Inventories: Additional Issues

REPORTING-LOWER OF COST OR MARKET

Normally ending inventory is stated at historical cost, but there are times when the original cost of the ending inventory is greater than the cost of replacement. Under this circumstance, the inventory has lost value. When preparing the financial statements, many companies go through a process to determine if their inventory has lost value. If the inventory has maintained value equal to historical cost, or increased in value, then the inventory is reported at historical cost. If the inventory has decreased in value below historical cost then the inventory is reduced in value on the balance sheet. The criterion for reporting inventory value is the lower of historical cost or market value. Any loss resulting from the decline in the value of inventory is charged to cost of goods sold in the accounting period that it is discovered.

Determining Market Value

To determine the market value of an inventory item we use three parameters. These parameters include the replacement cost of the item, and two calculated items called the ceiling and the floor.

q Current r eplacement cost represents the current cost of the inventory item and may be obtained through manufacturers or suppliers.

q The ceiling (also called the upper limit) is the net realizable value of the inventory item. Net realizable value is calculated as the selling price of the item less the estimated cost of completion and disposal.

q The floor (also called the lower limit) is the ceiling (net realizable value) less an allowance for normal profit margin.

The market value chosen is called the designated market value.

Example: Spencer Company purchased dog runs from a manufacturer for $550 and sells them for $1,200. Therefore, the normal gross profit on the dog runs is $650 ($1,200-$550). The selling costs (costs of disposal) are estimated to be $20 per unit. According to the manufacturer, the replacement cost of the dog run at year-end is $500. Based upon this information, at what amount will one unit be reported on the balance sheet using lower of cost or market?

To determine the designated market value we must compare replacement cost to the ceiling and the floor. The designated market value will be the middle value of the three parameters. In our example, the parameters are as follows:

In the above example the designated market will be the floor amount of $530 because it is the middle of the three market value parameters.

Reporting Inventory – Historical Cost versus Designated Market Value

Most business organizations have a large number of inventory items with replacement prices changing on a daily basis. At year end the company will count and price inventory at historical cost. At this point the test for lower of cost or market is performed, normally on the entire inventory. A designated market value is determined as described above and then compared to historical cost. The final inventory is reported at the lower amount.

Example: Spencer Company carries six categories of inventory. The following is an analysis of the lower of cost or market of the entire inventory.

For Inventory Category A:

q Designated market value is determined using the middle amount of the three parameters: replacement cost, the ceiling, and the floor. The designated market value is the replacement cost of $22,000.

q The designated market value is then compared to the historical cost of the inventory item and the lower value is called the lower of cost or market. Designated market value is $22,000 and historical cost is $20,000. Therefore, the lower of cost or market for Inventory Category A is $20,000.

This process is carried out for each inventory category. Finally, the total historical cost of the inventory ($345,000) is compared to the total lower of cost or market value of the inventory ($304,000). The lower amount is reported on the balance sheet.

Adjusting the Inventory Balance in the General Ledger

Currently the ending inventory in the general ledger is $345,000. The company will need to make a year-end adjusting journal entry to record the loss as a result of the inventory valuation. If the loss has a material effect on the cost of goods sold it would be recorded as follows:

If the loss does not have a material effect on the cost of goods sold it would most likely be recorded as follows:

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