“In the corporate world, sometimes things aren`t exactly black and white when it comes to accounting procedures.” —George W. Bush
Inventories (Part F)
by
Charles Lamson
Valuation of Inventory at Other than Cost
Cost is the primary basis for evaluating inventories. In some cases, however, inventory is valued at other than cost. Two such cases arise when (1) the cost of replacing items in inventory is below the recorded cost and (2) the inventory is not available at normal sales prices. This latter case may be due to imperfections, shop wear, style changes, or other causes. Valuation at Lower of Cost or Market If the cost of replacing an item in inventory is lower than the original purchase cost, the lower-of-cost-or-market (LCM) method is used to value the inventory. Market, as used in lower of cost or market, is the cost to replace the merchandise on the inventory date. This market value is based on quantities normally purchased from the usual source of supply. In businesses where inflation is the norm, market prices rarely decline. In businesses where technology changes rapidly (e.g., microcomputers and televisions), market declines are common. The primary advantage of the lower of cost or market method is that gross profit (and net income) is reduced in the period in which the market decline occurred. In applying the lower of cost or market method, the cost and replacement cost can be determined in one of three ways. Cost and replacement cost can be determined for (1) each item in the inventory, (2) major classes or categories of inventory or (3) the inventory as a whole. In practice, the cost and replacement cost of each item are usually determined. To illustrate, assume that there are 400 identical units of Item A in inventory, acquired at a unit cost of $10.25 each. If at the inventory date the item would cost $10.50 to replace, the cost price of $10.25 would be multiplied by 400 to determine the inventory value. On the other hand, if the item could be replaced at $9.50 a unit, the replacement cost of $9.50 would be used for evaluation purposes.  Exhibit 7 illustrates a method of organizing inventory data and applying the lower of cost or market method to each inventory item. The amount of the market decline, $450 ($15,520 - $15,070), may be reported as a separate item on the income statement or included in the cost of merchandise sold. Regardless, net income will be reduced by the amount of the market decline. EXHIBIT 7 Determining Inventory at Lower of Cost or Market  Valuation at Net Realizable Value As you would expect, merchandise that is out of date, spoiled, or damaged or that can be sold only at prices below cost should be written down. Such merchandise should be valued at net realizable value. Net realizable value is the estimated selling price less any direct cost of disposal, such as sales commissions. For example, assume that damaged merchandise costing $1,000 can be sold for only $800, and direct selling expenses are estimated to be $150. This inventory should be valued at $650 ($800 - $150), which is its net realizable value. Presenting Merchandise Inventory on the Balance Sheet Merchandise inventory is usually presented in the current assets section of the balance sheet, following receivables. Both the method of determining the cost of the inventory (fifo, lifo, or average) and the method of valuing the inventory (cost or the lower of cost or market) should be shown. It is not unusual for large businesses with varied activities to use different costing methods for different segments of their inventories. The details may be disclosed in parentheses on the balance sheet or in a footnote to the financial statements. Exhibit 8 shows how parentheses may be used. EXHIBIT 8 Merchandise Inventory on the Balance Sheet   A company may change its inventory costing methods for a valid reason. In such cases, the effect of the change and the reason for the change should be disclosed in the financial statements for the period in which the change occurred. end |
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