INTERMEDIATE
ACCOUNTING
Chapter 8
Inventories: Special Valuation Issues
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What is the Lower of Cost or Market Rule?
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The lower of cost or market (LCM) rule requires that a
company write down its inventory to its market value
when the inventory’s utility has declined.
By reporting inventory at the lower of its cost or market
value, a company reports a more representationally
faithful value for inventory on its balance sheet and a
loss (or expense) in its income statement in the period
the asset’s value declines rather than in the period the
goods are sold.
Therefore, the application of the lower of cost or
market rule is consistent with the conservatism principle.
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Determining Market Value
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To apply the lower of cost or market rule, the company
must estimate the market value of inventory in order to
compare it to cost to determine which amount is lower.
Under the lower of cost or market rule, market value is
defined as the current replacement cost—the cost the
company would pay to replace the item.
This replacement cost valuation of inventory is a more
relevant and representationally faithful value than the
original (higher) costs the company actually incurred.
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Replacement Cost
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To measure replacement cost, GAAP imposes an
upper (ceiling) and a lower (floor) constraint on the
market value as follows:
 Net
Realizable Value (ceiling): The market value should
not be more than the net realizable value—the
estimated selling price in the ordinary course of
business minus reasonably predictable costs of
completion and disposal.
 Net Realizable Value minus a Normal Profit Margin
(floor): The market value should not be less than the net
realizable value reduced by an estimate of a normal
profit margin or markup.
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Application of the
Lower of Cost or Market Rule (Slide 1 of 2)
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Step 1. Determine the market value. Calculate the
current replacement cost, ceiling, and floor, and select
the middle value of the three.
Step 2. Compare the market value to cost. Assign the
lower of the selected market value or the historical cost
to the value of inventory.
Step 3. Report the results in the financial statements.
Report the lower value on the balance sheet. If the
company recognizes a loss, report the amount on the
income statement as either a separate line item for loss
from an inventory write-down or by including it in cost
of goods sold.
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Application of the
Lower of Cost or Market Rule (Slide 2 of 2)
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Approaches to Implementing
the Lower of Cost or Market Rule
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A company may apply the lower of cost or market rule
to each individual item in inventory, each major
inventory category, or to the total of the inventory.
When the lower of cost or market rule is applied to
each major category or to the total of the inventory,
price declines of some of the units in inventory are
offset by price increases in other units of inventory in
the same category.
Therefore, applying the lower of cost or market rule to
groups of inventory will usually result in higher inventory
valuations and lower losses relative to applying the rule
to each individual item of inventory.
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Recording the Reduction of Inventory to Market
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A company can record the write-down of inventory
from cost to market value using either of two
methods:
 Direct
Method—The loss is recorded directly by
reducing the company’s inventory account and
increasing its cost of goods sold account.
 Allowance Method—The loss is recorded in a
separate inventory valuation account and loss account.
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Reporting Lower of Cost or Market
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Under the direct method, the write-down of
inventory is recorded directly in inventory and cost
of goods sold.
Under the allowance method, the write-down is
recorded in an allowance account and a loss
account.
The allowance account is reported as a contrainventory account in a company’s balance sheet.
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part
Can Inventory Be Valued Above Cost?
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Normally, a company will not value its inventory
above cost.
However, under certain circumstances, GAAP does
allow a company to report its inventory above cost.
This exception must be justified by:
 An
inability to determine appropriate costs
 Immediate marketability of the inventory at a quoted
market price
 The interchangeability of the units of inventory
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How is Inventory Estimated Using
the Gross Profit Method? (Slide 1 of 2)
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The gross profit method may be used in the following situations:
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To determine the cost of the inventory for interim financial statements. This
method is acceptable provided that the company discloses the method used
at the interim date and any significant adjustments that result from
reconciliations with the annual physical inventory.
To check the reasonableness of the reported cost of inventory by an auditor.
To estimate the cost of inventory that is destroyed by a casualty, such as a
fire.
To estimate the cost of the inventory from incomplete records. For example,
if a company’s inventory records are destroyed, the inventory can be
estimated if the cost of goods available for sale and the sales are known or
can be reconstructed.
To develop budgeted amounts for cost of goods sold and ending inventory
from a sales budget.
However, the gross profit method is not acceptable for annual financial
statements.
Instead, a physical count of inventory is required to verify the inventory
quantity.
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How is Inventory Estimated Using
the Gross Profit Method? (Slide 2 of 2)
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Step 1. Calculate the historical gross profit rate, as
Gross Profit from Prior Periods
Net Sales from Prior Periods
Step 2. Calculate the cost of goods available for sale in the current period, as
Beginning Inventory + Net Purchases
Step 3. Estimate the gross profit for the current period, as
Historical Gross Profit Rate x Net Sales Revenue (current period)
Step 4. Estimate the cost of goods sold for the period, as
Net Sales Revenue (current period) - Estimated Gross Profit
Step 5. Determine the estimated cost of the ending inventory, as
Cost of Goods Available for Sale - Estimated Cost of Goods Sold
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How is Inventory Estimated Using
the Retail Inventory Method? (Slide 1 of 3)
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As an alternative to the gross profit method, the retail
inventory method can be used to estimate the cost of
inventory when there is a consistent pattern between the
cost of a company’s purchases and its selling prices.
The retail inventory method has two main advantages
compared to the gross profit method:
While the gross profit method estimates a profit percentage
based on past periods, the retail inventory method uses a
current-period estimate of gross profit. This makes the retail
inventory method more sensitive to price changes and
produces a more accurate estimate of current period ending
inventory.
 The retail inventory method is allowed for both financial
reporting and income tax purposes.
