Lower-of-Cost-or-Market Value of Inventory
The principle of conservatism is important as it applies to determining the carrying value of the inventory account. Under conservatism, assets and revenues are not overstated, and liabilities and expenses are not understated. To ensure that financial information is reported fairly and is a true representation of a company's position, businesses review amounts to determine if they are current.
Regarding the inventory account, a business must report the value of its inventory each reporting period, as values can change due to factors such as obsolescence, deterioration, or price drop. The accountant determines if the original cost of the inventory is worth at least its carrying costs, or the costs of keeping and maintaining the inventory. If it is not, then an adjustment is needed.
The lower-of-cost-or-market (LCM) method compares the value or cost of inventory versus current market price, and the lower price is recorded. The LCM valuation method is used to determine if the carrying value or purchase cost of the inventory is too high compared to the current market price. The accountant must determine if the inventory could be acquired at the same or higher cost, or if the value of the inventory item has decreased in the marketplace. If the market price is lower than the cost paid for the item, then a journal entry must be made to lower the cost down to the current marketplace cost. However, if the market's cost is higher, nothing is done.
Determining LCM involves calculating the net realizable value (NRV), which is the current value of the inventory in the market as it relates to the estimated selling price minus all direct costs of disposing of the items. As a simplified example, the original cost of an item is $10, however, the current market price of the item is $8, and the estimated selling expenses are $1.50. Thus, the net realizable value is $6.50 . So, when comparing the original cost of $10 with the market value—net realizable value of $6.50—the company must make an adjustment to decrease the cost of its inventory down to $6.50 per item. The $6.50 is the lower-of-cost-versus-market. If the figures were reversed where the cost was $6.50, but the market price was $10, then the company would leave the inventory at the cost at $6.50.
Another factor in determining LCM involves comparing the replacement cost of an item in inventory with the net realizable value (NRV) and carrying value. The current market price is the replacement cost if it falls within the market ceiling and the market floor. The market ceiling is the NRV, and the market floor is the NRV minus the ordinary profit of the product. Once the market price is selected, the lower of the carrying value or market price is chosen. If the market price is lower, the inventory value is written down to the market price.
Errors on the Income Statement and Balance Sheet
Because the inventory account is updated in real time and all purchases and sales are recorded in the inventory account when using a perpetual inventory system, an organization can discover errors as they occur. While the goal is always to minimize and mitigate errors, a company will want to have a system in place to address these errors if they occur. Any errors in the inventory account will affect both the balance sheet (inventory) and the income statement (COGS). Remember: an error is an accident, while intentional malicious misconduct is fraud. There are several common errors:
- Miscounting occurs during the physical inventory.
- The FIFO, LIFO, or weighted average cost valuation method is incorrectly used.
- Inventory still in transit is included or excluded incorrectly.
- Consigned inventory, which is inventory shipped to another seller who acts as selling agent, is included or excluded incorrectly.
As a review, the COGS account has an inverse relationship with the ending inventory account. Therefore, if ending inventory is overstated, then COGS will be understated, and if ending inventory is understated, then COGS will be overstated. If COGS is too low, then gross profit will be too high. If COGS is too high, then gross profit will be too low. One error can create a domino effect on the financial statements.
Effect of COGS on Income Statement
|Income Statement Effect|
|Cost of Goods Sold||Understated||Overstated|
|Gross Profit/Net Income||Overstated||Understated|
Effect of Ending Inventory on Balance Sheet
|Balance Sheet Effect|
|Current Assets/Total Assets||Overstated||Understated|