How are the floor and ceiling limits calculated as per the lower of cost or market LCM method under US GAAP?

Although most CPAs know that inventory should be valued at the lower of cost or market (LCM) under U.S. GAAP, many do not realize the difficulties that might arise when trying to apply the LCM rules. Overcoming these difficulties can be quite challenging, even for those with experience. The following is a review of the current rules surrounding inventory valuation, highlighting some of the problems faced when applying the LCM rules (including the potential impact on the financial statements) and providing some practical suggestions for implementing them in accordance with U.S. GAAP. The Basics of LCM The cost of unsold inventory is an asset, and normally it becomes an expense only when the inventory is sold; however, when there is evidence that the utility of inventory will be less than its cost, the inventory must be written down to a lower value (ASC 330-10-35-1). Requiring a write-down prior to the sale of inventory results in a charge against income in the period when the decline in value becomes evident, rather than delaying that charge until the period when the inventory is sold, and avoids overstating the value of the impaired inventory on the balance sheet. The term "market" is generally not intended to represent sales value, but rather the purchase price or cost of reproduction; it is best thought of in terms of the equivalent expenditure that would have to be made in order to procure corresponding utility at the balance sheet date (ASC 330-10-35-3). Thus, although the phrase "lower of cost or market" is commonly used, it is probably more accurate to describe the procedure as "lower of original cost or replacement cost." Under U.S. GAAP, there are boundaries on the market value, based on the exit value to the entity (i.e., the sales price). If replacement cost exceeds the net realizable value (NRV), the NRV should be used as the market value. The NRV equals the estimated selling price minus estimated costs of completion and disposal, and it is commonly referred to as the "ceiling." If replacement cost is less than the "floor" (i.e., the NRV minus an allowance for a normal profit margin), then the floor should be used as the market value. Thus, the market value is interpreted as the replacement cost, with the additional requirements that market value cannot be more than the ceiling or less than the floor. Several estimates which vary in their degree of subjectivity and include replacement cost, sales price, costs of completion and disposal, and normal profit margin--are required to apply the LCM rules. Although these estimates should be made from a neutral standpoint, reporting entities might inappropriately manipulate them in order to manage the potentially significant financial statement impact of inventory write-downs. A detailed discussion of these topics is outside the scope of this article; thus, the examples discussed later assume that the estimated amounts needed to determine the final inventory values are given. To summarize the LCM process, one must first determine the replacement cost, ceiling, and floor for each inventory item. Next, one should choose the market value (i.e., designated market value [DMV]) from these three values by applying the rules discussed above; this is most easily done by ranking the three values from largest to smallest and selecting the median value as the DMV. The DMV is then compared to the inventory cost currently on the books, which is normally the original cost, unless a previous adjustment has been made to the cost basis of the inventory. The lower value is used as the inventory value at the balance sheet date. If cost is less than or equal to the DMV, no adjusting entry is necessary; if the DMV is less than cost, a write-down of the inventory is required. The LCM rule is one-sided--that is, it allows inventory to be valued at market only if the market value is lower than cost. U.S. GAAP (ASC 330-10-35-15) generally prohibits valuing inventory above cost, although doing so is allowed in special cases (which are not discussed in this article). Furthermore, if a write-down is required under the LCM rule, it creates a new cost basis for the inventory, and the reduced amount is to be considered the cost for subsequent accounting purposes (ASC 330-10-35-14). Companies may apply the LCM rule on an individual-item basis or to a combined level of inventory (i.e., the entire inventory or major categories of inventory). The aggregation basis used depends upon the nature of the inventory, and the method used should be the one that most clearly reflects periodic income (ASC 330-10-35-8). U.S. GAAP indicates a general preference toward applying the LCM rule on an individual-item basis, especially for nonmanufacturers; however, for companies that utilize several different inventory items in combination (i.e., manufacturers) to create a given end product, it might be more appropriate to combine those inventory items for purposes of the LCM calculation. Aggregation of inventory items might be proper when no loss of income is expected to occur as a result of a decline in the value of some items because other items--components of the same finished product--have a market value that is in excess of cost. Whichever method of aggregation is used, it should be applied consistently from year to year (ASC 330-10-35-10). Practical Considerations When Applying LCM Although many concerns must be considered when applying LCM, this discussion focuses on the following two implementation decisions: * Whether LCM should be applied to individual items or at an aggregate level * Whether the inventory detail should be adjusted to reflect any write-downs, as opposed to using an allowance account and not adjusting the inventory detail. A simple, two-year example is used to demonstrate the financial statement effects of each of these choices. It is assumed that the DMV for each inventory item has already been determined; thus, detailed information regarding the replacement cost ceiling, and floor for each item is not provided. Example: Year One

Formed in 2011, Bravis Co. is a retailer (nonmanufacturer) that sells only two items, A and B. Assume that Bravis uses a perpetual inventory system and the first-in, first-out (FIFO) inventory valuation method. Information for purchases, sales, and costs of each item for 2011 is shown in Exhibit 1.

