This is usually developed from analysis of historical rates of gross profit. Review this information and make sure it’s adequate for us to apply the gross profit method.

Gross Profit Method NOTE: The key to successfully applying this method is a reliable gross profit ratio. We were given the historic gross profit percentage, so the first step in our process is to determine the cost of goods available for sale. We add beginning inventory and net purchases for the period determine cost of goods available for sale of $965,700. The next step is to estimate gross profit for the period. To estimate gross profit multiply sales by the gross profit percentage of 43 percent. Estimated gross profit is $521,590. The next step is to determine estimated cost of goods sold. To determine this amount subtract estimated gross profit from sales to arrive at estimated cost of goods sold of $691,410. The final step is to subtract cost of goods sold from cost of goods available for sale to get an estimated ending inventory of $274,290.

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. As indicated by its name, the retail method was developed for retail establishments such as department stores. There is a major difference between the gross profit and retail method. In the retail method, we need to know both cost and selling price of certain accounts. Our objective in the retail method is to calculate ending inventory at retail, and then convert it from retail to cost. Objective: Convert ending inventory at retail to ending inventory at cost.

The Retail Inventory Method Retail Terminology Term   Meaning 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. To apply the retail inventory method properly it is important to understand terminology in the retail industry. A retail company purchases an item for resale at cost. The initial markup is the markup from cost to selling price. For example, if a company purchases an item for $6 and plans to sell it for $10, there is on initial markup of $4. If demand for the product is high, the company may raise the selling price to $12, so there is an additional markup of $2. If demand for the product at $12 slackens the price may be dropped to $10.50, the company would have a markup cancellation of $1.50.

An Example of the Terminology Retail Terminology An Example of the Terminology The terms on your screen are associated with changing retail prices of merchandise inventory, and are very common in all retail establishments. We are all familiar with the term markup, we usually associate it with the increase in selling price above the cost to the company. If demand for a product is very strong, the company may feel that an additional markup is in order. A markup cancellation occurs when the company reduces the selling price of a product to induce sales and reduce inventory.

The Retail Inventory Method Sales for the period. Beginning inventory at retail and cost. We need to know . . . Before we can successfully complete the retail inventory method, we need to know four pieces of information. We need to know sales for the period, net purchases at both retail price and cost, the value of beginning inventory at both retail and cost and, finally, whether there’s been an inventory adjustment to the retail price. These adjustments might include additional markups or additional markdowns and other items that apply to retail establishments. Net purchases at retail and cost. Adjustments to the original retail price.

The Retail Inventory Method Matrix Inc. uses the retail method to estimate inventory at the end of each month. For the month of May the controller gathers the following information: Beginning inventory at cost $27,000 (at retail $45,000) Net purchases at cost $180,000 (at retail $300,000) Net sales for May $310,000 Estimate the inventory at May 31. Matrix, a retail establishment, wishes to estimate its ending inventory at May 31. Information is gathered by the controller to help us accomplish this task. Read through the information carefully and we’ll begin the process to estimate ending inventory using the retail inventory method. Please note that purchases are equal to cost less returns and allowances, plus freight-in. Purchases at retail are equal to the selling price of purchased goods less returns at retail. Net sales are equal to gross sales less returns.

The Retail Inventory Method First, we add together beginning inventory and net purchases for May both at cost and retail. We divide the goods available for sale at cost by the retail price of goods available for sale to arrive at the cost-to-retail percentage of 60%. Next, we subtract our sales for May from the selling price of goods available for sale, to arrive at ending inventory at retail.

The Retail Inventory Method x Finally, we use our cost-to-retail percentage to convert our estimate of ending inventory at retail, $35,000, to our estimate of ending inventory at cost, by multiplying $35,000 by 60% which equals $21,000. ×

Retail Inventory Method Markups and Markdowns Matrix Inc. uses the retail method to estimate inventory at the end of July. The controller gathers the following information: Beginning inventory at cost $21,000 (at retail $35,000) Net purchases at cost $200,000 (at retail $304,000) Net markups $8,000 Net markdowns $4,000 Net sales for July $300,000 Estimate inventory at July 31. Matrix Inc. uses the retail method to estimate inventory at the end of July. The controller gathers the following information: Beginning inventory at cost $21,000 (at retail $35,000) Net purchases at cost $200,000 (at retail $304,000) Net markups $8,000 Net markdowns $4,000 Net sales for July $300,000 Let’s estimate inventory at July 31 using a method that approximates average cost. Using this method both markups and markdowns are included in the determination of goods available for sale at retail.

