Adjusting Lower Cost Or Market Inventory On Valuation Essay Writing
Lower of Cost or Market Overview
The lower of cost or market rule states that a business must record the cost of inventory at whichever cost is lower – the original cost or its current market price. This situation typically arises when inventory has deteriorated, or has become obsolete, or market prices have declined. The rule is more likely to be applicable when a business has held inventory for a long time, since the passage of time can bring about the preceding conditions. The rule is set forth under the Generally Accepted Accounting Principles accounting framework.
The “current market price” is defined as the current replacement cost of the inventory, as long as the market price does not exceed net realizable value; also, the market price shall not be less than the net realizable value, less the normal profit margin. Net realizable value is defined as the estimated selling price, minus estimated costs of completion and disposal.
Additional factors to consider when applying the lower of cost or market rule are:
- Analysis by category. You normally apply the lower of cost or market rule to a specific inventory item, but you can apply it to entire inventory categories. In the latter case, an LCM adjustment can be avoided if there is a balance within an inventory category of items having market below cost and in excess of cost.
- Hedges. If inventory is being hedged by a fair value hedge, then add the effects of the hedge to the cost of the inventory, which frequently eliminates the need for a lower of cost or market adjustment.
- Last in, first out layer recovery. You can avoid a write-down to the lower of cost or market in an interim period if there is substantial evidence that inventory amounts will be restored by year end, thereby avoiding recognition of an earlier inventory layer.
- Raw materials. Do not write down the cost of raw materials if the finished goods in which they are used are expected to sell either at or above their costs.
- Recovery. You can avoid a write-down to the lower of cost or market if there is substantial evidence that market prices will increase before you sell the inventory.
- Sales incentives. If there are unexpired sales incentives that will result in a loss on the sale of a specific item, this is a strong indicator that there may be a lower of cost or market problem with that item.
Lower of Cost or Market Example
Mulligan Imports resells five major brands of golf clubs, which are noted in the following table. At the end of its reporting year, Mulligan calculates the lower of its cost or net realizable value in the following table:
The concept of "net realizable value" crops up in two major categories of business bookkeeping: inventories and accounts receivable. Both are classified as current assets, meaning they are assets that a company expects to convert into cash within the next year -- by selling items out of its inventory and by collecting money owed by its customers. Net realizable value, commonly abbreviated NRV, comes into the picture because, under generally accepted accounting principles, businesses must report their inventories at the "lower of cost or market" and their accounts receivable "net of allowance for doubtful accounts." These rules acknowledge the reality that an asset sometimes isn't worth as much as it appears on paper.
Calculating NRV for Inventories
1. Take a full inventory of goods available for sale to customers.
2. Determine the expected selling price of each item. If you owned a shoe store, for example, and you had a pair of shoes that you believed you could sell for $40, then that would be the expected selling price. If the shoes had a list price of $40 but you believe you'd have to discount them to $30 to sell, that would be the expected price.
3. Determine how much money you will have to spend to get the items ready for sale and to actually sell them. For a shoe retailer, this could mean the cost of sales commissions, packaging or anything else required to get the shoes out the door.
4. Subtract the costs required to prepare the item for sale from the expected selling price. The result is the net realizable value of the item in inventory.
5. Add up the NRV for all items, and the result is the total net realizable value for the company's inventory.
Calculating NRV for Accounts Receivable
1. Add up the total amount owed by customers for goods and services that the company has delivered. Typically, a company adds a debt to accounts receivable only if it has satisfied all conditions to earn the money. So if, say, a shoe store ships an order of 100 pairs of shoes at $40 a pair and bills the customer for payment, then it increases accounts receivable by $4,000. But if the store merely signs an agreement to ship the shoes in three months, and to bill for them at that time, nothing happens to "A/R" until the shoes actually go out the door.
2. Determine the share of total accounts receivable that is likely to go uncollected. Every business arrives at this figure through its own experience. This amount is often called the "allowance for doubtful accounts" or "allowance for uncollectible accounts."
3. Subtract the amount of the doubtful-accounts allowance from the total accounts receivable. The result is the net realizable value of accounts receivable.
- On a company's balance sheet, inventory is typically listed "at cost," meaning the value reported is whatever it cost the company to acquire the inventory. If the net realizable value of an item is lower than its cost, however, then the item's balance-sheet value must be "written down" to NRV. This is called writing down to the lower of cost or market. The company must report the amount of the write-down as an expense.
- On a company's balance sheet, accounts receivable is typically reported as "accounts receivable, net." That means accounts receivable minus the value of the allowance for doubtful or uncollectible accounts -- in other words, net realizable value.
- Companies rely on past experience to estimate what percentage of A/R is uncollectible. They usually do this through an "aging analysis." The basic principle is that the longer a receivable is past due, the more likely it is to go uncollected. Say a company knows that it typically fails to collect on 2 percent of current accounts, 4 percent of accounts zero to 30 days overdue, 6 percent of those 30-60 days overdue and 10 percent of those 60 or more days overdue. It can then apply those percentages to its outstanding accounts to make sure it is maintaining a proper allowance.
- When a company determines that a particular debt cannot be collected, it reduces both A/R and the doubtful-accounts allowance by the amount of the bad debt. As a result, the net realizable value remains the same. Eventually, the company will have to "replenish" the allowance. When it does so, it reports an expense for the amount added to the allowance.
About the Author
Cam Merritt is a writer and editor specializing in business, personal finance and home design. He has contributed to USA Today, The Des Moines Register and Better Homes and Gardens"publications. Merritt has a journalism degree from Drake University and is pursuing an MBA from the University of Iowa.
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