Intermediate Accounting 11th edition
COPYRIGHT © 2010 South-Western/Cengage Learning

The lower of cost or market rule requires that a company write down its inventory to its market value when the inventory’s utility has declined.
2

Lower of Cost or Market
Inventory: Estimated selling price in completed condition
Less: Estimated costs to complete and sell
Net realizable value (ceiling)
Less: normal profit
NRV less normal profit (floor)
$1,150
150
$1,000
100
$ 900
3

Lower of Cost or Market
4

Lower of Cost or Market
(Ex. 9-1 p. 426)
A company’s unit of inventory has the following characteristics:
Selling price
Packaging cost
$165
10
Transportation cost 15
Profit margin 40
5

Case 1
Lower of Cost or Market
Selling price $165
Cost of completion (10)
Transportation cost (15)
Ceiling (NRV) $140
Normal Profit Margin = 40
Ceiling $140
Normal profit (40)
Floor $100
6

Case 1
Lower of Cost or Market
Selling price $165
Cost of completion (10)
Transportation cost (15)
Ceiling (NRV) $140
Cost =
$110
Current
Replacement Normal Profit Margin=$40
Cost = $120
Market =
$120
Ceiling $140
Normal profit (40)
Floor $100
LCM is the cost of
$110
7

Case 2
Lower of Cost or Market
Selling price $165
Cost of completion (10)
Transportation cost (15)
Ceiling (NRV) $140
Cost =
$110
Current
Replacement
Cost = $150
Normal Profit =$40
Ceiling $140
Normal profit (40)
Floor $100
Market =
$140
LCM is the cost of
$110
8

Case 3
Selling price $165
Cost of completion (10)
Transportation cost (15)
Ceiling (NRV) $140
Cost =
$110
Current
Replacement
Cost = $75
Normal Profit Margin=$20
Market =
$120
Ceiling $140
Normal profit (20)
Floor $120
LCM is the cost of
$110
9

Case 4
Lower of Cost or Market
Selling price $165
Cost of completion (10)
Transportation cost (15)
Ceiling (NRV) $140
Cost =
$110
Current
Replacement Normal Profit Margin=$40
Cost = $105
Ceiling $140
Normal profit (40)
Floor $100
Market =
$105
LCM is the market of
$105
10

Case 5
Lower of Cost or Market
Selling price $115
Cost of completion (10)
Transportation cost (15)
Ceiling (NRV) $90
Current
Replacement
Cost = $105
Normal Profit = $10
Ceiling $90
Normal profit (10)
Floor $80
Cost =
$110
Market =
$90
LCM is the market of
$90
11

Case 6
Lower of Cost or Market
Selling price $165
Cost of completion (10)
Transportation cost (15)
Ceiling (NRV) $140
Current
Replacement
Cost = $80
Normal Profit=$40
Ceiling $140
Normal profit (40)
Floor $100
Cost =
$110
Market =
$100
LCM is the market of
$100
12

The reduction of the value of the inventory to market and the recognition of a loss are appropriate for both a company’s balance sheet and income statement. GAAP defines assets as “probable future economic benefits.”
When the cost of the inventory exceeds the expected benefits, the lower market value is a better measure of the expected benefits. In other words, an unrecoverable cost is not an asset. A company should recognize the decline in value of the inventory as a reduction in the income of the period in which the loss occurs.
13
13

Estimating Inventory
Two commonly used methods of estimating inventory costs are (1) the gross profit method and (2) the retail inventory method.
14
14

Enhancing the Accuracy of the Gross Profit
Method
1.
A company should adjust the gross profit rate for known changes in the relationship between its gross profit and net sales.
2.
A company may use a separate gross profit rate for each department or type of inventory that has a different markup percentage.
3.
A company may use an average gross profit rate based on several past periods to average out period-to-period fluctuations.
15

Expressing Gross Profit Percentages
Divide gross profit by sales to calculate profit as a percentage of sales.
Gross Profit Gross Profit as a
Sales
=
Percentage of Sales
16

If the gross margin percentage is expressed as a percentage of cost, it must be converted to a gross margin as a percentage of sales.
Gross Profit as a % of Cost Gross Profit as a
=
Cost + Gross Profit as a % of Cost % of Sales
17

Another method of estimating inventory is the retail inventory method, which is widely used because it is allowed under
GAAP and for income tax purposes.
18

Step 1: The total goods available for sale is computed at both cost and retail value.
Beginning inventory
Purchases
Goods available for sale
Cost Retail
$10,000
50,000
$60,000
$ 17,000
83,000
$100,000
19

Retail Inventory Method
Step 2: A cost-to-retail ratio is computed.
Beginning inventory
Purchases
Goods available for sale
Cost-to-retail ratio:
$ 60,000
$100,000
= 0.60
Cost Retail
$10,000
50,000
$60,000
$ 17,000
83,000
$100,000
20

computed.
Beginning inventory
Purchases
Goods available for sale
Less: Sales
Ending inventory at retail
Cost Retail
$10,000
50,000
$60,000
$ 17,000
83,000
$ 100,000
(80,000)
$ 20,000
21

Retail Inventory Method
Step 4: The ending inventory at cost is computed.
Beginning inventory
Purchases
Goods available for sale
Less: Sales
Ending inventory at retail
Ending inventory at cost
0.60 × $20,000
Cost Retail
$10,000
50,000
$60,000
$ 17,000
83,000
$ 100,000
(80,000)
$ 20,000
$12,000
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Retail Inventory Method Terminology
Increased selling price to $12
Original selling price ($10)
Cost ($6)
Additional
Markup
Markup
23

Retail Inventory Method Terminology
Total Additional Markups
– Total Markup Cancellations
= Net Markup
Reduced selling price to $10.25
Markup
Cancellation
Cost ($6)
24

