One among other accounting issues, which is inevitable, in the inventory area is having future value of inventory that is in doubt (e.g. inventory items that are used, out-dated models, damage or any other obsolete conditions.) A similar situation also arise in the case that we find inventory items have been over charged.
Letting such inventory accounted at its original cost is definitely not acceptable. Doing so, may result in overstated assets in the balance sheet and mislead its users. What should you do?
Inventory value may be varying a product to another; they could have hundred or even thousand different values in the retail businesses—depends on how many types of inventory you have in the warehouse. But they have thing in common: they are reported at cost (i.e. the cost of goods sold.) Occasionally, however, it becomes necessary to report inventory at an amount that is lower than cost. This happens when the future value of the inventory is in doubt. How? Read on…
Valuing Inventory at Its Net Realizable Value
When inventory is damaged, used, or obsolete, it should be reported at no more than its “net realizable value.” This is the amount the inventory can be sold for, minus any selling costs.
Suppose, that your company produced 125 units of item that originally cost $180 per unit. They have unusual design for customized order last year and for some reason, you have 5 units left over, unshipped. The sales people have attempted to sell those so-called “unique” inventory items since last year but have not been sold yet, not even at cost $900 (=5 x $180.)
After getting approval from the management, the sales people stated that similar items could be sold on the eBay website, at $150 per unit (or $750 in total). Those inventory items could be reported at its “net realized value.”
Since eBay charged 11% commission, the net realizable value of the items is $667.50, or $232.50 less than cost. This lost is calculated as follows:
Cost = $900.00
Estimated selling price = $ 750.00
Less selling commission = $ (82.50)
Net sale value = $667.50 (-)
Loss = $232.50
To achieve a proper matching of revenues and expenses, a company must recognize this estimated loss as soon as it is determined that an economic loss has occurred (even before the inventory items are sold). The journal entry required to recognize the loss and reduce the inventory amount of the items is:
[Debit]. Loss on Write-Down of Inventory (Expense) = $232.50
[Credit]. Inventory = $232.50
(To write down inventory to its net realizable value)
By writing down inventory to its net realizable value, a company recognizes a loss when it happens and shows no profit or loss when the inventory is finally sold. Using net realizable values means that assets are not being reported at amounts that exceed their future economic benefits.
Inventory Valued at Lower of Cost or Market
Inventory must also be written down to an amount below cost if it can be replaced new at a price that is less than its original cost. In the electronics industry, for instance, the costs of computers and compact disc players have fallen dramatically in recent years.
When goods remaining in ending inventory can be replaced with identical goods at a lower cost, the lower unit cost must be used in valuing the inventory (provided that the replacement cost is not higher than net realizable value or lower than net realizable value minus a normal profit). This is known as the “lower-of-cost-or-market” (LCM) rule.
The “ceiling”, or maximum market amount at which inventory can be carried on the books, is equivalent to net realizable value, which is the selling price less estimated selling costs. The ceiling is imposed because it makes no sense to value an inventory item above the amount that can be realized upon sale.
Assume that a company purchased an inventory item for $10 and expected to sell it for $14. If the selling costs of the item amounted to $3, the “ceiling” or net realizable value would be $11 (=$14 – $3). The floor is defined as the net realizable value minus a normal profit.
Thus, if the inventory item costing $10 had a normal profit margin of 20%, or $2, the floor would be $9 (net realizable value of $11 less normal profit of $2). This is the lowest amount at which inventory should be carried in order to prevent showing losses in one period and large profits in subsequent periods.
In applying this LCM rule, you can follow certain basic guidelines:
Step-1. Define market value as:
- replacement cost, if it falls between the ceiling and the floor.
- the floor, if the replacement cost is less than the floor.
- the ceiling, if the replacement cost is higher than the ceiling.
(Note: as a practical matter, when replacement cost, ceiling, and floor are compared, market is always the middle value.)
Step-2. Compare the defined market value with the original cost and choose the lower amount.
The following chart gives four separate examples of the application of the LCM rule; the resulting LCM amount is highlighted in each case.
The LCM rule can be applied in one of three ways:
- By computing cost and market figures for each item in inventory and using the lower of the two amounts in each case;
- By computing cost and market figures for the total inventory and then applying the LCM rule to that total; or
- By applying the LCM rule to categories of inventory. For a clothing store, categories of inventory might be all shirts, all pants, all suits, or all dresses.
To illustrate, we will use the above data to show how the LCM rule would be applied to each inventory item separately and to total inventory. (The third method is similar to the second, except that it may involve several totals, one for each category of inventory.)
With the first method, applying the LCM rule to individual items, inventory is valued at $1,334, a write-down of $164 from the original cost. With the second method, using total inventory, the lower of total cost ($1,498) or total market value ($1,454) is used for a write-down of $44. The write-down is smaller when total inventory is used because the increase in market value of $120 in item D offsets decreases in items A, B, and C.
In practice, each of the three methods is acceptable, but once a method has been selected, it should be followed consistently.
The journal entry to write down the inventory to the lower of cost or market applying the LCM rule to individual items is:
[Debit]. Loss on Write-Down of Inventory (Expense) = $164
[Credit]. Inventory = $164
(To write down inventory to lower of cost or market)
Notice that the amount of this entry would have been $44 if the LCM rule had been applied to total inventory.
