Video Transcript: Departure of Cost Basis of Inventory Measurement

Hello and welcome back. We're going to discuss departures from the cost basis  of inventory measurement. Generally, companies should use historical cost of  value inventories and Cost of Goods Sold however, some circumstances justify  departures from historical cost. One of these circumstances is when the utility or value of inventory items is less than their cost, a decline in the selling price of  the goods or their replacement costs may indicate such a loss of utility  companies should not carry goods in the inventory at more than their net  realized value. Net realized value is the estimated selling price of an item, less  the estimated cost that the company incurs in preparing the item for sale and  selling it, damaged, obsolete or shop worn, goods often have a net realized  value lower than the historical cost and must be written down to the net realized  value. However, goods do not have to be damaged, obsolete or shop worn for  the situation to occur. Technological changes and increased competition have  caused significant reductions in selling prices for such products as computers,  TVs, DVDs and digital cameras. To illustrate a necessary write down in the cost  of inventory, assume that an auto dealer has a demonstrator on hand. The  dealer acquired the auto at a cost of $18,000 the auto had an original selling  price of $19,600 since the dealer used the auto as a demonstrator and the new  models are coming in, the the auto now has An estimated selling price of only  $18,100 however, the dealer can get the $18,100 only if the demonstrator  receives some scheduled maintenance, including the tune up and some paint  damage repairs, this work and the sales commission costs of $300 The net  realized value of the demonstrator, then is $17,800 which is the selling price of  18,100 plus the cost of 300 the inventory. For inventory purposes, the required  journal entry is required, so you have the loss due to decline in market value of  inventory, which is a debit for 200 and you're going to deduct that from your  merchandise inventory again and with a credit of $200 and your comment is  simply to write down inventory to a net realized value with a brief definition of  how you arrived at the $200 this entry treats the $200 inventory decline as a  loss in the period in which the decline utility occurred. Such an entry is  necessary only when the net realized value is less than cost, if net realized  value declines but still exceeds costs, the dealer would continue to carry the  item at cost. The lower of cost, or market method, is an inventory cost method  that values inventory at the lower of its historical cost or its current market  replacement cost. The term cost refers to historical cost of inventory as  determined under the specific identification, the FIFO, the LIFO, or the weighted  average inventory method market generally refers to a merchandise item's  replacement cost in the quantity usually purchased. The Basis assumption of the lower cost of market method is that if the purchase price of an item has fallen, its selling price also has fallen, or will fall. The lower cost of market method has  long been accepted in accounting. Under the lower cost method, inventory items are written down to market value when the market value is less than the cost of 

the items. For example, assume that the market value of the inventory is  $39,600 and its cost is 40,000 then the company would record a $400 loss  because the inventory has lost some of its revenue generating ability. The  company must recognize the loss in the period that the loss occurred. On the  other hand, if inventory ending inventory has a market value of 45,000 and a  cost of 40,000 the company would not recognize this increase in value. To do  so, would recognize revenue before the time of sale. If the lower cost of market  is applied on an item by item basis, ending inventory would be $5,000 the  company would deduct the 5000 ending inventory from cost of goods available  for sale on the income statement and report this inventory in the current asset  section of the Balance Sheet, under the class method, a company applies lower  cost of market to the total cost and total market for each class of items  compared, one class might be games, Another might be toys, then the company values each class at the lower of its cost or market amount. If the lower cost  market is applied on the total inventory basis, ending inventory would be $5,100  since total cost of $5,100 is lower than the total market of the $5,150 an annual  report of DuPont contains an actual example of applying lower cost of market.  The report states that substantially all inventories are valued at cost as  determined by the last in first out, which is the LIFO acronym, which is left in first out method in aggregate, such valuations are not in excess of market. The term  in the aggregate means that DuPont applied lower cost of market to total  inventory. To demonstrate the lower of cost or market method, we use three  items. You can see a 100 units for the unit cost of $10 and a unit market price of  $9 so you have the total cost and you have the total market cost. So you're  going to choose a lower cost of market on an item by item basis, and for a final  inventory valuation of $5,000 you just want to take your unit cost and what the  market value is and do that for the next three units. A company, using periodic  inventory procedure, may estimate its inventories for any of the following  reasons to obtain an inventory cost for use in monthly or quarterly financial  statements without taking a physical inventory. The effect of taking a physical  inventory can be very expensive and disrupts normal business operations once  a year, is often enough to compare with physical inventories, to determine  whether the shortages, shortages exist, and to determine the amount  recoverable from an insurance company when fire has destroyed inventory or  the inventory has been stolen.