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Unformatted text preview: 9-19INVENTORIES: SPECIAL VALUATION ISSUES CHAPTER OBJECTIVESAfter careful study of this chapter, students will be able to: 1. Understand the lower of cost or market method. 2. Explain the conceptual issues regarding the lower of cost or market method. 3. Understand purchase obligations and product financing arrangements. 4. Explain the valuation of inventory above cost. 5. Use the gross profit method. 6. Understand the retail inventory method. 7. Explain the conceptual issues regarding the retail inventory method. 8. Understand the dollar value LIFO retail method. 9. Understand the effects of inventory errors on the financial statements. 9-2SYNOPSISLower of Cost or Market1. The lower of cost or market(LCM) rule requires that a company recognize a decline in the inventory's utilityas a loss of the period, and that the company write down its ending inventory to the market value. This rule is consistent with the conservatism convention. 2. Market valueis defined as the current replacement costof inventory (notthe current selling price) by purchase or manufacture, with upper and lower constraints imposed. Market value cannot be higher than the ceiling constraint or lower than the floor constraint. Ceiling constraint: The market value cannot be greater than the net realizable value (estimated selling price in the ordinary course of business less reasonably predictable costs of completion and disposal). Floor constraint: The market value cannot be less than the net realizable value reduced by a normal profit margin (normal markup). The ceiling ensures that a write-down will cover all expected losses currently, and prevents the recognition of further losses in the future. The floor prevents the recognition of excessive losses currently, and excessive profits in the future. 3. To apply the LCM method, a company (1) calculates and ranks the current replacement cost, ceiling, and floor and selects the middle amount as the market value; (2) compares the selected market value to cost and uses the lower of the two amounts; (3) reports inventory at the lower value on its balance sheet and reports any loss on its income statement. The example below illustrates the calculation of LCM: CaseCurrent Replacement CostNet Realizable Value (Ceiling) Net Realizable Value Less a Normal Markup (Floor)Market (Constrained by Ceiling and Floor)CostLower of Cost or Market Inventory ValueLoss1. 2. 3. 4. 5. $4.00 7.00 3.00 3.00 7.00 $6.00 6.00 6.00 6.00 6.00 $3.00 3.00 4.00 4.00 3.00 $4.00 6.00 4.00 4.00 6.00 $5.00 5.00 5.00 2.00 8.00 $4.00 5.00 4.00 2.00 6.00 $1.00 0 1.00 0 2.00 Case 1. Replacement cost is used because it is between the ceiling and floor and is less than cost. Case 2. Cost is used because it is less than the ceiling, which is between replacement cost and the floor....
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- Spring '11