This chapter covers lower of cost of market (LCM) or net realizable value, gross profit method, retail inventory method and LIFO retail method.
Lower of Cost or Market LCM
Lump Sum Purchase | Relative Sales Value Method
Estimating Inventory Using Gross Profit Method
Example: Gross Profit Method for Estimating Ending Inventory
Retail Inventory Method: Conventional and Cost Method
Example: Retail Inventory Method
Chapter 9 concludes the discussion of inventories by addressing certain unique valuation problems not covered in Chapter 8. Chapter 9 also includes a description of the development and use of various estimation techniques used to value ending inventory without a physical count.
Lower-of-Cost-and-Net Realizable Value (LCNRV)
When the future revenue-producing ability associated with inventory drops below its original cost, the inventory should be written down in the period in which the loss occurs with the loss recognized in the income statement. Historical cost is abandoned when the future utility of the asset is no longer as great as its original cost. This is known as the lower-of-cost-and-Net Realizable Value (LCNRV) method of valuing inventory and is an accepted GAAP practice. When inventory declines in value below its original cost, the inventory should be written down to reflect the loss.
Methods of Applying LCNRV
The lower-of-cost-and-Net Realizable Value rule may be applied (a) directly to each item, (b) to each category, or (c) to the total inventory. The individual-item approach is preferred by many companies because tax rules require its use when practical, and it produces the most conservative inventory valuation on the balance sheet. The method selected should be the one that most clearly reflects income.
When inventory is written down to market, this new basis is considered to be the cost basis for future periods.
Recording Inventory at NRV Instead of Cost
Two methods are used to record inventory at market. The cost-of-goods-sold method substitutes the net realizable value for cost when valuing the inventory. This method results in burying the loss in the cost of goods sold, as no individual loss account is reported in the income statement. Under the loss method, an entry is made to debit a loss and credit an allowance account for the difference between cost and the net realizable value. Separately recording the loss and a contra account is preferable as it does not distort the cost of goods sold and clearly displays the loss separately.
For companies that use the LIFO or retail inventory methods of costing inventory, a “designated market value” instead of net realizable value of the inventory is compared to cost.
The term “market” in lower of cost or market generally refers to the replacement cost of an inventory item. However, market value should not exceed net realizable value (NRV), nor should it be less than net realizable value less a normal profit margin. These are known as the ceiling (upper) and floor (lower) limits of market, respectively. Market is defined as replacement cost if such cost falls between the upper and lower limits. Should replacement cost be above the upper limit, market would be defined as net realizable value. If replacement cost falls below the lower limit, market is defined as net realizable value less a normal profit margin.
For example, consider the following illustration.
Inventory at sales value…………………………………………… $800
Less: Estimated cost of completing and disposal……. 200
Net realizable value (NRV)………………………………………. 600
Less: Allowance for normal profit margin……………….. 100
NRV less a normal profit margin……………………………… $500
To arrive at the final inventory valuation, a designated market value must be chosen and then compared to cost. The designated market value is determined by comparing replacement cost of the inventory with the upper and lower limits, i.e., the ceiling and floor. The middle numerical amount is selected, and labeled as the designated market value. It is then compared to cost, and the lower of cost or designated market becomes the basis at which inventory is reported.
Valuation at Net Realizable Value
Reporting inventory at selling price less estimated cost to complete and sell (net realizable value) is acceptable in certain instances, even when that amount is above cost. To be accorded this treatment, the item should (a) have a controlled market with a quoted price applicable to all quantities and (b) when no significant disposal costs are involved. Certain minerals sold in a controlled market and agricultural products that are marketable at fixed prices provide examples of inventory items carried at selling price.
Valuation Using Relative Sales Value
When a group of varying inventory items is purchased for a lump sum price, a problem exists relative to the cost per item. The relative sales value method allocates the total cost to individual items on the basis of the selling price of each item.
Purchase commitments represent noncancelable contracts for the purchase of inventory at a specified price in a future period. If material, the details of the contract should be disclosed in a note to the buyer’s financial statements. If the contract price is in excess of the market price and it is expected that losses will occur when the purchase is effected, the loss should be recognized in the period during which the market decline took place.
Gross Profit Method
The gross profit method is used to estimate the cost of ending inventory. Its use is not appropriate for financial reporting purposes; however, it can serve a useful purpose when an approximation of ending inventory is needed. Such approximations are sometimes required by auditors or when inventory and inventory records are destroyed by fire or some other catastrophe. The gross profit method should never be used as a substitute for a yearly physical inventory unless the inventory has been destroyed.
