Lower
Lower of
of Cost
Cost or
or Market
Market (LCM)
(LCM)
Inventories:
Inventories
Additional Valuation Issues
REMEMBER
REMEMBERCONSERVATISM!
CONSERVATISM!
The
Thegeneral
generalrule
ruleisisthat
that-The
Thehistorical
historicalcost
costprinciple
principleisisabandoned
abandonedwhen
whenthe
thefuture
futureutility
utility(revenue(revenueproducing
ability)
producing ability)of
ofthe
theasset
assetisisno
nolonger
longeras
asgreat
greatas
asits
itsoriginal
originalcost.
cost.
Note
Note“abandoned”
“abandoned”isisnot
notthe
theword
wordIIwould
wouldchoose.
choose. Good
Goodrule
ruleof
ofthumb
thumbisisthat
thathistorical
historical
cost
costshould
shouldbe
beadjusted
adjustedfor
forimpairments.
impairments.
New
NewTerm:
Term: Net
NetRealizable
RealizableValue
Value(NRV)=
(NRV)=normal
normalselling
sellingprice
priceless
lesscosts
coststo
tosell
sell
Chapter
Chapter
HOW
HOWIT
ITWORKSWORKSInventory
Inventoryisisrecorded
recordedat
atthe
theLOWER
LOWERof
ofcost
costor
ormarket
marketwhere:
where:
–– Cost
Cost(easy,
(easy,what
whatyou
youhave
haveon
onthe
thebalance
balancesheet
sheetififyou
youdon’t
don’tdo
doanything)
anything)
–– Market=
Market=replacement
replacementcost,
cost,but
butcan
cannot
notbe:
be:
9
»» Greater
Greaterthan
thanNRV
NRV(ceiling)
(ceiling)
»» Less
Lessthan
thanNRV
NRVminus
minusnormal
normalprofit
profitmargin
margin(floor)
(floor)
Market
MarketValue
ValueStated
Statedanother
anotherway:
way:market
marketvalue
valueisisthe
themiddle
middlevalue
valueof
of
replacement
replacementcost,
cost,NRV
NRVand
andNRV
NRVless
lessnormal
normalprofit
profitmargin.
margin.
Slide 9-1
Slide 9-2
UCSB, Anderson
Market
Market
Lower of Cost or Market Example
Ceiling
Ceiling ==
NRV
NRV
Not >
Cost
Cost
Replacement
Replacement
Cost
Cost
=
Market
Market
Not <
What is the rationale for these two limitations?
Slide 9-3
450
470
460
45
500
480
450
440
60
540
900
830
610
90
900
460
440
610
1,000
500
(45)
455
(100)
355
540
(60)
480
(108)
372
900
(90)
810
(180)
630
1,200
(130)
1,070
(240)
830
Middle Value= designated mkt value
Cost
LCM= Ending inventory
455
470
455
440
450
440
630
830
630
1,000
960
960
Inventory adjustment necessary
(15)
(10)
(200)
-
Replacement cost
Less: Normal profit margin f 20%
NRV less normal profit margin
B
C
UCSB, Anderson
2002 catalog selling price
A
B
C
D
$450
$480
$900
$1,050
FIFO cost per inventory (12/31/02)
470
450
830
960
Est. cost to manufacture (12/31/02)
460
440
610
1,000
2003 catalog selling price
45
60
90
130
500
540
900
1,200
The
The2002
2002catalog
catalogwas
wasinineffect
effectthrough
throughNovember
November2002,
2002,and
andthe
the2003
2003catalog
catalog
isiseffective
effectiveas
asof
ofDecember
December1,
1,2002.
2002.All
Allcatalog
catalogprices
pricesare
arenet
netof
ofthe
theusual
usual
discounts.
Generally,
the
company
attempts
to
obtain
a
20%
gross
margin
discounts. Generally, the company attempts to obtain a 20% gross margin
on
selling
price
and
has
usually
been
successful
in
doing
so.
on selling price and has usually been successful in doing so.