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How is Inventory Estimated Using
the Retail Inventory Method? (Slide 2 of 3)
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The retail inventory method requires a company to
maintain accounting records that contain the following
information:
beginning inventory at cost and retail value
 goods purchased at cost and retail value
 changes in selling price resulting from additional markups
and markdowns
 sales
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Note that information related to both beginning
inventory and purchases must be provided at both cost
and retail values, where retail values are the current
selling prices of the goods.
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How is Inventory Estimated Using
the Retail Inventory Method? (Slide 3 of 3)
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Step 1. Compute the total goods available for sale at
both cost and retail value.
Step 2. Compute the appropriate cost-to-retail ratio.
Step 3. Compute the ending inventory at retail.
Retail Value of Goods Available for Sale x Net Sales Revenue
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Step 4. Compute the ending inventory at cost.
Ending Inventory at Retail x Cost-to-Retail Ratio
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Retail Inventory Method Terminology
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Retail stores typically make changes in selling prices after setting the
original price.
The following seven terms describe these changes:
 Markup: the original markup from cost to the original selling price
 Additional Markup: an increase above the original sales price
 Markup Cancellation: a reduction in the selling price after there has
been an additional markup; the markup cancellation cannot be
greater than the additional markup
 Net Additional Markup: the total additional markups minus the total
markup cancellations
 Markdown: a decrease below the original selling price
 Markdown Cancellation: an increase in the selling price after there
has been a markdown; the markdown cancellation cannot be
greater than the markdown
 Net Markdown: the total markdowns minus the total markdown
cancellations
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Application of the Retail Inventory Method
(Slide 1 of 2)
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By changing the inputs of the cost-to-retail ratio, companies can use the
retail inventory method to develop inventory valuations under different cost
flow assumptions.
FIFO. Exclude the cost and the retail value of the beginning inventory from
the computation of the cost-to-retail ratio for the period. The ratio should
include both net additional markups and net markdowns.
Average Cost. Include the cost and the retail value of the beginning
inventory and net additional markups and net markdowns in the cost-toretail ratio.
LIFO. Compute separate ratios for each layer in the beginning inventory
and for the purchases of the current period. Include both net additional
markups and net markdowns in the cost-to-retail ratio for the current
period.
Lower of Average Cost or Market. Include the cost and retail value of the
beginning inventory and net additional markups in the cost-to-retail ratio.
Net markdowns are excluded from the cost-to-retail ratio. This method is
also known as the conventional retail method.
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Application of the Retail Inventory Method
(Slide 2 of 2)
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Retail Lower of Average Cost or Market
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The retail inventory method can also be used to
approximate the valuation of inventory at the lower of
cost or market by excluding net markdowns from the
computation of the cost-to-retail ratio.
The rationale for excluding net markdowns is that
companies will normally mark down inventory to
indicate a decrease in utility (e.g., obsolescence, lower
demand for the goods).
Excluding net markdowns will result in a lower cost-toretail ratio which, consistent with the lower of cost or
market rule, leads to a lower approximation of ending
inventory.
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Additional Adjustments under the Retail Method
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The application of the retail method is complicated
when a company considers other typical costs and
activities such as:
 freight
charges
 purchase discounts
 purchase returns and allowances
 sales returns and allowances
 sales discounts
 inventory shrinkage
 employee discounts
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What is the Dollar-Value Retail Method?
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The previous discussion of the retail LIFO method
assumed that there were no changes in the retail
price of inventory during the period.
However, when prices change during a period, a
company can combine the principles of the retail
LIFO method with the dollar-value LIFO method to
eliminate the effects of this price change.
This combination is called the dollar-value LIFO
retail method.
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Example: Dollar-Value Retail Method
(Slide 1 of 6)
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Step 1. The ending inventory at retail is computed by adding the beginning
inventory, purchases, and the markups, and subtracting the markdowns and
sales. Alternatively, ending inventory could be computed at year-end by
taking a physical inventory and multiplying the units in ending inventory by
the current-year retail prices.
Step 2. The ending inventory at retail is converted to base-year retail
prices by applying the base-year conversion index:
Ending Inventory at Retail x
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Base−Year Retail Price Index
Current−Year Price Index
Step 3. The change in the inventory at retail in base-year prices is
computed by comparing the ending inventory with the beginning inventory
when both are measured at retail in base-year prices.
Step 4. The change in the inventory at retail in base-year prices is
converted to current-year retail prices by multiplying it by the appropriate
conversion index. If there is an increase, the current year conversion index is:
Current−Year Price Index
Base−Year Price Index
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Increase at Base-Year Retail Prices x
Example: Dollar-Value Retail Method
(Slide 2 of 6)
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Step 4. (cont’d) If there is an decrease, the current year
conversion index for the appropriate LIFO layer is:
Decrease at Base-Year Retail Prices x
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Price Index of Most Recently Added Layer
Base−Year Price Index
Note that for large decreases that affect more than one layer of
inventory, the price index applicable to each layer must be used
in the conversion index.
Step 5. The change in inventory at current-year retail prices is
converted to cost by multiplying it by the cost-to-retail ratio for
the appropriate year.
Step 6. The ending inventory at cost is computed by adding
(subtracting) the increase (decrease) in inventory at cost to the
beginning inventory at cost.
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What are the Effects of Inventory Errors?
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Errors in the valuation of inventory or the recording of
purchases can result in inaccurate values on the
company’s balance sheet and income statement.
The discovery of inventory errors requires careful
analysis and adjusting entries to correct the company’s
accounts.
If a company discovers an error in the same accounting
period that the error was made, it reverses the
erroneous entry and records a correct entry.
However, if a company discovers a material error after
it has closed the books, it treats the correction as a prior
period adjustment.
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Effects of Inventory Errors
(Slide 1 of 2)
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Effects of Inventory Errors
(Slide 2 of 2)
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