The LCM rule has gained wide acceptance because it reports inventory on the balance sheet at amounts that are consistent with future economic benefits. With this method, losses are recognized when they occur, not necessarily when a sale is made.
When coming into a “value” in term of financial reporting, however, things could become much more complex than what the rest of us think about. Such situation commonly happened, in the inventory area, when dealing with inventory items that are out of date in style—particularly in the ‘fast-moving-product’ industries (e.g. apparels or jewelry.) They may be just produced one month ago or two, but in fact they are becoming out of date as the trend is moving so fast.
Next, let’s do a quick overview on what is the situation of the fair value accounting in general. And the distinct of “Fair Value” (FV) and “Fair Market Value” (FMV.) Read on..
Fair Value of Financial Reporting (in general)
After centuries, a recent, third step in the use of valuations has arrived: the push by accounting regulators to incorporate fair values into financial statements. Businesses have long been perceived by investors as always looking for the most favorable accounting and financial reporting treatments so as to convey as optimistic an outlook as possible.
The increasing use of fair value information is perceived by regulators, analysts, and investors as a more objective approach to financial reporting, a tool that may help or hurt the entity. In turn, this belief has placed great pressure on valuators to arrive at “correct” answers that enhance the objectives of financial reporting.
IASB and FASB have agreed to move toward a convergence of financial reporting standards, with the ultimate objective of GAAP users completely converting to IFRS standards.
It appears that the push for rapid convergence, followed by conversion, has slowed down. Nonetheless, it is inevitable that GAAP and IFRS will come together, particularly with respect to fair value information.
IASB, however, has announced that an exposure draft for a new IFRS standard on fair value measurement will be issued in the second quarter of 2009. This is anticipated to follow closely Statement of Financial Accounting Standards (SFAS) 157 with some variations.
The entire push to fair value accounting and disclosure seems to be predicated on the fundamental assumption that a true estimate of fair value can be developed and disclosed and that the world will be a superior place because of this “better” financial reporting. Unfortunately, that fundamental premise is deeply flawed; massive efforts by many professionals have failed to communicate that valuation involves a vast amount of judgment.
Therefore, any fair value conclusions are far from precise and perhaps not even totally reliable. Analysts, accountants, and standard setters have trouble with the idea that the same asset can have different values for different owners or for different purposes. We, accountants often consider our activities, though many involve assumptions, estimates, and judgments, to be precise and expect that valuation should have equal “precision.” Of course, the very concepts of Fair Value or Fair Market Value are difficult to pin down.
After the profession had spent over 100 years developing Fair Market Value, in June 2001, FASB introduced fair value with SFAS 141, followed in September 2006 with a new definition in SFAS 157, which totally changed the fundamental concept and instituted a brand-new approach to value.
Professional judgment is always involved in a valuation, even if only with respect to knowledge of the asset or business; no one would hire a real estate specialist to determine the fair market value of antique furniture, nor a financial expert for insurable values of machinery or equipment.
A different, also important, kind of judgment, which users of valuation information often disregard, is that normally there is really not a single answer but a range of correct answers in any specific valuation situation, whether for real estate financing, placement of insurance, or an allocation of the purchase price in a business combination.
Valuators have created the regrettable situation where clients receiving an appraisal report feel that the indicated amount is in fact “the” value. Most end up with a single-point estimate, a number that is sometimes carried to five significant figures; such deterministic answers actually promote confidence because of their seeming precision. However, in my personal view, this aura of precision is the cause of much of the discussion regarding weaknesses in fair value, its determination, and its use in financial reporting.
Many readers—especially the management—are often surprised by valuation result (by valuators) for most of them still generally believe that there is a single “true” fair value, which should be determined and then disclosed.
That the same asset can have far differing values to various people for diverse purposes is not yet fully accepted. When preparers of financial statements complain about the difficulty and cost of obtaining fair value information, or protest about its relevance, some security analysts and academics often assert that “the company does not want to disclose Fair Value because they have something to hide.”
There are at least three different premises of value: value in use, value in exchange, and value in liquidation. This fact has not prevented FASB from putting unwarranted emphasis on value in exchange in “active markets.”
Fair Value Versus Fair Market Value
For many years, there has been a standard definition of Fair Market Value developed for the International Glossary of Business Valuation Terms by a group of North American valuation organizations, including the National Association of Certified Valuation Analysts, IACVA’s U.S. charter and the American Institute of Certified Public Accountants (AICPA). It is:
“The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.”
The International Valuation Standards Council (IVSC) has a definition of Market Value used in much of the rest of the world; this is similar in that it deals with an arm’s-length transaction between a willing buyer and a willing seller:
“The estimated amount for which a property should exchange on the date of valuation between a willing buyer and a willing seller in an arm’s-length transaction after proper marketing wherein the parties had each acted knowledgeably, prudently, and without compulsion.”
The first definition, or one conceptually very close to it, served the valuation profession and clients in the United States without controversy; in it, “fair” qualifies “market,” not “value.” The very similar concept, called just “market value,” dates back centuries in Europe. These definitions acknowledge that different premises of value can coexist depending on the purpose of the assignment and the interests of the parties while insisting that the perspectives of both buyer and seller had to be explicitly recognized. What I would like to say is, various views about the future outlook still could result in diverse conclusions of value.
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