UCSB, Anderson
FINANCIAL STATEMENT PRESENTATION
D
1,050
960
1,000
130
1,200
NRV
Estimated sales price
Less: Costs to sell
A
Finished Desks
Slide 9-4
UCSB, Anderson
Previous Slide Computation
Finished Desks
2002 Catalog selling price
FIFO cost per inventory (12/31/02)
Est Cost to Manufacture (12/31/02)
Sales commissions and disposal costs
2003 catalog selling price
Grant
GrantWood
WoodCompany
Companymanufactures
manufacturesdesks.
desks.Most
Mostof
ofthe
thecompany’s
company’s
desks
desksare
arestandard
standardmodels
modelsand
andare
aresold
soldon
onthe
thebasis
basisof
ofcatalog
catalog
prices.
At
December
31,
2002,
the
following
finished
desks
prices. At December 31, 2002, the following finished desksappear
appearinin
the
company’s
inventory:
the company’s inventory:
Sale commissions and disposal costs
Floor
Floor==
NRV
NRVless
lessNormal
Normal
Profit
Profit Margin
Margin
LCM
LCM
Slide 9-5
UCSB, Anderson
Can
Canuse
use allowance
allowanceor
ordirect
direct method:
method:
ALLOWANCE:
ALLOWANCE:
 Separate
Separateline
lineon
on balance
balance sheet
sheetto
to show
show “inventory
“inventory
allowance”
allowance”
 Separate
Separateline
lineon
onincome
incomestatement
statement to
toshow
show “loss
“losson
on
inventory”
inventory”
DIRECT:
DIRECT:
 Charge
Chargedirectly
directlyto
toinventory,
inventory, no
noallowance
allowanceon
onbalance
balance
sheet
sheet
 Charge
directly
to
COS,
no
line
for
“loss
on
Charge directly to COS, no line for “loss on
inventory”
inventory” in
inthe
the income
incomestatement.
statement.
Slide 9-6
UCSB, Anderson
ABC Company
Income Statement
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
Slide 9-7
Allowance
$ 200,000
120,000
80,000
ABC Company
Balance Sheet
Direct
$ 200,000
132,000
68,000
45,000
20,000
65,000
12,000
5,000
(7,000)
8,000
2,400
$
5,600
45,000
20,000
65,000
$
A llo w a n c e
C u r r e n t a s s e ts :
C ash
A c c o u n ts r e c e iv a b le
In v e n to r y
L e s s : in v e n to r y a llo w a n c e
P r e p a id s
T o ta l c u r r e n t a s s e ts
UCSB, Anderson
Backs
Backsinto
intoinventory
inventoryusing
using aarollforward
rollforwardand
and estimating
estimating
the
the cost
costof
ofgoods
goods sold
soldby
byreducing
reducingsales
salesby
bythe
theprofit.
profit.
 Company
has
sales
of
$100,000
and
normal
Company has sales of $100,000 and normal profit
profit
margin
marginof
of 10%,
10%, so
sothey
theymake
makethe
thefollowing
followingentry:
entry:
A/R
A/R $100,000
$100,000
Sales
$100,000
Sales
$100,000
COS
COS $90,000
$90,000
Inventory
Inventory $$90,000
90,000
Slide 9-8
2 0 ,0 0 0
1 ,2 2 8 ,0 0 0
UCSB, Anderson
Retail
Retail Inventory
Inventory Method
Method
 Provides
Provides an
an estimate
estimate of
of ending
ending inventory
inventory
without
without aa physical
physical count.
count.
 Produces
Produces estimates
estimates that
that may
may be
be acceptable
acceptable
for
for financial
financial statement
statement (reporting)
(reporting) purposes.
purposes.
