Extreme Confusion Regarding Lower-of-Cost-or-Market Concept

[LYAK]

I am extremely confused about the concept of lower-of-cost-or-market (LCM). I believe the textbook I am reading isn't doing a great job of explaining the concept.

The textbook reads: "A company abandons the historical cost principle when the future utility (revenue-producing ability) of the asset drops below its original cost." On the same page, the book reads: "For example, say Target purchased a Timex calculator wristwatch for $30 for resale. Target can sell the wristwatch for $48.95 and replace it for $25. It should therefore value the wristwatch for inventory purposes under the lower-of-cost-or-market rule."

Am I missing something or are these two statements inconsistent with one another? The revenue-producing ability of the asset did not drop below its original cost; it stayed the same. What is the reason for the reduction of the value of the inventory.

The ceiling and floor concepts to me make absolutely no sense in my mind as of right now. The concept of the ceiling and floor specifies that market is limited to an amount that is not more than net realizable value or less than the net realizable value less a normal profit margin. Net realizable value is defined as the estimated selling price in the ordinary course of business, less reasonably predictable costs of completion and disposal (often referred to as net selling price). Net realizable value less a normal profit margin is defined as the previously mentioned definition less a normal profit margin. So, going back to the Target example, I find that:

Selling Price = $48.95
Original Cost = $30

Selling Price = $48.95
Less Selling Expenses = $10 (assumed)
Net Realizable Value = $38.95
Profit Margin = 10% (assumed)
Net Realizable Value less Normal Profit Margin = $34.06
Replacement Cost = $25

The replacement cost is lower than the net realizable value less a normal profit margin, so why the reduction of value in inventory?

Also, say for instance, the original cost of an item was $10, and now its replacement cost is $9. The replacement cost is lower than the original cost. The selling price is of the item is $15, as it always has been, despite the drop in the replacement cost. After subtracting an assumed $3 selling expense, the net realizable value is $12, as it has always been. The normal profit margin is assumed to be 10%, giving a value of $10.50 for the net realizable value less a normal profit margin. So, do I assigned a value of $10.50? Or do I have discretion in assigning the value, being able to choose a value anywhere in the $10.50 - $12 range? Also, even at the floor, $10.50, my inventory value increases when replacement cost decreased? I don't know what I am missing here.

Also, say the replacement cost does fall in between the ceiling or floor, and you change your inventory value to that amount. The ceiling is the net selling price less selling expenses. Well, when you initially purchase inventory and value it, you don't reduce it by selling expenses, so why do you when the market price is less?

 

[kirby]

Yeah that textbook stinks. In the real world, once the cost fell to $25 then in a competitive market other retailers would have lowered the price and so would target. That would have changed the net realizable value too. You are thinking about all this in the right way.
A professor I had told my class that one time
he was teaching a graduate level class and made a chart on the board which was a spiral to explain pricing, just to see if they would stop him. He was upset because the class just took notes and no one challenged such a bizarre nonsensical chart.
You would have stopped him - good work!

 

[LYAK]

Yeah that textbook stinks. In the real world, once the cost fell to $25 then in a competitive market other retailers would have lowered the price and so would target. That would have changed the net realizable value too. You are thinking about all this in the right way.
A professor I had told my class that one time
he was teaching a graduate level class and made a chart on the board which was a spiral to explain pricing, just to see if they would stop him. He was upset because the class just took notes and no one challenged such a bizarre nonsensical chart.
You would have stopped him - good work!

Yeah; I have a problem just accepting accounting concepts without understanding the rationale behind them and understanding how they actually work. I'm still confused, however. I understand that the replacement cost being lower translates into a lower cost in the market in which Target is selling. Say, for example, Target lowered the selling price to $45; now, after subtracting the same assumed $10 selling expense, the NRV is $35; less a 10% profit margin, we have an NRV less normal profit margin of $30.50. The replacement cost of $25 is less than the $30.50 but lower than the $35, so how would I treat inventory value? The market cost is lower, but too low according to one of the two constraints. However, if I value the inventory at $30.50, the floor, it actually increases the value of the inventory by $0.50, even after the fall in replacement cost.

Also, when is the actual red flag thrown up indicating a departure from the historical cost concept needs to take place? Is it a fall in replacement cost? Is it a fall in the revenue-producing ability of the revenue? Is there a range in the replacement cost category, as it seems that prices would vary all the time, causing it extremely difficult to have to apply LCM constantly.

 

[LYAK]

I did some research on the topic on AccountingCoach.com and am now even more confused. On the website there is a chart with the following values: Cost, Replacement Cost, Expected Selling Price, Cost to Complete & Dispose, and Normal Profit. The following values for product A are:

Cost - $6
Replacement Cost - $4.50
Expected Selling Price - $10
Costs to Complete & Dispose - $3
Normal Profit (assumed as 20% of selling price) - $2

If you are selling the product for $10, then how do you have a profit of $2 if $6 goes to cover cost of goods sold and $3 goes to cover selling expenses? Where did the other dollar come from?

 

[Triest123]

I did some research on the topic on AccountingCoach.com and am now even more confused. On the website there is a chart with the following values: Cost, Replacement Cost, Expected Selling Price, Cost to Complete & Dispose, and Normal Profit. The following values for product A are:

Cost - $6
Replacement Cost - $4.50
Expected Selling Price - $10
Costs to Complete & Dispose - $3
Normal Profit (assumed as 20% of selling price) - $2

If you are selling the product for $10, then how do you have a profit of $2 if $6 goes to cover cost of goods sold and $3 goes to cover selling expenses? Where did the other dollar come from?

=> Selling price 10
Less : Cost of goods sold (5) => stated at value
Selling exp (3)
Profit 2

 

[LYAK]

=> Selling price 10
Less : Cost of goods sold (5) => stated at value
Selling exp (3)
Profit 2

So what you are saying is the goods were originally valued at $5 and now replacement cost dips down to $4.50 and the goods are now valued higher? This goes against the conservatism principle and revenue recognition principle. Please let me know if I missing anything here. Thank you.

 

[kirby]

Going back to that $2 profit. That only works if you ignore the $1 loss from the writedown of the cost from $6 to $5. Else we are back to a $1 profit, which is what we do have. And again the problem is with poor construction of the accounting example.