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