When inventory is written down to comply with the lower of cost or market rule the total amount of?
2022 Curriculum CFA Program Level I Financial Reporting and Analysis Show IntroductionMerchandising and manufacturing companies generate revenues and profits through the sale of inventory. Further, inventory may represent a significant asset on these companies’ balance sheets. Merchandisers (wholesalers and retailers) purchase inventory, ready for sale, from manufacturers and thus account for only one type of inventory—finished goods inventory. Manufacturers, however, purchase raw materials from suppliers and then add value by transforming the raw materials into finished goods. They typically classify inventory into three different categories: raw materials, work in progress, and finished goods. Work-in-progress inventories have started the conversion process from raw materials but are not yet finished goods ready for sale. Manufacturers may report either the separate carrying amounts of their raw materials, work-in-progress, and finished goods inventories on the balance sheet or simply the total inventory amount. If the latter approach is used, the company must then disclose the carrying amounts of its raw materials, work-in-progress, and finished goods inventories in a footnote to the financial statements. Inventories and cost of sales (cost of goods sold) are significant items in the financial statements of many companies. Comparing the performance of these companies is challenging because of the allowable choices for valuing inventories: Differences in the choice of inventory valuation method can result in significantly different amounts being assigned to inventory and cost of sales. Financial statement analysis would be much easier if all companies used the same inventory valuation method or if inventory price levels remained constant over time. If there was no inflation or deflation with respect to inventory costs and thus unit costs were unchanged, the choice of inventory valuation method would be irrelevant. However, inventory price levels typically do change over time. International Financial Reporting Standards (IFRS) permit the assignment of inventory costs (costs of goods available for sale) to inventories and cost of sales by three cost formulas: specific identification, first-in, first-out (FIFO), and weighted average cost. US generally accepted accounting principles (US GAAP) allow the same three inventory valuation methods, referred to as cost flow assumptions in US GAAP, but also include a fourth method called last-in, first-out (LIFO). The choice of inventory valuation method affects the allocation of the cost of goods available for sale to ending inventory and cost of sales. Analysts must understand the various inventory valuation methods and the related impact on financial statements and financial ratios in order to evaluate a company’s performance over time and relative to industry peers. The company’s financial statements and related notes provide important information that the analyst can use in assessing the impact of the choice of inventory valuation method on financial statements and financial ratios. This reading is organized as follows: Section 2 discusses the costs that are included in inventory and the costs that are recognised as expenses in the period in which they are incurred. Section 3 describes inventory valuation methods and compares the measurement of ending inventory, cost of sales and gross profit under each method, and when using periodic versus perpetual inventory systems. Section 4 describes the LIFO method, LIFO reserve, and effects of LIFO liquidations, and demonstrates the adjustments required to compare a company that uses LIFO with one that uses FIFO. Section 5 describes the financial statement effects of a change in inventory valuation method. Section 6 discusses the measurement and reporting of inventory when its value changes. Section 7 describes the presentation of inventories on the financial statements and related disclosures, discusses inventory ratios and their interpretation, and shows examples of financial analysis with respect to inventories. A summary and practice problems conclude the reading. Learning OutcomesThe member should be able to:
SummaryThe choice of inventory valuation method (cost formula or cost flow assumption) can have a potentially significant impact on inventory carrying amounts and cost of sales. These in turn impact other financial statement items, such as current assets, total assets, gross profit, and net income. The financial statements and accompanying notes provide important information about a company’s inventory accounting policies that the analyst needs to correctly assess financial performance and compare it with that of other companies. Key concepts in this reading are as follows:
What is lower of cost or market rule for inventory?The lower of cost or market rule states that a business must record the cost of inventory at whichever cost is lower – the original cost or its current market price. This situation typically arises when inventory has deteriorated, or has become obsolete, or market prices have declined.
When the value of inventory is lower than its cost?The lower of cost or net realizable value concept means that inventory should be reported at the lower of its cost or the amount at which it can be sold. Net realizable value is the expected selling price of something in the ordinary course of business, less the costs of completion, selling, and transportation.
Why are inventories stated at lower of cost or market?The lower of cost or market method lets companies record losses by writing down the value of the affected inventory items.
When reporting inventory using the lower of cost or market method market should not be more than?The lower of cost or net realizable value. When reporting inventory using the lower of cost or market, market should not be less than: Net realizable value less a normal profit margin.
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