UCSB, Anderson
Slide 9-10
Retail
Retail Inventory
Inventory Variations
Variations
Textbook
TextbookIllustrates:
Illustrates:
 LCM
LCMMethod
Method(conventional
(conventionalretail)
retail)
–– Computes
Computescost
costratio
ratioafter
aftermarkups
markups(and
(andmarkup
markupcancellations)
cancellations)only
only
»» More
Moreconservative,
conservative,excluding
excludingmarkdowns
markdownsfrom
fromratio
ratioresults
resultsiningreater
greaterCOS
COS
Cost
CostMethod
Method(average
(averagecost)
cost)
–– Computes
Computescost
costratio
ratioafter
afterboth
bothmarkups
markupsAND
ANDmarkdowns
markdowns(and
(andcancellations
cancellationsto
toboth)
both)
»» LESS
LESSconservative,
conservative,including
includingmarkdowns
markdownsininratio
ratioresults
resultsininlower
lowerCOS
COS
Appendix
Appendix9A:
9A:
 LIFO
LIFOretail
retailat
atcost
costwith
withstable
stableprices
prices(LIFO
(LIFOretail)
retail)COVEREDCOVERED-computes
computesratio
ratio
after
afterBOTH
BOTHM-ups
M-upsand
andM-downs
M-downs

$ 1 0 0 ,0 0 0
3 5 0 ,0 0 0
7 5 8 ,0 0 0
Not
Notnormally
normallyacceptable
acceptablefor
forfinancial
financialreporting
reporting
purposes,
purposes,but
butsometimes
sometimespractical
practicalfor
forinterim
interim
reporting.
reporting.
Slide 9-9

1 0 0 ,0 0 0
3 5 0 ,0 0 0
7 7 0 ,0 0 0
(1 2 ,0 0 0 )
2 0 ,0 0 0
1 ,2 2 8 ,0 0 0
5,000
5,000
8,000
2,400
5,600
GROSS PROFIT METHOD

$
D ir e c t
NOT
NOTCOVERED
COVEREDAND
ANDSTUDENTS
STUDENTSNOT
NOTRESPONSIBLE
RESPONSIBLEFOR
FORIN
INTHIS
THISCLASS:
CLASS:
LIFO
LIFOat
atcost
costwith
withfluctuating
fluctuatingprices
prices(dollar-value
(dollar-valueLIFO
LIFOretail)
retail)
UCSB, Anderson
Retail
Retail Inventory
Inventory Example
Example
Jared
JaredJones
JonesInc.
Inc.uses
usesthe
theretail
retailinventory
inventorymethod
methodto
toestimate
estimateending
ending
inventory
inventoryfor
forits
itsmonthly
monthlyfinancial
financialstatements.
statements.The
Thefollowing
followingdata
data
pertain
pertainto
toaasingle
singledepartment
departmentfor
forthe
themonth
monthof
ofOctober
October2002:
2002:
Cost
Retail
Inventory, October 1, 2002
$52,000
$78,000
Purchases, net
273,000
415,000
Additional markups
Markup cancellations
9,000
Markdowns, net
3,600
2,000
380,000
Sales
Prepare
Prepareaaschedule
schedulecomputing
computingending
endinginventory
inventoryusing
usingthe
the(1)
(1)
cost,
cost,(2)
(2)conventional
conventional(LCM),
(LCM),and
and(3)
(3)LIFO
LIFOretail
retailmethods.
methods.