Retail Inventory Method Terminology
Markup
Cancellation
Reduced selling price to $9
Cost ($6)
Markdown
25

Retail Inventory Method Terminology
Total Additional Markdowns
– Total Markdown Cancellations
= Net Markdown
Increased selling price to $9.60
Cost ($6)
Markdown
Cancellation
26

For methods using cost, such as average cost, FIFO and
LIFO, the net markdowns are included in calculating the cost-to-retail ratio.
27

Retail Inventory Method — FIFO
The FIFO method excludes the beginning inventory in determining the cost-to-retail ratio.
FIFO
28

Retail Inventory Method — FIFO
Purchases
Net markups
Net markdowns
Beginning inventory
Goods available for sale
Less: Sales
Ending inventory at retail
Cost Retail
$40 $ 80
$40
20
$60
5
(10)
$ 75
35
$110
(66)
$ 44
$40
$75
= 0.533
Ending inventory at FIFO cost (0.533 × $44) = $23.45
29

Retail Inventory Method — Average Cost
The average cost method includes the beginning inventory in determining the cost-toretail ratio.
Average
Cost
30

Retail Inventory Method — Average Cost
Beginning inventory
Purchases
Net markups
Net markdowns
Goods available for sale
Less: Sales
Ending inventory at retail
Cost Retail
$20
40
$60
$ 35
80
5
(10)
$110
(66)
$ 44
$60
$110
= 0.545
Ending inventory at average cost (0.545 × $44) = $24
31

Retail Inventory Method — LIFO
Separate cost-to-retail ratios for the beginning inventory and the purchases must be calculated for the LIFO method.
LIFO
32

Retail Inventory Method — LIFO
Beginning inventory
Purchases
$20
Net markups $35
Net markdowns $40
= 0.57
= 0.533
$75
Goods available for sale
Less: Sales
Ending inventory at retail
Cost Retail
$20
40
$60
$ 35
80
5
(10)
75
$110
(66)
$ 44
$35 × 0.57 (beginning inventory layer)
$ 9 × 0.533 (added layer)
Ending inventory at LIFO cost
$20.00
4.80
$24.80
33

Retail Inventory Method — Lower of
Average Cost or Market
The lower of cost or market method includes the beginning inventory, but excludes any net markdowns in determining the cost-to-retail ratio.
Lower of Cost or Market
34

Retail Inventory Method — Lower of Average
Cost or Market
Cost Retail
Beginning inventory
Purchases
Net markups
$60
$120
Net markdowns
Goods available for sale
Less sales
Ending inventory at retail
= 0.50
$20
40
$60
$60
$ 35
80
5
$120
(10)
$110
(66)
$ 44
Ending inventory at lower of cost or market (0.50 × $44) =
$22
35

Conceptual Evaluation — Lower of
Average Cost or Market
The lower of cost or market method is accurate only if either markups and markdowns do not exist at the time or if all the markeddown items has been sold.
Under other conditions, the lower of average cost or market produces an inventory value that is less than cost but only approximates the lower of cost or market.
36

Dollar-Value LIFO Retail Method
Information for following slides
37

Dollar-Value LIFO Retail Method
Step 1: Calculate the ending inventory at retail.
Beginning inventory
Purchases
Net markups
Net markdowns
Goods available for sale
Sales
Ending inventory at retail
Cost Retail
$ 8,000
20,400
$28,400
$ 12,000
32,000
3,000
(1,000)
$ 46,000
(29,800)
$ 16,200
38

Dollar-Value LIFO Retail Method
Step 2: Compute ending inventory to base-year retail prices by applying the base-year conversion index.
Ending
Inventory at
Base-Year
Retail Prices
=
Ending
Inventory at Retail
×
Current-Year Price Index
Base-Year Price Index
$15,000 = $16,200
×
100
108
39

Dollar-Value LIFO Retail Method
Step 3: The increase (decrease) in the inventory at retail is computed by comparing the ending inventory with the beginning inventory.
Ending inventory at base-year retail price……
Beginning inventory, 1/1/2010
Increase
$15,000
12,000
$ 3,000
40

Dollar-Value LIFO Retail Method
Step 4: The increase (decrease) in the inventory at retail is converted to current-year retail prices.
Layer Increase at Current-Year
=
Retail Prices
Increase at
Base-Year
Retail
Prices
×
Current-Year Price Index
Base-Year Price Index
$3,240 = $3,000
×
100
108
41

Dollar-Value LIFO Retail Method
Step 5: The increase (decrease) at current-year retail prices is converted to cost.
$3,240 × 0.60 = $1,944
Cost of purchases was $20,400 in 2010 while purchases adjusted for net markups and net markdowns was $34,000 (32,000 +
$3,000 – $1,000)
$20,400 ÷ $34,000 = 60%
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• Step 6: The ending inventory at cost is computed by adding (subtracting) the increase
(decrease) at cost to the beginning inventory at cost. $1,944 + $8,000 = $9,944
Beginning
Inventory at Cost
43

•
• P9-11
• 1.
Cost Retail
•
• Purchases
• Less: Purchases discounts taken
• Freight-in
• Net markups ($60,000 - $12,000)
•
• Net markdowns ($15,000 - $4,000)
• $330,000 $637,000
(6,000)
•
•
• Cost-to-retail ratio:
•
• Beginning inventory 100,000
•
• Goods available for sale
• Less: Net sales ($610,000 - $30,000) a
• Ending inventory at retail
• Ending inventory at cost ($237,000 x 0.518)
$430,000
$122,766
•
• a Note: Sales discounts are ignored because they are considered
• to be financing items and not part of the original markup.
48,000
(11,000)
180,000
$817,000
(580,000)
$237,000
$320,000
16,000
$600,000
44