Lower of Cost or Market
Accounting "conservatism" requires inventory to be
recorded at the lower of cost or market.
As a result, firms are required to "write-down" their
inventory when the market value of their inventory
In order to make this determination, you need to know the
"cost" and the "market" values of your inventory.
Cost is easy. It is the historical cost as determined by your
inventory cost method.
Market is more difficult.
Determining the "Market" Value of
• The market value is not defined as the current sales price
of the inventory.
• Market value is generally equal to the inventory's current
replacement cost (how much it would cost to replace the
• Market value cannot exceed the "net realizable value"
• Market value cannot be less than the net realizable
value less a normal profit margin.
Net realizable value is the selling price less any additional
costs to complete or sell the inventory.
Application of Lower of Cost or Market
Generally, firms will choose between replacement cost and
net realizable value, based upon the reliability of the two
• Most of the time net realizable value will be the
easiest number to compute.
• If a firm uses net realizable value, it does not have to
worry about whether the market value is in the
The lower of cost or market adjustment can be applied to
individual inventory items, logical categories, or the entire
inventory. The broader the category, the higher the
inventory and the lower the adjustment.
Once inventory has been written-down, the revised value
becomes the "cost" value for future adjustments.
Any future recovery is ignored.
The proper journal entry is:
Dr. Loss from write-down of inventory
If the amounts are relatively small, firms will instead
Dr. Cost of Goods Sold
The problem with the second entry is that it distorts cost of
goods sold (because the sales revenue for the units has not
been recorded) and gross profit margins.
Example from Text, Page 384
The normal profit margin is 25% of the selling price
(In $ thousands)
Net realizable value
NRV - normal profit
If the firm uses two inventory categories, Category A (101
& 102) and Category B (201 and 202):
• Which costs should be capitalized?
• How do you value "intangible assets?"
• Noncash Acquisitions
• Research and Development
• Depreciation Methods
• Accelerated vs. Straight-Line
• Partial Periods
• Changes in estimates
• Changes in method
• Amortization of Intangibles
• Depletion of Natural Resources
• Impairment of Value
Which Costs should be Capitalized?
Why is this important?
General Rule: All costs that are reasonable and necessary to
prepare the asset for use.
• Freight and transportation
Depreciation begins when the asset begins
production. Subsequent costs are generally
expensed. Exceptions include costs that
substantially alter the asset or extend the asset's
useful life (can be capitalized).
Allocation of Costs: Common costs are generally allocated
based upon the relative fair market values.
• Land: The basic rules apply, however the issues are more
• Lump-sum purchases are common (land and
• Costs of preparation are large (removal of old
• You do not depreciate land.
• Interest: Can be capitalized if the loans are used to
finance the construction of an asset.
• You do not capitalize interest if the loan is used to
finance the purchase of the asset.
• Loans can be specifically dedicated to the project, or
can be general long-term financing.
• Issues that arise include the determination of an
interest rate and the allocation to construction costs.
Research and Development
General Rule: R&D expenditures are expensed when
• Includes depreciation of assets and an allocation of
• Does not include most general and administrative costs.
• Includes expenditures incurred until the product is ready
for commercial production.
Rationale: Future benefits associated with R&D are very
uncertain. There are problems in determining the dollar
value of the benefits (whether they are greater than the
expenditures) and the period of benefit.
R&D Special issues
R&D Limited Partnerships
Software Development Costs
R&D Limited Partnerships (Not in text): One way firms
used to avoid the expensing of R&D was to form an R&D
limited partnership. The sponsoring firm purchases an
interest in the limited partnership with an option to
purchase the results of the R&D. The investment in the
limited partnership is treated as an asset. In SFAS #68, the
FASB adjusted the accounting for such arrangements to
substantially close this loophole.