What account should be debited to record the $2,000 write-down? Although cost of goods sold (COGS) might be debited, doing so is technically inaccurate, because the merchandise that triggered the write-down has not been sold but is still on hand. The alternative is to charge a separate loss account, appropriately labeled to disclose to readers the nature of the loss (e.g., loss from write-down of inventory to market value). Although both methods have the same effect on net income, the latter approach is conceptually preferable because it shows the loss separate from COGS in the income statement. Assume, for now, that the inventory account (rather than an allowance account) is credited, and that the inventory detail is adjusted to reflect the $16 unit value for Item A. Based on these facts and assumptions, Bravis would make the following journal entry at December 31, 2011:

For reference purposes, the results (summarized below) of the individual-item approach, without the use of an allowance account, are referred to as the "year one benchmark":

For a company with thousands of inventory items and numerous write-downs, it might be impractical to adjust the detailed records. To avoid this task, an allowance account (a contra-inventory account) may be used to capture the effect of the writedown on inventory. At first glance, the decision about whether to use an allowance account would seem to have no effect on the other side of the write-down entry; however, in future years (beyond year one), the entry to the allowance will be a net number that captures the effect of 1) new inventory write-downs, which should be debited to a loss account, and 2) adjustments for sales of inventory items in the current year that were written down in a prior year, which should be credited to COGS. (The inventory detail was not adjusted, so COGS will be overcharged when these items are sold.) Separating this entry into its components (COGS versus a loss from new write-downs) would be quite complex and would require the company to keep track of detailed information on prior write-downs; this level of detailed recordkeeping would defeat the purpose of using an allowance account. For this reason, when using an allowance account, assume that the other side of the adjusting entry will be entirely to COGS (rather than to a loss account or to some combination of the two accounts). Based on these assumptions, Bravis would make the following journal entry at December 31, 2011:

As this demonstrates, the allocation of any write-down (or write-up) to specific inventory items is arbitrary under the aggregate approach. For this reason, the use of an allowance account, with no adjustment to the inventory detail, is the only feasible alternative when using this method. Bravis would make the following journal entry at December 31. 2011:

The financial statement effects of the aggregate approach, as compared to the year one benchmark, are shown in Exhibit 2.

Individual-item approach. Assume purchases and sales during 2012, as well as the amounts for COGS and ending inventory (if no allowance account is used), are indicated in Exhibit 3. Because the inventory detail was adjusted at December 31, 2011, the original $20 unit cost for the 500 units of Item A in beginning inventory was replaced by the $16 DMV; as a result, when those units are sold (and under FIFO, all are considered sold during 2012), the correct unit cast of $16 is charged to COGS. An adjusting entry must be made (and the inventory detail adjusted) to write down the 700 units of Item A in ending inventory from the recorded unit value of $16 to the DMV of $15, as shown below:

For reference purposes, the results (summarized below) of the individual-item approach, without the use of an allowance account, are referred to as the "year two benchmark":

Using the individual-item approach, the desired credit balance in the allowance account at December 31, 2012, is $700 (the $13,300 in the inventory detail minus the $12,600 proper balance under individual LCM). Because the current balance (carried over from December 31, 2011) is a $2,000 credit, a $1,300 debit to the allowance account is indicated, resulting in the following entry:

Aggregate approach. The market value of the entire inventory ($12,900) is less than cost ($13,300), indicating a required credit balance of $400 in the allowance. Because the current balance (carried over from December 31, 2011) is a $1,200 credit, an $800 debit entry to the allowance account is required, as follows:

The financial statement effects of the aggregate approach, compared to the year two benchmark, are summarized in Exhibit 4.

In the year two example, it was assumed that all of the units of hem A that were on hand at December 31, 2011, were sold during 2012. But what if some of those units remain unsold at the next reporting date? Using the same data for year one, continue to assume that all inventory purchases made in 2012 occur at December 31, 2011, prices ($16 for Item A and $7 for Item B); however, assume that the DMV at December 31, 2012, of Item A is $17 (instead of the $15 used previously for year two) and the DMV of Item B is $8. For this example, it is assumed that Bravis uses the individual-item approach, in conjunction with an allowance account. Additional information for year two, under this modified example, is shown in Exhibit 5.

The LCM analysis, as performed, indicates a required credit balance of $600 ($9,300 - $8,700) in the allowance. Because the current balance (carried over from December 31, 2011) is a $2,000 credit, the following entry will be made:

Bruce Wampler, DBA, CPA, is an associate professor and Travis Holt, PhD, CPA, is a UC Foundation assistant professor, both in the college of business at the University of Tennessee at Chattanooga