I love to shop, and I'm a sucker for a sale. There's just nothing better than going shopping and coming home with things that I have purchased for less than half of their original price. And having racks and racks of choices, well, that's just icing on the cake!
Sometimes the accounting fanatic comes out in me and I find myself wondering what the value is of all the inventory in my favorite stores. I know that generally accepted accounting principles (GAAP), which are the guidelines for financial recording and reporting, require that on hand inventory at the end of an accounting period be valued at the lowest value possible, but how is that done, and what exactly is inventory valuation anyway?
Inventory valuation is the total dollar amount that is attributed to the inventory on hand. Though there are three GAAP-approved ways to value inventory, in this lesson, we're going to discuss one of those: the lower of cost or market. The lower of cost or market, which is also known as LCM, is the inventory valuation method that records inventory value as the lower of cost or market. That seems simple enough, doesn't it?
Well, now let's break it down into the two components: cost and market. Cost is the acquisition price of inventory. Now notice that I didn't just say it was the purchase price of the inventory, because it isn't. Cost, in this case, is the sum of the purchase price, shipping costs, storage costs, and any other costs that are directly associated with the inventory item. It can be a little confusing, so let's look at a quick example.
I own a retail store. I purchased 50 scarves to sell in my store. I paid the supplier $150 for the scarves. Shipping costs were $18. Storage costs for keeping the scarves in inventory and ready for sale were $13. So the total cost of the scarves that would be used for inventory value would be $181, or $3.62 per scarf.
Market, which is the other part of this concept, is a bit more complex. Market is defined as the amount that would have to be paid to replace a unit of inventory with an identical product. Market has limits on the amount that it can be. The upper limit, which is called the ceiling, is the net realizable value of the inventory. The net realizable value (NRV) is the sales price of an item minus the selling costs associated with that item. The lower limit, which is called the floor, is the net realizable value minus the expected profit of the item. I know, that's quite a few terms, so let's look at another example to bring this concept into perspective.
Remember the scarves that I purchased to sell in my store? I paid $3.00 per scarf when they were purchased. The current replacement cost of each scarf is $2.80. I'm selling the scarves for $7.00 each. I expect to incur $2.50 in selling expenses per scarf. Using these numbers, it's easy to see that the NRV per scarf is $4.50. Since the ceiling is equal to the NRV, then the market ceiling is $4.50.
Now the market floor is the NRV minus the expected profit per item. The expected profit per scarf is $4.20. That's the $7.00 I'm selling the scarves for minus $2.80, which is the replacement cost of each scarf. Since the NRV is $4.50, we can see that the market floor is $0.30. Since the replacement cost of each scarf is $2.80, and that price falls well between the market ceiling and floor, then it's an acceptable market price to use for comparison.
Now let's see which price inventory would be valued at. We're looking for the lower of cost or market. The total cost for each scarf that we have calculated is $3.62. The market price is $2.80. Since the market price is lower than cost, the scarves would be valued at $2.80 each. If there were 18 scarves left in inventory at the time that their value needs to be recorded in the accounting records, then the total dollar amount recorded would be 18 scarves * $2.80 = $50.40
All inventory has value that must be recorded in a company's accounting records based on GAAP principals. GAAP are the guidelines for financial reporting and recording. They require that on-hand inventory at the end of an accounting period be valued at the lowest value possible.
Inventory valuation is the total dollar amount that is attributed to the inventory on hand. One way to do this is to use the lower of cost or market concept. The lower of cost or market is the inventory valuation method that records inventory value as the lower of cost or market.
Cost is the acquisition price of inventory. Acquisition price is the sum of the purchase price, shipping costs, storage costs, and any other costs that are directly associated with the inventory item.
Market is the amount that would have to be paid to replace a unit of inventory with an identical product. In order to determine whether the cost or the market value is the amount recorded in the accounting books, both of these amounts are calculated, and the lesser amount is the amount that is assigned as the inventory value.
Use this lesson to practice these actions:
- Memorize the definitions of GAAP, inventory valuation and LCM
- Analyze the lower of cost or market
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Lower of Cost or Market of Inventory - A Practical Exercise
The following exercise is designed to enable students to apply their knowledge on the principle of lower of cost or market of inventory rule.
You are an accountant for Not-Cool Clothing Inc, a fashion company located in New York City that produces high-end leather gloves and purses. The company uses the same leather for both of its products since it is a special type of leather obtained from Italy. You are now preparing the financial statements for the company's 2019 fiscal year. This year was tough for the company. The leather gloves, in particular, did not sell well at all. This was largely due to a review in Vogue magazine stating that the gloves were "so 2018 style". That being said, the purses performed very well. You collect the following information:
|Leather - Raw Materials||$550,000||$550,000|
|Gloves - Finished Goods||$900,000||$200,000|
|Purses - Finished Goods||$400,000||$1,100,000|
1. Using the lower of cost or market of inventory rule, compute the value of inventory that will be reported on the balance sheet in compliance with GAAP.
2. Your colleague does not agree with your answer. She says that the total value of cost is equal to the total value of the market value, so no write-down is necessary. What is your response?
1. See below.
|Item||Cost||Market value||Lower of Cost or Market|
|Leather -Raw Materials||$550,000||$550,000||550,000|
|Gloves - Finished Goods||$900,000||$200,000||200,000|
|Purses - Finished Goods||$400,000||$1,100,000||400,000|
The answer is thus $1,150,000.
2. As per GAAP, the lower of cost or market of inventory rule must be applied to each type of inventory separately. Therefore, the answer above is correct.
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