Slide 9-11
UCSB, Anderson
Slide 9-12
UCSB, Anderson
SOLUTIONSOLUTION- CONVENTIONAL RETAIL LIFO
SOLUTIONSOLUTION- CONVENTIONAL & COST
Cost
52,000
273,000
325,000
Beginning Inventory
Purchases, net
Merchandise available for sale
Additional markups
Markup cancellations
Conventional/ LCM method Ratio
Markdowns, net
Total before sales
Cost method Ratio
DEDUCT SALES
ENDING INVENTORY AT RETAIL
325,000
(3,600)
496,400
65.0%
65.5%
(380,000)
116,400
ENDING inventory using conventional/ LCM method
Ending inventory using cost method
Slide 9-13
325,000
Retail
78,000
415,000
493,000
9,000
(2,000)
500,000
75,660
76,209
UCSB, Anderson
Appraisal
Appraisal of
of Retail
Retail Inventory
Inventory Method
Method
Cost
52,000
Beginning Inventory
LIFO OPENING POOL RATIO
Purchases
Markups
Markup cancellations
Markdowns, net
New inventory
LIFO current layer ratio
78,000
67%
273,000
415,000
9,000
(2,000)
(3,600)
418,400
65%
273,000
Total including Beg. Inventory
Net sales
Ending inventory at retail
Ending at Retail
116,400
Retail
not necessary
496,400
(380,000)
116,400
Layers at retail
Ratio
Ending at LIFO Cost
October 1
78,000
67%
52,000
October 31
38,400
65%
25,055
77,055
ENDING INVENTORY
AT LIFO COST
Slide 9-14
UCSB, Anderson
Inventory
Inventory Disclosure
Disclosure
Method
Method permits:
permits:
 the
computation
the computation of
of net
net income
income without
without aa
physical
physical count
count of
of inventory
inventory
 aa control
control measure
measure in
in determining
determining inventory
inventory
shortages.
shortages.
 regulation
regulation of
of quantities
quantities of
of merchandise
merchandise on
on
hand.
hand.
 information
information needed
needed for
for insurance
insurance purposes.
purposes.
 Composition
Composition of
of manufactured
manufactured inventory
inventory .......
.......
Slide 9-15
Slide 9-16
UCSB, Anderson
OTHER INVENTORY CONCEPTS
Relative
Relative Sales
Sales Value
Value Method:
Method:
 Multiple
Multiple items
items purchased
purchased together,
together, cost
cost is
is
assigned
assigned by
by allocating
allocating cost
cost using
using relative
relative
proportion
proportion of
of estimated
estimated selling
selling price.
price.
Purchase
Purchase Commitments:
Commitments:
 Because
Because itit is
is “executory”
“executory” in
in nature
nature (both
(both
parties
parties have
have yet
yet to
to fulfill
fulfill contractual
contractual
obligation)
obligation) no
no recordation.
recordation.
–– Disclosure
Disclosurerequired
requiredfor
for all
all commitments;
commitments;
–– IfIfcommitment
commitmentis
isdifferent
differentthan
thancost,
cost,then
then aaliability
liability
should
be
recorded.
should be recorded.
Slide 9-17
UCSB, Anderson
(raw
(raw materials,
materials, WIP,
WIP, and
and finished
finished goods)
goods)
 Unusual
Unusual or
or significant
significant financing
financing arrangement
arrangement
(related
(related party
party transactions,
transactions, firm
firm purchase
purchase
commitments,
commitments, etc.)
etc.)
 Inventory
Inventory costing
costing methods
methods used.
used.
 Consistency
Consistency of
of costing
costing methods
methods from
from one
one
period
period to
to another.
another.
UCSB, Anderson
SPECIAL ITEMS
The
The following
following chart
chart will
will help
help you
you remember
remember how
how
to
to treat
treat certain
certain items
items when
when applying
applying the
the
various
various retail
retail inventory
inventory methods:
methods:
COST
RETAIL
Freight costs
Purchase returns
Purchase discounts and allowances
++Sales returns and allowances
Sales discounts
Using gross method
Using net method
++Normal shortages (breakage, shrinkage, etc.)
Abnormal shortages
++Employee discounts
Add
Deduct
Deduct
-
Deduct
Deduct*
Reduce sales
Deduct
-
Deduct
Deduct
Deduct
Deduct
* Allowances Not included in retail component if they are not reflected as a
reduction to the sales price.
++ NOT included in the ratio computation– only in arriving at ending retail inventory.
Slide 9-18
UCSB, Anderson
SPECIAL ITEMS ILLUSTRATION
Special items solution
Illustration
Illustration9-22
9-22in
inchapter
chapter9.
9.
