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What does the term "Market" mean in the phrase "the lower-of-cost-or-market" (LCM)
The cost to replace the item by purchase or reproduction.
Ex. Nordstrom refers to "market" in which it purchases goods, not the market in which it sells them.
What is the rule for market?
Companies value goods at cost or cost to replace, which ever is lower.
Ex. Target purchases a Timez watch for $30 for resale. Target can sell it for $48.95 and replace it for $25. It should therefore value the watch at $25 for inventory purposes under the LCM rule.
How is cost justified from a departure?
a company should charge a loss of utility against revenues in the period in which the loss occurs, not in the period of sale.
Note: LCM is a conservative approach to inventory valuation. When doubt exists about the value of the asset, a co.should use the lower value of the asset which reduces Net Income
Why use replacement cost to represent market value?
Because a decline in the replacement cost of an item usually reflects or predicts a decline in selling price. Allows a co. to maintain a consistent rate of gross profit on sales (normal profit margin)
What valuations do you use if there is a reduction in the replacement cost of an item fails to indicate a reduction in its utility?
- 2 additional valuation limitations to value ending inventory:
- Net Realizable Value & Net Realizable Value Less a normal profit margin
What is upper limit (ceiling)?
The net realizable value of inventory
What is the lower limit (Floor)?
Net realizable value less a normal profit margin
What is the rational for Net Realizable Value and Net Realizable Value less a normal profit margin?
Establishing these limits for the value of the inventory prevents companies from over- or understating inventory
What does the maximum limitation, not to exceed the ceiling (NRV) prevent?
overstatement of the value of obsolete, damage, or shopworn inventories. That is, replacement cost exceeds its NRV, don't report inventory at replacement cost.
Company can only receive only the selling price less cost of disposal.
How do you report inventory at replacement cost?
Overstatement of inventory and understatement of the loss in the current period
Staples paid $1000 for a color printer that can now replace for $900. The printer's NRV is $700. At what amount should Staples report in its financial statements?
- Replacement cost of 900 overstates End.Inv.
- Understates loss for the period.
Report the printer at $700
What does the minimum limitation (floor) establish?
A value below which a company should not price inventory below net realizable value less a normal margin.
What does the minimum amount (floor) measure?
what the company can receive for the inventory and still earn a normal profit
Deters understatement of inventory and overstatement of loss in the current period.
What is the designated market value?
the amount that a co. compares to cost.
it's always the middle value of three amounts: replacement cost, NRV and net realizable value less a normal profit margin
What does the application of LCM rule incorporate?
Only losses in value that occur in the normal course of business from such causes as style changes, shift in demand, or regular shop wear.
a company reduces damaged or deteriorated goods to NRV.
What methods can be used to record the income effect of valuing inventory at market?
COGS and Loss Method
debit COGS for the write down of inventory to market.
co. does not report loss in IS Because COGS already includes amount of loss
Debits a loss account for the write down of the inventory to market.
Shows loss separate from COGS in IS
Recording Allowance to reduce inventory to market under the Loss Method.
Debit loss due to decline of inventory to market
Credit Allowance to reduce inventory to market
What does the use of allowance method under COGS or Loss Method permit?
The BS to reflect Inventory measured
agreements to buy inventory weeks, months or even years in advance.
Seller retains title to merchandise or materials covered
If contract price > market price
Buyer expects losses will occur when purchase is effected
Buyer should recognize losses in the period during which such declines in market prices take place.
What is hedging?
Purchaser in purchase commitments simultaneously enters into a contract in which it agrees to sell in the future the same quantity of the same or similar goods at a fixed price.
What is the purpose of the hedge?
Offset the price risk of the buy and sell positions.
Co. will be better under one contract by approx.or exactly the same amount by which it is worse off under the other contract.
Hedge ex. Co could have hedged its pur.commitments contract with a future K for timber rts. of same amount.
A loss on purch.commitment could have been offset by a gain on the futures contract.
Gross profit (margin) Method-
Method for verifying or determining inventory