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Chapter_9_Lecture - Chapter 9 LECTURE This chapter...

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Chapter 9 LECTURE This chapter describes inventory valuation problems and estimation techniques. Appendix 9-A describes the application of the LIFO retail method under two assumptions: (1) stable prices and (2) fluctuating prices. I am sure many of you students are aware of the LCM valuation rule for inventory but have not dealt with the ceiling and floor constraints. Similarly, many of you were exposed to a retail inventory method (usually the conventional retail method) but have no experience with LIFO retail, and are unfamiliar with such complications as markups, markdowns, employee discounts, normal and abnormal spoilage, etc. Chapter 9 inventory techniques do not represent complete departures from the FIFO, LIFO, and average cost bases of valuing inventory. For example, the LCM rule results in inventory being stated at the lower of FIFO cost or market," or "lower of average cost or market," etc. Similarly, the retail method can be adapted to approximate any of the major cost flow assumptions: FIFO, LIFO, or average cost. A. Lower of Cost or Market (LCM). 1. The general rule is that the historical cost principle is abandoned when the future utility of the asset is no longer as great as its original cost. 2. The term "market" in the LCM rule means the cost to replace the item by purchase or reproduction. This is a measurement of entry value. a. The market amount is limited by ceiling and floor restrictions that are based on measurements of exit value. (1) The ceiling is equal to net realizable value: estimated selling price less estimated disposal cost. (2) The floor is equal to the ceiling less normal profit margin. b. The reasons for this lower of cost or "constrained market" rule: (1) A decline in the selling price of an item is not always accompanied by a decline in cost. That is, entry values do not always respond immediately and proportionately to changes in exit values. (2) If an item has not lost its revenue-producing power, a writedown to replacement cost in the current period would understate current income and overstate income in the period of sale. 3. The two-step computational approach to LCM valuation: 9-1
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Review Illustration 9-1 for the lower of cost or market technique. The 2-step approach is demonstrated for two different examples. a. First find the designated "market" figure: This is the middle value of replacement cost, the ceiling, and the floor. b. Then find the lower of historical cost or "designated market." 4. The LCM rule may be applied either (a) directly to each item or (b) to the total of the inventory or (c) in some cases, to the total of the components of each major category. As soon as the inventory is written down to market, the new basis is considered to be the cost basis for future periods. 5. Recording market declines in inventory. Two possibilities: a. Direct method —Show the inventory at market in both the balance sheet and the cost of goods sold section of the income statement. The disadvantage is that the market decline is buried in the cost of goods sold figure.
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