Conventional Retail Method: Markups and Markdowns When using the average cost approach, we include the net markups (markups less markup cancellations) and net markdowns (markdowns less markdown cancellations) in the calculation of the cost-to-retail percentage. Notice that net markups and net markdowns only impact only the retail column because they are normally applied to the recorded retail amounts. The first step it to determine the cost-to-retail percentage shown here as 64.43 percent.

Conventional Retail Method: Markups and Markdowns The next step is to subtract sales for the period from the total retail value of goods available for sale of $343,000. The result is an estimate of the ending inventory at retail amount. The final step is to convert the estimate of ending inventory at retail to an estimate of ending inventory at cost. To do this we multiply the estimate of ending inventory at retail by the cost-to-retail percentage to arrive at our estimate of ending inventory at cost of $27,705. Now lets look at an example of the retail inventory method that approximates lower of cost of market.

Conventional Retail Method: Markups and Markdowns When using the conventional retail method to approximate lower-of-cost-or-market, we include the net markups (markups less markup cancellations) but exclude the net markdowns (markdowns less markdown cancellations) in the calculation of the cost-to-retail percentage. Notice that net markups impact only the retail column because they are normally applied to the recorded retail amounts. The first step is to determine the cost-to-retail percentage, which in our case is 63.69 percent.

Conventional Retail Method: Markups and Markdowns The next step is to subtract the net markdowns for the period to arrive at goods available at cost and retail. Next, we subtract sales for the month of July from the retail value of goods available for sale to determine the retail value of ending inventory of $43,000. Finally, we multiply the retail value of ending inventory by the cost-to-retail percent to arrive at the cost of ending inventory of $27,387. $43,000 × 63.69% = $27,387

Changes in Inventory Method Recall that most voluntary changes in accounting principles are reported retrospectively. This means reporting all previous periods’ financial statements as though the new method had been used in all prior periods. Most voluntary changes in accounting principles involving inventory are reported retrospectively. This means that all previous financial statements disclosed are restated as though the new principle had been used. Changes in inventory methods, other than a change to LIFO, are treated retrospectively.

Change to the LIFO Method When a company elects to change to LIFO, it is usually impossible to calculate the income effect on prior years. As a result, the company does not report the change retrospectively. Instead, the LIFO method is used from the point of adoption forward. A disclosure note is needed to explain (a) the nature of the change, (b) the effect of the change on current year’s income and earnings per share, and (c) why retrospective application was impracticable. When a company changes to the LIFO inventory method from any other method, it usually is impossible to calculate the income effect on prior years. To do so would require assumptions as to when specific LIFO inventory layers were created in years prior to the change. As a result, a company changing to LIFO usually does not report the change retrospectively. Instead, the LIFO method simply is used from that point on. The base year inventory for all future LIFO determinations is the beginning inventory in the year the LIFO method is adopted. A disclosure note is needed to explain the nature and justification for the change as well as the effect of the change on current year’s income and earnings per share. The note also must explain why retrospective application was impracticable.

Inventory Errors When analyzing inventory errors, it’s helpful to visualize the way cost of goods sold, net income, and retained earnings are determined. When analyzing inventory errors, it’s helpful to visualize the way cost of goods sold, net income, and retained earnings are determined. Here is an overview of this flow. Beginning inventory and net purchases are added in the calculation of cost of goods sold. If either of these is overstated (understated) then cost of goods sold would be overstated (understated). On the other hand, ending inventory is deducted in the calculation of cost of goods sold, so if ending inventory is overstated (understated) then cost of goods sold is understated (overstated)

Overstatement of ending inventory Inventory Errors Overstatement of ending inventory Understates cost of goods sold and Overstates pretax income. Understatement of ending inventory Overstates cost of goods sold and Understates pretax income. This slide explains the impact of errors in ending inventory on cost of goods sold and pretax income. Because the error impacts cost of goods sold and therefore pretax net income, it also will impact the balance in retained earnings.

