Slide 1LCM ApproachDiscussion QuestionDetermining Market ValueExample 1: LCMExample 1: ContinuedApplying Lower of Cost or MarketExample 2: LCM applicationsExample 2: ContinuedEvaluation of LCM RuleValuation at Net Realizable ValuePurchase CommitmentsPurchase CommitmentsPurchase CommitmentsInventory Estimation TechniquesGross Profit MethodExample 3: Gross Profit MethodExample 3: ContinuedEvaluation of Gross Profit MethodRetail Inventory MethodRetail Inventory MethodThe Retail Inventory MethodLCM PracticeLCM PracticeLCM PracticeLCM PracticeCHAPTER 9 INVENTORIES:ADDITIONAL VALUATION ISSUESSommers – ACCT 3311LCM ApproachLower-of-cost-or-market approach to valuing inventoryGAAP generally require the use of historical cost to value assets, but a departure from cost is necessary when the utility of an asset is no longer as great as its cost. The utility or benefits from inventory result from the ultimate sale of the goods. This utility could be reduced below cost due to deterioration, obsolescence, or changes in price levels. To avoid reporting inventory at an amount greater than the benefits it can provide, the lower-of-cost-or-market approach to valuing inventory was developed. This approach results in the recognition of losses when the value of inventory declines below its cost, rather than in the period in which the goods are ultimately sold.Discussion QuestionQ9-2 Explain the rationale for the ceiling and floor in the lower-of-cost-or-market method of valuing inventories.Determining Market ValueCeilingNRVCeilingNRVReplacementCostReplacementCostNRV – NPFloorNRV – NPFloorDesignatedMarketDesignatedMarketCostCostNot More ThanNot Less ThanOrStep 1Determine Designated MarketStep 2Compare Designated Market with CostLower of CostOr MarketLower of CostOr MarketExample 1: LCMTatum Company has four products in its inventory. Information about the Dec 31, 2011, inventory is as follows:The normal gross profit percentage is 25% of cost.Determine the balance sheet inventory carrying value at Dec 31, 2011, assuming the LCM rule is applied to individual products.ProductTotal CostTotalReplacementCostTotal NetRealizableValue101 $ 120,000 $ 110,000 $ 100,000102 90,000 85,000 110,000103 60,000 40,000 50,000104 30,000 28,000 50,000Example 1: ContinuedProduct RCCeiling NRVFloor NRV-NPDesignated Market CostInventory Value101 $110,000$100,000 $70,000102103104Applying Lower of Cost or MarketLower of cost or market can be applied 3 different ways. 1. Apply LCM to each individual item in inventory.2. Apply LCM to each class of inventory.3. Apply LCM to the entire inventory as a group.Example 2: LCM applicationsAlmaden Hardware Store sells two distinct types of products, tools and paint products. Information pertaining to its 2011 year-end inventory is as follows:Determine balance sheet inventory carrying value at year-end, assuming the LCM rule is applied to individual products, then product type, and then total inventory.Inventory, by Product Type QuantityPer Unit CostDesignated MarketTools: Hammers 100 $5.00 $5.50 Saws 200 10.00 9.00 Screwdrivers 300 2.00 2.60Paint products: 1-Gallon cans 500 6.00 5.00 Paint brushes 100 4.00 4.50Inventory, by Product Type CostDesignated MarketIndividual LCMTypeLCMTotal Inventory LCMTools: Hammers $500 $550 Saws 2,000 1,800 Screwdrivers 600 780 Total tools: 3,100 3,130Paint products: 1-Gallon cans $3,000 2,500 Paint brushes 400 450 Total paint: 3,400 2,950 Total: $6,500 $6,080Example 2: ContinuedExpense recorded when loss in utility occurs. Profit on sale recognized at the point of sale.Inventory valued at cost in one year and at market in the next year.Net income in year of loss is lower. Net income in subsequent period may be higher than normal if expected reductions in sales price do not materialize.LCM uses a “normal profit” in determining inventory values, which is a subjective measure. Some Deficiencies:Evaluation of LCM Rule(1) a controlled market with a quoted price applicable to all quantities, and (2) no significant costs of disposal (rare metals and agricultural products) or(3) too difficult to obtain cost figures (meatpacking).Permitted by GAAP under the following conditions:Valuation at Net Realizable Value►Generally seller retains title to the merchandise.►Buyer recognizes no asset or liability. ►If material, the buyer should disclose contract details in footnote.►If the contract price is greater than the market price, and the buyer expects that losses will occur when the purchase is effected, the buyer should recognize a liability and a corresponding loss in the period during which such declines in market prices take place.Purchase CommitmentsPurchase Commitments•Purchase commitments are contracts that obligate a company to purchase a specified amount of merchandise or raw materials at specified prices on or before specified dates.In July 2011, the Lassiter Company. signed two purchase commitments.The first requires Lassiter to purchase inventory for $500,000 by November 15, 2011. The inventory is purchased on November 14, and paid for on December 15. On the date of acquisition, the inventory had a market value of $425,000.The second requires Lassiter to purchase inventory for $600,000 by February 15, 2012. On December 31, 2011, the market value of the inventory items was $540,000. On February 15, 2012, the market value of the inventory items was $510,000.Lassiter uses the perpetual inventory system and is a calendar year-end company.Purchase CommitmentsSingle-period commitmentNovember 14, 2011Inventory (market price) 425,000Loss on purchase commitment 75,000Accounts payable 500,000December 15, 2011Accounts payable 500,000Cash 500,000Multi-period commitmentDecember 31, 2011Unrealized loss on commitment 60,000Est liab on purch commitment 60,000February 15, 2012Inventory (market price) 510,000Loss on purchase commitment 30,000Est liab on purch commitment 60,000Cash 600,000Inventory Estimation TechniquesEstimate instead of taking physical inventory •Less costly •Less time consuming•Sometimes only option!Two popular methods are . . .•Gross Profit Method•Retail Inventory Method (next time)Relies on Three Assumptions:(1) Beginning inventory plus purchases equal 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.Gross Profit MethodThe gross profit