Based
Basedon
onthe
thebelow
belowfacts,
facts,compute
computeConventional
Conventionalretail
retailinventory:
inventory:
 Beginning
inventory
$1,000
Beginning inventory $1,000at
atcost
cost$1,800
$1,800at
atretail;
retail;
 Purchases
at
$30k
and
$60k
at
cost
and
retail,
respectively;
Purchases at $30k and $60k at cost and retail, respectively;
 Freight
Freightin
in$600;
$600;
 Purchase
Purchasereturns
returnsof
of$1,500
$1,500and
and$3,000
$3,000at
atcost
costand
andretail,
retail,
respectively;
respectively;
 Markups
$9,000;
Markups $9,000;
 Abnormal
Abnormalshortage
shortage$1,200
$1,200and
and$2,000
$2,000at
atcost
costand
andretail,
retail,
respectively;
respectively;
 Net
Netmarkdowns
markdowns$1,400
$1,400
 Sales
Sales$36,000
$36,000
 Sales
Salesreturns
returns$900
$900
 Employee
Employeediscounts
discounts$800
$800
 Normal
Normalshortage
shortage$1,300
$1,300
Slide 9-19
UCSB, Anderson
Beginning inventory
Purchases
Freight in
Purchase returns
Markups
Abnormal shortage
RATIO
Inventory
$
Sale
Periodic
Count
-Replacement cost
-NRV
-NRV-Normal Profit
$
Perpetual
Middle value of above=
“Designated Market Value”
No-Count,
but “cycle count” for controls
Apply Method- see summary next slide
Slide 9-20
GAAP INVENTORY!
Slide 9-21
UCSB, Anderson
Disclosure of Inventory




Composition of manufactured inventory .......
(raw materials, WIP, and finished goods)
Unusual or significant financing arrangement
(related party transactions, firm purchase
commitments, etc.)
Inventory costing methods used.
Consistency of costing methods from one
period to another.
20
Slide 9-23
UCSB, Anderson
Retail
1,800
60,000
(3,000)
9,000
(2,000)
65,800
(1,400)
(35,100)
(800)
(1,300)
27,200
43.92%
11,947
Ratio
Ending inventory
UCSB, Anderson
METHODS COVERED






FIFO=LISH
FIFO=LISH
LIFO=FISH
LIFO=FISH
SPEC.
SPEC.IDENTIFICATIONIDENTIFICATION-COMPUTER
COMPUTER TRACKING
TRACKING
AVERAGE
AVERAGE COST
COST
DOLLAR
DOLLAR VALUE
VALUE LIFO=D.S.M.A
LIFO=D.S.M.A(Strips
(Stripsout
outeffects
effectsof
of
increasing
increasingcosts
costs in
inapplying
applying LIFO)
LIFO)
RETAIL
RETAIL METHODS
METHODS(Relies
(Relieson
on Retail
RetailTracking
Tracking and
and
cost:retail
cost:retailratio
ratioto
to“back
“backinto”
into”ending
endinginventory)
inventory)
–– Conventional/
Conventional/LCM=
LCM=M-Ups
M-Upsonly
only
–– Cost/
Cost/Average
AverageCost=
Cost=M-ups
M-upsand
andM-downs,
M-downs,less
lessconservative
conservative
than
than“conventional
“conventionalretail
retail
–– LIFO
LIFORetail=
Retail=Use
Useretail
retailmethod
methodbut
butdetermine
determineratios
ratiosin
in
“Layers”
“Layers”hence
henceLIFO
LIFOmethod.
method.Uses
UsesM-ups
M-upsAND
ANDM-downs
M-downs
Inventory at “Cost”
Lower of
“Cost” or
“Market”
(1,200)
28,900
43.92%
Markdowns
Sales, net of returns
Employee discounts
Normal shortage
INVENTORY SUMMARY
Company
Cost
1,000
30,000
600
(1,500)

Gross
GrossProfit=
Profit= NOT
NOTGAAP,
GAAP,but
but sufficient
sufficientfor
forinternal
internal
management
managementreporting.
reporting.
Slide 9-22
UCSB, Anderson