Nov 6th , 2015 (Friday).

Corporate
Financial
Reporting
Submitted to: Maam Javera Asim

[Post-Mid Assignment 1]
Student Name
Tehniat Zafar
Major: BBA (Hons.)
Semester: 7 Sec: B

Question
INVENTORY VALUATION
Assets are generally stated in the financial statements according to the cost principle.
However, in case of inventory, cost principle is abandoned and lower of cost or market
(LCM) rule takes its place. This rule states that inventory should be measured at the lower of:
Cost; or
Market Value
Market value means the replacement cost of the inventory. Replacement cost may be in the
form of purchase cost or manufacturing cost. In other words, market value is amount that we
would have to pay to acquire inventory of the same quantity and quality through purchase or
through manufacture. However, upper and lower limits have been placed on the market value
of inventory.
The basis of accounting for inventories is cost. This straightforward concept is frequently
complicated by the entitys inability to match actual cost flow with specific physical units.
US GAAP allows many ways (e.g., retail method) to measure the cost of inventory. The three
basic and most popular methods are:
1) FIFO (first-in, first-out)
2) LIFO (last-in, first-out)
3) Weighted average.
Once the cost is measured, then the LCM rule is applied to the result to determine the
monetary amount to be reported in the financial statements. The LCM rule represents an
application of the concept of conservatism which has been one of the dominant approaches
used in forming and applying accounting rules under US GAAP. It is a practical attitude that
attempts to avoid overstating assets and net income in the event of uncertainty. Conservatism
is not an accounting principle, but the definition and application can be found in any
accounting principles or intermediate accounting book. Conservatism, as used by many

practicing accountants, is to record anticipated losses now and defer gains until realized. A
conservative approach was used in forming the LCM rule.
The application of LCM uses a conservative approach in an attempt to measure loss of value
in the period in which it occurs. It compares inventory cost (i.e., value) as recorded on the
financial books regardless of the method (e.g., LIFO, FIFO) used with market value. The
term market, for this purpose, is defined as current replacement cost not to exceed a ceiling
of net realizable value (selling price less costs of completion and disposal) or be less than a
floor of net realizable value less a normal profit margin. This computed market value is then
compared to the inventory value recorded on the books. Inventory is written down to the
lower of the two values (i.e., historical cost or market value). The adjusted value then
becomes the new cost basis going forward under US GAAP. There is no provision for
reversals. Any such recovery would be deferred until the inventory is sold or disposed of. The
LCM acts as a conservatively approached safety valve by recording anticipated losses
currently and deferring gains until realized.

Example
Company A owns an item of inventory having original cost of $900. Its replacement cost is
$880. The company expects to sell it at $980. However an expense of $40 must be incurred to
make the sale. Calculate the value of inventory according to lower of cost of market rule.

Solution
Upper Limit: NRV
= 980 40
= $940
Replacement Cost
= $880
Lower Limit: NRV Normal Profit
= 940 (980 880)
= $840
Since the replacement cost of $880 lies within the limits set by LCM rule, it is allowable
market value of the inventory. This market value is to be compared to the original cost of
inventory which is $900. Since the market value of inventory is lower than its original cost
therefore it should be stated at $880 in the financial statements.