Lower of Cost or Marke Flashcards
The original cost of an inventory item is below both replacement cost and net realizable value. The net realizable value less normal profit margin is below the original cost.
Under the lower of cost or market method, the inventory item should be valued at
A. Replacement cost. B. Net realizable value. C. Net realizable value less normal profit margin. D. Original cost.
D
Using small numerical examples or a visual helps to solve this type of question. In the diagram below, the higher an amount is listed, the greater its dollar amount.
—-> RC and NRV amounts are the highest; although which of the two is the higher is not given
—-> Original cost
—-> NRV - normal profit margin
Under LCM, the market value of the inventory is the middle figure (in dollar amount) from among RC, NRV and NRV - normal profit margin. Thus, market must be either RC or NRV, and it does not matter which one of the two is the middle amount. Thus, original cost is less than market, meaning the inventory is valued at original cost (which is the lower of cost or market).
The replacement cost of an inventory item is below the net realizable value and above the net realizable value less a normal profit margin. The inventory item’s original cost is above the net realizable value. Under the lower of cost or market method, the inventory item should be valued at
A. Original cost.
B. Replacement cost.
C. Net realizable value.
D. Net realizable value less normal profit margin.
B
The easiest way to answer a question like this is to make up simple numbers. The following simple numbers were made up to fit the abstract information in the question. Lower of cost or market states you record the inventory at the lower of original cost or market value (replacement cost) within the range of a ceiling and a floor. The numbers below show that replacement cost is lower than original cost and within the floor and ceiling. Replacement cost is the correct answer. Original cost $10 Net realizable value 9 Replacement cost 8 NRV less normal PM 7
Moss Co. has determined its December 31, 2004 inventory to be $400,000 on a FIFO basis. Information pertaining to that inventory follows:
Estimated selling price $408,000 Estimated cost of disposal 20,000 Normal profit margin 60,000 Current replacement cost 360,000 Moss records losses that result from applying the lower of cost or market rule. On December 31, 2004, what should be the net carrying value of Moss' inventory?
A. $400,000 B. $388,000 C. $360,000 D. $328,000
C
Under the LCM valuation method, market value is the middle figure (in dollar amount) of the following three items:
Replacement cost: $360,000
Net realizable value: $408,000 - $20,000 = 388,000
Net realizable value less
normal profit margin: $388,000 - $60,000 = 328,000
Thus, market value is $360,000. This value is less than the cost of $400,000. Thus, LCM equals $360,000, the valuation or carrying value of the inventory at the end of the year.
The original cost of an inventory item is above the replacement cost. The inventory item’s replacement cost is above the net realizable value. Under the lower of cost or market method, the inventory item should be valued at
A. Original cost.
B. Replacement cost.
C. Net realizable value.
D. Net realizable value LESS normal profit margin
C
Inventory must be carried at lower of cost (such as LIFO, FIFO) or market. Market is replacement cost subject to a ceiling and floor. The ceiling for replacement cost is net realizable value (selling price less cost to complete) and the floor is net realizable value less normal profit margin. Use simple numbers to help solve this abstract question. In this question original cost (assume = 100) is greater than market ((replacement cost) assume = 80). Market (80) is greater than net realizable value (assume = 70). Market is subject to a ceiling of net realizable value (70). In this case the inventory would be valued at net realizable value.
Kahn Co., in applying the lower of cost or market method, reports its inventory at replacement cost. Which of the following statements are correct? The original cost is greater than replacement cost The net realizable value, less a normal profit margin, is greater than replacement cost Yes Yes Yes No No Yes No No
Yes No
Under LCM, the market value of inventory is the middle of three figures (in amount):
replacement cost
net realizable value
net realizable value less normal profit margin.
If the middle figure (market) is less than cost, then the inventory is reported at market. The inventory in this question is reported at replacement cost, which means that replacement cost is market value and replacement cost is less than cost. Also, replacement cost is the middle of the three figures (or tied with one of the other two).
Net realizable value less normal profit margin could not exceed replacement cost because that would imply that replacement cost is the lowest of the three figures, which contradicts the fact that replacement cost is market value.
Therefore, in terms of the question,
(1) original cost is greater than replacement cost, and
(2) net realizable value less normal profit margin is not greater than replacement cost
At the end of the year, Ian Co. determined its inventory to be $258,000 on a FIFO (first in, first out) basis. The current replacement cost of this inventory was $230,000. Ian estimates that it could sell the inventory for $275,000 at a disposal cost of $14,000. If Ian’s normal profit margin for its inventory was $10,000, what would be its net carrying value?
A. $244,000 B. $251,000 C. $258,000 D. $261,000
B
The “ceiling” for LCM (lower of cost or market) valuation is $261,000 net realizable value ($275,000 selling price less $14,000 disposal cost). The “floor” is net realizable value less normal profit margin or $251,000 ($261,000 - $10,000). Replacement cost of $230,000 is below the floor so “market” value is the floor, or middle, of the three amounts ($251,000). This amount is less than cost of $258,000. Therefore, the lower of cost or market valuation is $251,000.
Which of the following attributes would not be used to measure inventory? A. Historical cost. B. Replacement cost. C. Net realizable value. D. Present value of future cash flows.
