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Intermediate Chapter 8 Notes

by: Emily Sears

Intermediate Chapter 8 Notes 3310

Marketplace > Auburn University > Accounting > 3310 > Intermediate Chapter 8 Notes
Emily Sears
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These notes cover Chapter 8 materials
Intermediate Accounting I
Dr. Duane Brandon
Class Notes
Intermediate 1, Accounting
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This 6 page Class Notes was uploaded by Emily Sears on Saturday January 30, 2016. The Class Notes belongs to 3310 at Auburn University taught by Dr. Duane Brandon in Spring 2016. Since its upload, it has received 17 views. For similar materials see Intermediate Accounting I in Accounting at Auburn University.


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Date Created: 01/30/16
CHAPTER 8: Inventories- Special Valuation Issues Lower of Cost or Market (LCM) The reduction of the value of the inventory tomarket and the recognition of a loss are appropriate for both a company’s balance sheet and income statement Recall, GAAP defines assets as “probable future economic benefits.” When inventory costs > expected benefits, the lower market value is a better measure of the expected benefits. That is, an unrecoverable cost is NOT an asset A company should recognize the decline in value of the inventory as a reduction in the income of the period in which the loss occurs Thus, inventory is valued at LCM, “lower of cost or market” where, Cost= historical cost (computed via specific identification, LIFO, FIFO, Weighted-Average, etc) and Market Value= current replacement cost (market price at which goods can be purchased or reproduced) Ceiling and floor constraints are placed on the market value LCMConstraints An upper (ceiling) and lower (floor) constraint on the market value are imposed as follows: 1. The upperconstraint is that the market value should not be more than the net realizable value (estimated selling price in the ordinary course of business, minus reasonable predictable costs of completion and disposal) 2. The lower constraint is that the market value should not be less than the net realizable value, reduced by an estimate of normal profit margin or markup Example Ceiling and Floor Computation Inventory: Estimated selling price in completed condition $1,150 Less: Estimated costs to complete and sell 150 Net realizable value (ceiling on market value) $1,000 Less: normal profit 100 NRV less normal profit (floor on market value) $ 900 Thus, if current replacement cost is between $1,000 and $900, the replacement cost would be used as the market value. If replacement cost is above $1,000, the ceiling would be used. If replacement cost is below $900, the floor would be used. Purpose of Constraints The upperconstraint (“ceiling”) prevents overstatement of obsolete or damaged inventory and understatement of losses The lower constraint (“floor”) prevents understatement of inventory and overstatement of losses. Also, prevents excessive “profits” once sold LCMConcept Example Application of LCMMethod In summary, when applying the LCM rule: 1. Calculate (i) current replacement cost, (ii) ceiling, and (iii) floor. Select the middle value of the three as the market value 2. Choose the lower of the selected market value or the historical cost 3. Report the lower value on the Balance Sheet and, if necessary, record the loss. The loss may be reported as part of COGS on the Income Statement See Example 8.2 and 8.2a for applications of the LCM method LCM Implementation The LCM rule can be applied to 1. Individual inventory items, 2. Total of major inventory categories (most common 8.2b), or 3. Total inventory Applying LCM rule to individual items always results in an inventory value less than (or equal to) values obtained by approaches (2) and (3). Under (2) and (3), price declines of some items will be offset by price increases of other items. Once inventory is reduced to market value, it is NOT written back up if market value subsequently rises. However, loss recoveries may be implicitly recognized. LCMWrite-Down Two approaches for recording write-down tomarket value – Direct Method Dr. COGS ← Loss flows thru COGS Cr. Inventory ← Reduce inventory Allowance Method Dr. Loss due to market valuation ← Loss flows thru separate acct. as an adjustment to COGS Cr. Allowance to reduce inventory to market ← Increase allowance (contra inventory) (Journal entries above assume perpetual system.) Valuation above Costs Only in exceptional cases may inventory be stated above cost. Expectation must be justified by:  An inability to determine appropriate costs  Immediate marketability of the inventory at quoted market price  The interchangeability of the units of inventory For example,  Precious metals having a fixed monetary value with no substantial cost of marketing  Agricultural, mineral, and other products, units are interchangeable and have an immediate marketability at quoted prices, and for which appropriate costs may be difficult to obtain. Estimating Inventory Two commonly used methods of estimating inventory costs: 1. Gross profit method 2. Retail inventory method Why would inventory be estimated? 1. Interim (quarterly) reporting 2. Audit purposes (reasonableness check or roll forward of interim procedures) 3. Estimate destroyed inventory 4. Incomplete records 5. Budgeting We will focus primarily on gross profit method Gross Profit Inventory Method How isGross Profit Methodapplied? Assume gross profit rate (ex: gross profit/net sales) is constant andwe know Sales, BI, and Net Purchases. We can first estimateCOGS and then EI. Steps-  Estimate gross profit by multiplying historical gross profit rate by actual net sales  Subtract estimated gross profit from actual net sales to determine estimated COGS  Subtract estimated COGS from actual cost of goods available for sale to determine estimated cost of ending inventory Recall: EI = BI + Net Purchases - COGS Applying the Gross Profit Method Retail Inventory Method How is Retail method applied? Assume relation between cost of purchases and retail (selling) prices is constant. Inventory Errors Inventory errors can affect balance sheet and income statement (in current & subsequent periods)


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