Chapter 9 handout
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Transcript of Chapter 9 handout
![Page 1: Chapter 9 handout](https://reader030.fdocuments.us/reader030/viewer/2022013107/543e2d68b1af9f2d338b475e/html5/thumbnails/1.jpg)
MGT 220 Chapter 9
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Lower of Cost or Market
• The lower of cost or market (LCM) is an exception to the historical cost principle
• When the future potential of the asset is less than its original cost:– Re-state asset at cost to market
• The loss is charged against revenues of the period
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Lower of Cost or Market
• LCM is justified for two reasons:– Current assets reported at a value
approximately equal to the amount of cash they can be converted to
– Matching principle: loss of utility reported in the period the loss occurred
• LCM falls in line with conservatism
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Lower of Cost or Market
LCM conceptual deficiencies:
1. Inconsistent
2. Potentially produces aggressive income in subsequent periods
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Lower of Cost or Market
When would the ‘market’ price be lower than the cost of the inventory?
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What Is Market?• CICA Handbook, Section 3030 reflects the
desire to provide a more specific description of ‘market’
• Use of the terms:– Replacement cost– Net realizable value (NRV)– Net realizable value less a normal profit margin
• Net realizable value most commonly used– All three are acceptable methods– Method adopted must be disclosed
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What Is Market?
• Replacement:Amount required to obtain an equivalent item
• NRV:Estimated selling price in the ordinary course of business less costs to complete and dispose of the item
• NRV less a normal profit margin:NRV (as defined above) less normal profit margin
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Lower of Cost or Market
• The lower of cost or market may be applied on a(n):1. item-by-item basis (as in the example)
2. category basis
3. total inventory basis
• Whichever method is selected, it should be consistently applied
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Application of LCM
Item Category CostMarket
1. Patio Furn. $10 $ 8
2. Patio Furn. $20 $24
3. Indoor Furn. $18 $18
4. Indoor Furn. $15 $14
$63 $64
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Application of LCM
Item-By-Item
Item Cost Market LCM
1. $10 $8 $ 8
2. $20 $24 $20
3. $18 $18 $18
4. $15 $14 $14
$63 $64 $60
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Application of LCM
By Category
Category Cost Market LCM
Patio Furn. $30 $32$30
Indoor Furn. $33 $32 $32
$63 $64$62
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Application of LCM
Total Inventory
Cost Market LCM
$63 $64 $63
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LCM-Decline in Value
If cost <= market then do nothing
If cost > market then make an adjusting journal entry
• Direct Method
• Allowance method (indirect method)
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LCM-Decline in Value
Direct Method
Charge decline in value to CGS:
CGS $1,000
Inventory $1,000
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LCM-Decline in Value
Allowance Method
Charge decline in value to a separate loss account:
Loss Due to Decline in
Market Value $1,000
Allowance to Reduce
Inventory to Market Value $1,000
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Valuation Basis: Relative Sales Values
• Relative sales values is an appropriate basis when basket purchases are made
• Basket purchases involve a group of varying units
• The purchase price is paid as a lump sum amount
• The lump sum price is allocated to units on the basis of their relative sales values
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Relative Sales Values: Example
• Intell Company buys three different lots (A, B and C) in a basket purchase, paying $300,000
• The lots were then sold as follows:A $ 75,000B $150,000 C $200,000
for a total of $425,000• Determine the allocated cost to A, B and C and the
gross profit for each lot
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Relative Sales Values: Example
Lot Sales Value Allocated Cost Gross Profit
A $75,000 ($75,000/$425,000) X $300,000= $ 52,941 $ 22,059
B $150,000 ($150,000/$425,000) X $300,000= $105,882 $ 44,118
C $200,000 ($200,000/$425,000) X $300,000= $ 141,176 $ 58,824
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Margin vs. Mark-up
Gross Margin
= Gross Profit/Selling Price = $15/75 = 20%
Markup
= Gross Profit/Cost = $15/60 = 25%
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Gross Profit Method • The gross profit method is used to estimate ending
inventory (e.g., interim reporting, fire loss, testing reasonableness of cost from another method).
• The method is based on the assumptions that:
1.beginning inventory + net purchases= CGAS
2.CGAS – sales*(1-Gross margin %) = ending inventory
3.Goods not sold are in ending inventory
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Gross Profit Method: Example
Given:• Beginning inventory (at cost): $ 60,000• Net Purchases (at cost) : $ 200,000• Sales (net) : $ 280,000• Gross Profit percentage on sales 30%
Estimate the ending inventory using the Gross Profit Method.
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Gross Profit Method: Example
Beg. Inventory + Net Purchases - CGS = Estimated Ending Inventory
$60,000 + $200,000 - ($280,000X0.7) = Ending Inventory$60,000 + $200,000 - ($196,000) = $64,000
Cost of goods sold = Sales X (1 - 0.3)
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Limitations of Gross Profit Method• Provides only an estimate; physical inventory
count still required• Uses past information (gross profit percentage) to
determine a current inventory value– A current gross profit percentage more relevant
• A ‘blanket’ gross profit percentage may be applied– Different product lines may have materially
different gross profit percentages, which produce more accurate estimates
• Not accepted for year-end financial reporting, appropriate for interim reporting (with disclosure)
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Financial Statement Presentation
• The following items must be disclosed:
i. The basis of valuation.
ii. Any change in the basis of valuation and the effect of such a change on net income for the period.
• It is also desirable to disclose the amount of the major categories making up total inventory.
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Inventory Ratios
a) Inventory turnover
= CGS/average inventory
b) # days inventory
= (average inventory/CGS) x 365