The gross profit method is based on the assumptions that (a) the beginning inventory plus purchases equals total goods to be accounted for; (b) goods not sold must be on hand; and (c) the sales, reduced to cost, deducted from the sum of the opening inventory plus purchases, equal ending inventory.
Retail Inventory Method
The retail inventory method is an inventory estimation technique based upon an observable pattern between cost and sales price that exists in most retail concerns. This method requires that a record be kept of (a) the total cost and retail of goods purchased, (b) the total cost and retail value of the goods available for sale, and (c) the sales for the period.
Basically, the retail method requires the computation of the cost-to-retail ratio of inventory available for sale. This ratio is computed by dividing the cost of the goods available for sale by the retail value (selling price) of goods available for sale. Once the ratio is determined, total sales for the period are deducted from the retail value of inventory available for sale. The resulting amount represents ending inventory priced at retail. When this amount is multiplied by the cost-to-retail ratio, an approximation of the cost of ending inventory results. Use of this method eliminates the need for a physical count of inventory each time an income statement is prepared. However, physical counts are made at least yearly to determine the accuracy of the records and to avoid overstatements due to theft, loss, and breakage.
To obtain the appropriate inventory figures under the retail inventory method, proper treatment must be given to markups, markup cancellations, markdowns, and markdown cancellations.
When the cost-to-retail ratio is computed after net markups (markups less markup cancellations) have been added, the retail inventory method approximates lower-of-cost-or-market. This is known as the conventional retail inventory method. If both net markups and net markdowns are included before the cost-to-retail ratio is computed, the retail inventory method approximates cost.
The retail inventory method becomes more complicated when such items as freight-in, purchase returns, and purchase discounts and allowances are involved. In essence, the treatment of the items affecting the cost column of the retail inventory approach follows the computation of cost of goods available for sale. Freight costs are treated as a part of the purchase cost; purchase returns are ordinarily considered a reduction of the price at both cost and retail; and purchase discounts and allowances usually are considered as a reduction of the cost of purchases.
Other items that require careful consideration include transfers-in, normal shortages, abnormal shortages, and employee discounts. Transfers-in from another department should be reported in the same way as purchases from an outside enterprise. Normal shortages should reduce the retail column because these goods are no longer available for sale. Abnormal shortages should be deducted from both the cost and retail columns and reported as a special inventory amount or as a loss. Employee discounts should be deducted from the retail column in the same way as sales.
The retail inventory method is widely used (a) to permit the computation of net income without a physical count of inventory, (b) as a control measure in determining inventory shortages, (c) in regulating quantities of inventory on hand, and (d) for insurance information.
Presentation of Inventories
Because inventories normally represent one of the most significant assets held by a business entity, the accounting profession has mandated certain disclosure requirements. Some of the disclosure requirements include: the composition of the inventory, the inventory financing arrangements, inventory costing methods employed, and whether costing methods have been consistently applied.
Analysis of Inventories
Two common financial ratios used to analyze inventory are (1) the inventory turnover and (2) the average days to sell inventory. The inventory turnover measures the number of times on average a company sells the inventory during the period. The average days to sell inventory represents the average number of days sales for which a company has inventory on hand.
Many accountants suggest a LIFO assumption be adopted for use with the application of the retail inventory method. Use of LIFO in connection with the retail inventory method is thought to result in a better matching of costs and revenues.
The application of LIFO retail is made under two assumptions (a) stable prices, and
(b) fluctuating prices. Because the LIFO method is a cost method, not a cost or market approach, both the markups and markdowns must be considered in obtaining the proper cost to retail percentage. Beginning inventory is excluded from the computation of the cost to retail percentage because of the layer effect that results from the use of the LIFO method.
The advantages and disadvantages of the lower-of-cost-or-market method (conventional retail) versus LIFO retail are the same as for nonretail operations. In the final analysis, the ultimate decision concerning which retail inventory method to use is often based on the method that results in the lower taxable income. If changes in the price level occur, the effect of such changes must be eliminated when using the LIFO retail method.
If a company wishes to change from conventional retail to LIFO retail, the beginning inventory must be restated to conform with the LIFO assumption. In effecting the change, the inventory of the prior period must be recomputed on the LIFO basis. This amount then serves as the beginning inventory for the LIFO retail method applied in the current period.