Overstatement of beginning inventory Inventory Errors Overstatement of beginning inventory Overstates cost of goods sold and Understates pretax income. Understatement of beginning inventory Understates cost of goods sold and Overstates pretax income. Here we show the impact of errors in beginning inventory on cost of goods sold and pretax income. Again, because the error impacts cost of goods sold and therefore pretax net income, it also will impact the balance in retained earnings.

When the Inventory Error is Discovered the Following Year Inventory Errors When the Inventory Error is Discovered the Following Year If an error was made in 2013, but not discovered until 2014, the 2013 financial statements were incorrect as a result of the error. The error should be retrospectively restated to reflect the correct inventory amount, cost of goods sold, net income, and retained earnings when the comparative 2014 and 2013 financial statements are issued for 2014. When the Inventory Error is Discovered Subsequent to the Following Year If an error was made in 2013, but not discovered until 2015, all previous years’ financial statements that were incorrect as a result of the error also are retrospectively restated to reflect the correct inventory, cost of goods sold, retained earnings, and net income even though no correcting entry is needed in 2015. The error has self-corrected and no prior period adjustment is needed. If an error was made in 2013, but not discovered until 2014, the 2013 financial statements were incorrect as a result of the error. The error should be retrospectively restated to reflect the correct inventory amount, cost of goods sold, net income, and retained earnings when the comparative 2014 and 2013 financial statements are issued for 2014. If an error was made in 2013, but not discovered until 2015, all previous years’ financial statements that were incorrect as a result of the error also are retrospectively restated to reflect the correct inventory, cost of goods sold, retained earnings, and net income even though no correcting entry is needed in 2015. The error has self-corrected and no prior period adjustment is needed.

BE9-6 Kiddie World uses a periodic inventory system and the retail inventory method to estimate ending inventory and cost of goods sold. The following data are available for the quarter ending September 30, 2013: Estimate ending inventory and cost of goods sold (average cost).

Brief Exercise 9-14 In 2013, Winslow International, Inc.’s controller discovered that ending inventories for 2011 and 2012 were overstated by $200,000 and $500,000, respectively. Determine the effect of the errors on retained earnings at January 1, 2013. (Ignore income taxes.)

Brief Exercise 9-14 This is a timing error. The 2011 error caused 2011 net income to be overstated, but since 2011 ending inventory is 2012 beginning inventory, 2012 net income was understated the same amount. So, the income statement was misstated for 2011 and 2012, but the balance sheet (retained earnings) was incorrect only for 2011. After that, no account balances are incorrect due to the 2011 error.

BE 9-14 Analysis: U = Understated O = Overstated 2011 2012 Beginning inventory ® O Plus: net purchases ­ Less: ending inventory Cost of goods sold U Revenues Less: cost of goods sold Less: other expenses Net income â Retained earnings corrected

BE 9-14 However, the 2010 error has not yet self-corrected. Both retained earnings and inventory still are overstated as a result of the second error. Analysis: O = Overstated U = Understated 2012 ® Beginning inventory ­ Plus: net purchases Less: ending inventory O Cost of goods sold U Revenues Less: cost of goods sold Less: other expenses Net income â Retained earnings Retained earnings on January 1, 2011, in this case, would be overstated by $500,000 (ignoring income taxes).

Brief Exercise 9-12 In 2013, Hopyard Lumber changed its inventory method from LIFO to FIFO. Inventory at the end of 2012 of $127,000 would have been $145,000 if FIFO had been used. Inventory at the end of 2013 is $162,000 using the new FIFO method but would have been $151,000 if the company had continued to use LIFO. Describe the steps Hopyard should take to report this change. What is the effect of the change on 2013 cost of goods sold?

Brief Exercise 9-12 Apply the FIFO method retrospectively; to all prior periods reported in the annual report; as if it always had used that method. 2013 cost of goods sold is $7,000 higher than it would have been if the company did not switch to FIFO. This is because beginning inventory is $18,000 higher ($145,000 – 127,000) and ending inventory is $11,000 higher ($162,000 – 151,000). So gross profit will be $7,000 higher.