D
Discounting is not allowed in the valuation of inventory. Historical cost is the primary valuation basis used in inventory but the other two answer alternatives are also encountered in practice.
The lower of cost or market rule for inventories may be applied to total inventory, to groups of similar items, or to each item.
Which application generally results in the lowest inventory amount?
A. All applications result in the same amount.
B. Total inventory.
C. Groups of similar items.
D. Separately to each item.
D
When LCM is applied to each item, the lowest overall inventory amount is achieved because in no case will market exceed cost.
However, when LCM is applied to groups or to the total inventory, the total difference between items with cost exceeding market is partially offset by items with market exceeding cost. Thus, the resulting inventory valuation is not the lowest possible. An example illustrates the point:
Inventory Item Cost Market LCM-individual basis A1 $4 $1 $1 A2 5 6 5 Total group cost $9 Total group market $7 LCM-group basis $7 LCM-individual basis $6 In this case, LCM applied separately to each item results in an inventory valuation of $6, the sum of the separate LCM amounts. LCM applied to the group cost and group market values yields an inventory valuation of $7, which is higher than if LCM were applied individually. This occurs because A2's market value of $6 is higher than its cost yet it is counted in the group market value.
Thus, a market value higher than cost is used in the inventory valuation. This excess of market over cost partially offsets the excess of A1’s cost over its market value. This cannot occur when LCM is applied on an individual item basis because market could never exceed cost for any of the items
Thread Co. is selecting its inventory system in preparation for its first year of operations.
Thread intends to use either the periodic weighted average method or the perpetual moving average method, and to apply the lower of cost or market rule either to individual items or to the total inventory. Although a few individual prices will decrease, inventory prices are expected to generally increase throughout 2005.
What inventory system should Thread select if it wants to maximize the inventory carrying amount for December 31, 2005?
Inventory method Cost or market application Perpetual Total inventory Perpetual Individual item Periodic Total inventory Periodic Individual item
Perpetual Total Inventory
To maximize the ending inventory, the latest possible prices must be assigned to it. With prices rising steadily during the year, the moving average (perpetual) system combined with the total inventory application of LCM will result in the highest ending inventory amount.
The total inventory LCM application allows some items with market value lower than cost to be offset by other items with market value higher than cost. Thus, compared to individual application, which captures the lowest valuation for each unit and then sums over all inventory, total inventory application yields the highest valuation.
With prices rising, the average cost for the year is higher than the average cost computed for any shorter period that starts at the beginning of the year. The moving average (perpetual system) method costs each sale with the average cost to that point, which must be lower than the average for the year applied to all sales by the weighted average (periodic system) method. Therefore, higher costs remain in ending inventory under the perpetual (moving average) system.
The replacement cost of an inventory item is below the net realizable value and above the net realizable value less the normal profit margin. The original cost of the inventory item is below the net realizable value less the normal profit margin.
Under the lower of cost or market method, the inventory item should be valued at
A. Net realizable value. B. Net realizable value less the normal profit margin. C. Original cost. D. Replacement cost.
C
In LCM, market value is replacement cost if replacement cost is between the ceiling value (net realizable value) and the floor value (net realizable value less normal profit margin).
This is the situation in this question. The original cost is below the floor value. Thus, market exceeds cost and the item is recorded at cost (lower of cost or market).
Which of the following statements are correct when a company applying the lower of cost or market method reports its inventory at replacement cost?
I. The original cost is less than replacement cost.
II. The net realizable value is greater than replacement cost.
A. I only. B. II only. C. Both I and II. D. Neither I nor II.
B
When a company reports its inventory at replacement cost (market value), original cost must exceed replacement cost. Lower of cost or market means the inventory is reported at replacement cost when replacement cost is less than original cost. Thus, statement I is not correct.
When determining market value, net realizable value is the ceiling or maximum amount. If replacement cost is less than net realizable value, then replacement cost is used as market (as long as replacement cost exceeds net realizable value less a normal profit margin - the floor or minimum value for market).
The firm in the question is reporting the inventory at replacement cost. Therefore, replacement cost must be less than net realizable value.
Based on a physical inventory taken on December 31, 2004, Chewy Co. determined its chocolate inventory on a FIFO basis at $26,000 with a replacement cost of $20,000.
Chewy estimated that, after further processing costs of $12,000, the chocolate could be sold as finished candy bars for $40,000. Chewy’s normal profit margin is 10% of sales.
Under the lower of cost or market rule, what amount should Chewy report as chocolate inventory in its December 31, 2004, balance sheet?
A. $28,000 B. $26,000 C. $24,000 D. $20,000
C
Market is the middle figure of replacement cost - $20,000, net realizable value - $28,000 ($40,000 - $12,000 processing cost), and net realizable value less normal profit margin - $24,000 ($28,000 - .10 x $40,000). Therefore, market is $24,000, the middle value of the three.
The lower of cost ($26,000) or market ($24,000) is market ($24,000), and market is the reported amount for the inventory.
Determining Market Value
Market is generally replacement cost subject to a range of a ceiling to a floor
The ceiling value is net realizable value (NRV)
This is equal to the selling price less the cost to complete
The floor is the NRV less the normal profit margin
