When should a company abandon the historical cost principal?
When the future revenue producing ability of the asset drops below its original cost.
Cost
The acquisition price of inventory computed using one of the historical cost-based methods
What are the historical cost based methods?
Specific identification, average cost, FIFO, LIFO
What does the term market in the phrase lower of cost or market mean?
The cost to replace the item by purchase or reproduction
What does the company value goods at when using lower of cost or market?
The cost or market whichever is lower.
Why should the lower-of-cost-or-market method be used?
A company should charge a loss of utility against revenues in the period in which the loss occurs, this is a conservative approach to inventory valuation.
Net realizable value (NRV)
The estimated selling price in the ordinary course if business, less reasonably predictable costs of completion and disposal.
How is the floor amount determined?
A normal profit margin is subtracted from NRV to arrive at the net realizable value less a normal profit margin.
What is the general lower-of-cost-or-market rule?
A company values inventory at the lower-of-cost-or-market, with market limited to an amount that is not more than net realizable value or less than the net realizable value less a normal profit margin.
What is the ceiling amount?
net realizable value
What is the designated market value?
The amount that a company compares to cost. It is always the middle of three amounts; replacement cost, net realizable value, and net realizable value less a normal profit margin.
How can lower-of-cost-or-market be applied?
LCM can be applied directly to each item, to each category, or to the total of the inventory.
Which method of LCM is typically used?
Companies usually price inventory on an item-by-item basis. Tax rules require this method.
Cost of goods sold method
Debits cost of goods sold for the write down of the inventory to market, as result company does not report a loss in the income statement because cost of goods sold already includes loss.
Loss method
Debits a loss account for the write down of the inventory to market.
Allowance to Reduce Inventory to Market
Allowance account for market adjustments
When can the Allowance to Reduce Inventory to Market account be closed?
When the company has sold the goods associated with the account.
What are the disadvantages to the LCM method?
1-A company recognizes the loss in the period the loss occurs not when the sale occurs.
2-Can result in inconsistency since cost used some years and market others
3-LCM values inventory conservatively but may not effect income statement conservatively.
When does GAAP permit recording inventory at net realizable value instead of LCM?
1-When there is a controlled market with a quoted price applicable to all quantities.
2-When there is no significant cost for disposal
3-When it is too difficult to obtain cost figures.
Lump Sum Purchase
Also, called basket purchase, occurs when a company buys a group of varying units in a single purchase.
Relative Sales Value
Allocates the total of lump sum purchase amount the various units, to accurately value each unit.
What industry uses the relative sales value method frequently?
Petroleum industry
Purchase commitments
Agreements to buy inventory weeks, months, or even years in advance. Generally the seller retains title to the merchandise or materials covered in the purchase commitments.
How are ordinary orders that are subject to cancellation treated?
Ordinary orders for which the buyer and seller will determine the prices at the time of shipment and which are subject to cancellation do not represent either an asset or a liability to the buyer.
What happens if a buyer enters into a formal, noncancelable purchase contract?
The buyer recognizes no asset or liability at the date of inception because the contract is executory in nature. If material in nature should disclose in notes.
Where is the unrealized holding loss reported?
Under other expenses and losses on the income statement
Hedging
The purchaser in the purchase commitment simultaneously enters into a contract in which it agrees to sell in the future the same quantity of the same of similar goods at a fixed price.
Gross profit method
A substitute method of verifying inventory used by auditors when only an estimate needed or if there is a fire or other catastrophe that destroys inventory.
What are the 3 assumptions that the gross profit method rely on?
1-The beginning inventory plus purchases equals total goods to be accounted for.
2-Goods not sold must be on hand
3-The sales reduced to cost, deducted from the sum of the opening inventory plus purchases equal ending inventory.
Why is gross profit on selling price the most common method for quoting profit?
1-Most companies state goods on a retail basis not a cost basis.
2-A profit quoted on selling price is lower than one based on cost.
3- The gross profit based on selling price can never exceed 100%
Gross profit selling price formula
Gross Profit on Selling Price = % markup on cost/100% + % markup on cost
Percentage markup on cost
gross profit on selling price/ 100%-gross profit on selling price
What are the major disadvantages of the gross profit method.
1-It provides an estimate
2-Uses past percentages
3-Companies should be careful in applying blanket gross profit rates.