Lower of Cost or Market (LCM)

Inventory must be reported at Inventory must be reported at lowerlower of cost or market.of cost or market.

Inventory must be reported at Inventory must be reported at lowerlower of cost or market.of cost or market.

Market is defined as Market is defined as current current replacement replacement

costcost (not sales (not sales price).price).

Consistent withConsistent withthe conservatismthe conservatism

principle.principle.

Market is defined as Market is defined as current current replacement replacement

costcost (not sales (not sales price).price).

Consistent withConsistent withthe conservatismthe conservatism

principle.principle.

“LOWER OF COST or MARKET” (LCM) VALUATION

For illustration -- follow class handout file (Word doc.) and next slide.

Historical cost = $100.  Replacement cost at end of Year 1= $80

Year_1 LCM Write down: Loss on Inventory 20

Inventory 20 (from $100 to $80)

Conservative for Year 1?:

Income Statement Loss of $20 will lower Net Income

Balance Sheet Asset Inventory reduced to $80.

 Year 2 If Sell for $200 at beginning of

Year 2:

Accounts Rec. 200 Sales Revenue

200 Cost of Good Sold 80 Inventory 80

Conservative for Year 2?: Income Statement shows

‘income’ of $120. What would the income have been IF the ‘conservative’ LCM had NOT been followed in Year 1?

(CAN “CONSERVATISM CONCEPT” Possibly Lead to “BIG BATH” Accounting????)

Estimating the Ending Inventory Balance

Many companies

use the gross margin

method to estimate the

current period’s ending

inventory.

Gross Margin Method of Estimating Inventory

Provides an estimateNot acceptable for GAAPWhen to use for interim (any period less than a year)

reporting purposes when physical inventory not possible

(casualty) a check on the accuracy of the physical

count do we have a problem with theft?

1) Calculate the expected gross margin ratio using prior period’s financials. Then subtract from 100% to get the expected Cost of Goods Sold percentage.

2) Multiply the expected cost of goods sold percentage by the current period’s sales to estimate the amount of cost of goods sold expense.

3) Subtract the estimated cost of goods sold expense from the amount of goods available for sale to estimate the ending inventory.

1) Calculate the expected gross margin ratio using prior period’s financials. Then subtract from 100% to get the expected Cost of Goods Sold percentage.

2) Multiply the expected cost of goods sold percentage by the current period’s sales to estimate the amount of cost of goods sold expense.

3) Subtract the estimated cost of goods sold expense from the amount of goods available for sale to estimate the ending inventory.

The Gross Profit Method

ExampleGiven the following:

Beginning Inventory $ 1,000 (cost)Purchases 9,000 (cost)Sales 12,000 (retail)

Assume that gross margin has been 40% of sales. Estimate the Cost of Goods Sold for the period. Then you can “plug” the Estimated Cost of the Ending Inventory.

If the Gross Margin rate is 40%, what is the Cost of Goods Sold %?

Net Sales 100%Less: Cost of G.S. X%=Gross Margin 40%

Use these %’s and a partial income statement to find the “missing” amounts.

= 60%

Sales $12,000

Less: Cost of Goods Sold:

Beg. Inv. $1,000

+ Purchases, net 9,000

Goods Avail. $10,000

- End. Inv. (?) “plug” this last

Cost of Goods Sold (?) (60% x Net Sales)

Use given amounts and known %’s

Sales $12,000

Less: Cost of Goods Sold:

Beg. Inv. $1,000

+ Purchases, net 9,000

Goods Avail. 10,000

- End. Inv. (?)

Cost of Goods Sold (7,200) (60% x Net Sales)

Use given amounts and known %’s

Sales $12,000

Less: Cost of Goods Sold:

Beg. Inv. $1,000

+ Purchases, net 9,000

Goods Avail. 10,000

- End. Inv. (2,800) “plug” ($10,000 - $7,200)

Cost of Goods Sold (7,200) (60% x Net Sales)

Use given amounts and known %’s

Fraud Avoidance in Merchandising Businesses

Because inventory and cost of goods sold accounts are so significant, they are

attractive targets for concealing fraud.

Because of this, auditors and financial analysts carefully examine them for signs of

fraud.

Fraud Avoidance in Merchandising Businesses

Ending Inventory is

Accurate

Ending Inventory is Overstated

Beginning Inventory 4,000$ 4,000$ Purchases 6,000 6,000 Cost of Goods Aval. for Sale 10,000 10,000 Ending Inventory (3,000) (4,000) Cost of Goods Sold 7,000$ 6,000$

Sales 11,000$ 11,000$ Cost of Goods Sold (7,000) (6,000) Gross Margin 4,000$ 5,000$

Ending Inventory is

Accurate

Ending Inventory is Overstated

Assets Cash 1,000$ 1,000$ Inventory 3,000 4,000 Other Assets 5,000 5,000 Total Assets 9,000$ 10,000$

Stockholders' EquityCommon Stock 5,000$ 5,000$ Retained Earnings 4,000 5,000 Total Stockholders' Equity 9,000$ 10,000$

Errors in Measuring Ending Inventory

Misstatements in inventory may cause errors in the following areas: Income Statement

Cost of Goods Sold, Gross Profit, Taxes, Cost of Goods Sold, Gross Profit, Taxes, Net IncomeNet Income

Balance Sheet Inventory, Payables, Retained EarningsInventory, Payables, Retained Earnings

Because the ending inventory of one period becomes the beginning inventory of the next period, ending inventory errors affect twotwo accounting periods (two Income Statements but only one Balance Sheet).