Chapter 9 Notes

Chapter 9 Notes - Chapter 9: Inventories: Additional...

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Chapter 9: Inventories: Additional Valuation Issues Lower-of-Cost-or-Market - If inventory declines in value below its original cost, a major departure from the historical cost principle occurs o A company should write down the inventory to market to report this loss - A company abandons the historical cost principle when the future utility (revenue- producing ability) of the asset drops below its original cost - Companies report inventories at the lower-of-cost-or-market (LCM) at each reporting period - Illustration 9-1 - The term market when used in LCM means the cost to replace the item by purchase or reproduction - The rule really means that companies value goods at cost or cost to replace, whichever is lower - A departure from cost is justified because a company should charge a loss of ustility against revenues in the period in which the loss occurs - The method is a conservative approach to inventory valuation Ceiling and Floor - Use this method because decline in the replacement cost of an item usually reflects or predicts a decline in the selling price - Sometimes, however, a reduction in the replacement cost of an item fails to indicate a corresponding reduction in its utility – this requires using 22 additional valuation limitations to value ending inventory o Net Realizable Value (NRV) - the estimated price in the ordinary course of business, less reasonably predictable costs of completion and disposal A normal profit margin is subtracted from that amount to arrive at net realizable value less a normal profit margin Illustration 9-2
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- The general lower-of-cost-or-market rule is: A company values inventory at the lower-of- cost-or-market, with market limited to an amount that is not more than net realizable bale or less than net realizable value less a normal profit margin - Upper (ceiling) - the net realizable value of inventory - Lower (floor) - the net realizable value less a normal profit margin o Establishing these amount prevents companies form overstating or understating inventory - Illustration 9-3 How Lower-of-Cost-or-Market Works - Designated Market Value - the amount that a company compares to cost o Always the middle value of the 3 amounts: Replacement cost Net realizable value Net realizable value less a normal profit margin o Illustration 9-4 o Illustration 9-5 Methods of Applying Lower-of-Cost-or-Market - Companies may apply LCM to rule to each item, to each category, each individual type of product, or to the total of the inventory - Illustration 9-6 - When a company uses a major categories or total inventory approach, market values higher than cost offset market values lower than cost - Companies usually price inventory on an item-by-item basis o Tax rules require that companies use an individual-item basis barring practical difficulties o The individual item approach gives the most conservative valuation for balance sheet purposes - Method selected should be one that most clearly reflects income - Should apply the selected method consistently from on period to another Page 2 of 12
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This note was uploaded on 02/22/2011 for the course BUAD 362 taught by Professor Frazer during the Spring '10 term at Millersville.

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Chapter 9 Notes - Chapter 9: Inventories: Additional...

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