Financial Accounting

Learn the toughest concepts covered in your Financial Accounting class with step-by-step video tutorials and practice problems.

5. Inventory

Lower of Cost or Market

If the value of our inventory has decreased, we must evaluate whether we need to take a loss in the current period related to this decrease in value. This is common in technological industries, where products become obsolete over time.



Lower of Cost or Market

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Alright now let's see what happens when we purchase some inventory and have difficulty selling it. So we have what's called the rule of conservatism in accounting. Okay? And this tells us that we're gonna be looser when we record losses than when we record gains. We want to be a little more conservative, right? When something bad happens we want to be more likely to record something than when something good happens, we want to really make sure that good thing has happened. Okay? So if an asset has lost value right? There is a bad thing. If an asset has lost value, we generally will take an expense or lost in the period that it changed value. So if some asset, if we find out that the machine that we have actually, you know might not last as long as it was supposed to or it's just not worth as much, we might lower the value of that machine in this period. Right now compare that to the opposite. If an asset has gained value, we generally will not take any revenue or any gain until it is sold. Okay? So if we have some land that we purchased and we use it all the time and we find that that land is worth more than we paid for it. Well we're not gonna take any of that gain, we're not gonna say well it's worth more, we should say we took the gain, we're not gonna take the gain until we sell the land, okay, So it's gonna stay at that price that we paid for it. Unless, right we see situations where it goes down, That's the conservatism. Okay, so let's talk about inventory, right? Let's see how this idea relates to inventory. We have what's called the lower of cost or market rule, Okay. We have to mark our inventory, we have to value our inventory at the lower of what we paid for it, the cost, right? The historical cost of the inventory and that's what we paid for it or the market. Right? So when we say lower of cost or market, that's super straightforward. It's either the we're gonna say inventory is worth cost or inventory is worth market. Right? So let's define market. So market is what we call the net realizable value of the inventory Or just the current replacement cost. Right? The current replacement cost is the market price, right. If right. If you had paid $50 per unit for inventory and right now, you know, for whatever reason it got cheaper to produce, those units are now selling for 30 per unit. That would be the current replacement cost. Right? That current market price Net realizable value is a little bit different. Net realizable value. We're gonna estimate a selling price which they're gonna have to give you in the question, they're gonna have to say we expect to be able to sell these for $50, but then we're gonna have some disposal costs, okay, disposal costs might be you might have to pay a commission to the salesmen if you do sell it right, you'll have some sort of disposal cost. It's not just the money coming in, you might have some expenses in selling this product. Okay. So when we do mark down our inventory which you most likely will when you have a lower cost of lower of cost or market question, you're probably gonna be in a situation where you're lowering inventory. Well you're gonna write a loss from write down inventory. Okay. A loss. So this goes up goes up with a dead it right? Because it's a loss which is similar to an expense. So those go up with debits there. Okay. So that would be a a loss if we have to write down our inventory. Cool. So let's go ahead and do this example for so so we can kind of drive this in ob soco or purchased inventory four years ago for $84,000 In the current year. Corp estimated it could sell this inventory for $86,000. So it could sell it for 86,000 while incurring selling expenses of 7000 in its financial statements. So corpse should report inventory app. So remember we're either going to record it at cost or at market. So let's make two columns. Let's say what is our cost and what is our market? And remember it has to be the lower of cost or market. So cost it tells us that he purchased it four years ago for $84,000. Easy enough. That's the cost of the inventory. Now the market In this situation. They didn't tell any, tell us any information about current replacement cost. Right? They didn't say currently you could buy this inventory for so and so I know what they told us was information about net realizable value, right? They told us the estimated selling price and the disposal costs. Right? Those selling expenses of 7000. So to get to our market we would do our net realizable value formula estimated selling is 86,000 right? Just like it tells us in the problem While incurring expenses of 7000. So our net realizable value is gonna be 86,000 minus 7000. That's gonna be 70 79,000. Right 79,000, yep. So last step which one's lower? Right? This is lower of cost or market. Well in this case market is lower right? So the market is the lower one. So that's what we should value our inventory yet. Right now. Our inventory says it's worth 84,000 but we haven't sold it. It's still sitting there. It's just sitting on our books at 84,000. And now we? Re evaluated that we think it's only worth 79,000 when we sell it. Okay so we should take that loss now. So the inventory should be marked down to 79,000. And just to drive it in. Let me show you what the the entry might look like. We would have a journal entry where we would debit loss from right down of inventory. And I'm gonna put W. D. For write down of inventory. So that would be our loss. And that's the debit in this situation. So how much is the loss? Well the loss is we were at 84,000 right 84,000 is what it's currently valued at but it should be valued 79,000. Right so that means the loss is 5000 in this situation. Right? We lost 5000 in value. You can see that. So 84,000 is the historical cost. That's what we paid for. It minus this new the market price that we just calculated as 79. That means we need to write down our inventory by 5000 currently it's on our books for 84 but we wanted on our books for 79. So we're going to debit this loss for 5000. So that's the debit of this entry. And then we're going to credit inventory right to lower the value of inventory with the credit and there we go. That would be the entry that we make To lower the value of inventory from 84,000 down to 79,000. But the answer here they were just asking us what should we value inventory and the answer would be 79,000. Cool let's go ahead and move on to the next video.

Using the following data, determine the value of inventory at the lower of cost or market. Apply lower of cost or market to each inventory item. Assume expenses of $2 per unit are expected to be incurred in selling the inventory.