Friday, August 6, 2010

Cost or Market Whichever is Lower--Inventory Valuation:

American costing tradition follows the practice of pricing year-end inventories at cost or market, whichever is lower (lower of cost or market). This departure from any experienced cost basis is generally defined on the grounds of conservatism. A more logical justification for cost or market inventory valuation is that a full stock is necessary to expedite production and sales. If physical deterioration, obsolescence, and price declines occur, or if stock when finally utilized cannot be expected to realize its stated cost plus a normal profit margin, the reduction in inventory value is an additional cost of the goods produced and sold during the period when the decline in value occurred.

American Institute of Certified Public Accountants (AICPA) Cost or Market Rules--Inventory Valuation:

The American Institute of Certified Public Accountants (AICPA) moved away from the traditional cost or market, whichever is lower principle of valuing inventories.

After defining inventory and that the major objective of accounting for inventories is the proper determination of income through the process of matching appropriate costs against revenue, the AICPA states:
The primary basis of accounting for inventories, is cost, which has been defined generally as the price paid or consideration given to acquire an asset. As applied to inventories, cost means in principle the sum of the applicable expenditures and charges directly or indirectly incurred in bringing an article to its existing condition and location.
The American Institute of Certified Public Accountants (AICPA) takes the position that cost may properly be determined by any of the common methods. The position of the AICPA is clearly stated in the following sentence: "In keeping with the principle that accounting is primarily on cost, there is a presumption that inventories should be stated at cost." Having advocated the basic cost principle, the AICPA then reverts at least part way to the traditional cost or market value rule. The AICPA in effect says it is mandatory that cost be abundant in valuing inventory when usefulness of goods is no longer as great as its cost. This, then, becomes a principle of cost or residual useful cost, whichever is lower, as described below:
A departure from the cost basis of pricing the inventory is required when the utility of the goods is no longer as great as its cost. Where there is evidence that the utility of goods, in their disposal in the ordinary course of business will be less than cost, whether due to physical deterioration, obsolescence, changes in price levels, or other causes, the difference should be recognized as a loss of the current period. This is generally accomplished by stating such goods at a lower level commonly designated as market.
The last sentence returns to the traditional meanings of cost or market, whichever is lower by saying that the residual useful cost is "market," which in turn is defined as "replacement cost." In the AICPA's cost or market approach to inventory valuation, it is clear that the institute does not hold that a replacement cost should be used for inventory value merely because it is lower than the acquisition cost figure. The real test is the usefulness of the inventory (whether it will sell at its cost). The AICPA is more precise in stating which figure should be used in case the inventory cost cannot be recovered:
As used in the phrase lower of cost or market, the term market means current replacement cost (by purchase or by reproduction, as the case may be) except that:
  1. Market should not exceed the net realizable value (i.e., estimated selling price in the ordinary course of business less reasonably predictable costs of completion and disposal); and
  2. Market should not be less than net realizable value reduced by an allowance for an approximately normal profit margin.
The position of American Institute of Certified Public Accountants (AICPA) in regard to inventory valuation may be interpreted as follows:
  1. In principle, inventories are to be priced at cost.
  2. Where cost cannot be recovered upon sale in the ordinary course of business, a lower lower figure is to be used.
  3. This lower figure is normally market replacement cost, except that the amount should not exceed the expected sales price less a deduction for costs yet to be incurred in making the sales. On the other hand, this lower market figure should not be less than the expected amount to be realized in the sale of the goods, reduced by a normal profit margin.

Example:

Assume that a certain commodity sells for $1; the marketing expense is 20 cents; the normal profit is 25 cents. The lower of cost or market as limited by the forgoing receipt is developed in each case.
Case Cost
Market
Lower of cost or market
replacement cost Floor (Estimated sales price less costs of completion and disposal and normal profit) Ceiling (Estimated sales price less costs of completion and disposal) Market (Limited by floor and ceiling values)
A
B
C
D
E
F
$.65
$.65
$.65
$.50
$.75
$.90
$.70
$.60
$.50
$.45
$.85
$1.00
$.55
$.55
$.55
$.55
$.55
$.55
$.80
$.80
$.80
$.80
$.80
$.80
$.70
$.60
$.55
$.55
$.80
$.80
$.65
$.60
$.55
$.50
$.75
$.80
A: Market is not limited by floor or ceiling; cost is less than market.
B: Market is not limited by floor or ceiling; market is less than cost.
C: Market is limited to floor; market is less than cost.
D: Market is limited to floor; cost is less than market.
E: Market is limited to ceiling; cost is less than market.
F: Market is limited to ceiling; market is less than cost.
The lower of cost or market may be applied to each inventory item, to major inventory groupings, or the inventory as a whole. Application of this procedure to the individual inventory items will result in the lowest inventory value. However, application to inventory groups or to the inventory as a whole may provide a sufficiently conservative valuation with less effort. The application method selected by a company must be followed consistently from year to year. Work in process and finished goods inventories are also subject to the lower of cost or market principle.

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