LOWER OF COST OR MARKET: (LCM) inventories are recorded at their cost but when inventory decreases in value, 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 original cost). In actuality, the rule really means that companies will value their goods either at cost (by LIFO, FIFO, average cost, or specific identification) or cost to replace, whichever is lower. A departure from cost is justified b/c a company should charge a loss of utility against revenues in the period in which the loss occurs, not the period of sale. LCM is a CONSERVATIVE approach to inventory calculation. Using LCM reduces net income. Ceiling and Floor: A decline in repurchase price usually represents a decline in selling price Net Realizable Value (NRV)is the estimated selling 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. (General LCM rule: A company values inventory at LCM, with market limited to an amount that is not more than NRV or less than NRV less a normal profit margin.) The ceilingis the NRV and the flooris the NRV less a normal profit margin. These limits prevent over and understating of inventory. These rules should not be broken, regardless of the replacement cost of an item in inventory. How LCM Works: the designated market valueis the amount that a company compares to cost. It is ALWAYS the middle of the three amounts: replacement cost, NRV, and NRV less a normal profit margin. The application of the LCM rule incorporates only losses in value that occur in the normal course of business from such causes as style changes, shift in demand, or regular shop wear. A company reduces damaged or deteriorated goods to net realizable value. Methods of Applying LCM: Companies may apply the LCM rule either directly to each item, to each category, or to the total of the inventory. If a company follows a major category or total inventory approach in applying LCM, increases in market prices tend to offset decreases in market prices. Inventory is USUALLY priced on an item-by-item basis. Whichever method a company selects, it should apply the method consistently from one period to another.Recording “Market” instead of Cost: Two methods; 1) DIRECT method. This method substitutes the lower market value figure for cost when valuing inventory. 2) INDRECT of ALLOWANCE method. This method does not change the cost amount but rather establishes a separate contra asset account and a loss account to record the write-off. (Identifying the loss due to market decline shows the loss separate from COGS on the income statement, but not as an EI. The advantage is COGS is not distorted. Direct method buries the loss in the COGS. Thus, indirect method is preferable because the loss is clearly disclosed) The problem is raised as to how to dispose of the balance in the allowance account in the following period.
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