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Inventory Write-downs | Lower of Cost or Market | Ceiling, Floor, Replacement | Accounting How To |
Oct 4, 2022
Inventory Write-downs | Lower of Cost or Market | Ceiling, Floor, Replacement | Accounting How To | How to Pass Accounting Class is an accounting tutorial explaining the concept of inventory write-downs and Lower of Cost or Market method using a homework example. This is an accounting tutorial for accounting students, business owners, and bookkeepers to explain accounting basics for beginners. Featuring Terrance the T-Account Rex and accounting educator, Caroline Grimm, this accounting tutorial is part of the playlist series: How to Pass Accounting Class and Intermediate Accounting 🎥 Playlists: 🎥 Inventory Write-Downs https://www.youtube.com/playlist?list=PLPDomDzptO11Lphun9JboORWMMk2UmnIH 🎥 How to Pass Accounting Class Playlist: https://youtube.com/playlist?list=PLP... 🎥 Intermediate Accounting https://www.youtube.com/playlist?list=PLPDomDzptO108xDRxDAHKCCHlN2Un2e3F 🔥 Smoking Hot Deal! Use this link https://quickbooks.grsm.io/accounting-how-to to access special pricing for new QuickBooks customers. Accounting How To receives a small commission if you sign up through this link. That helps keep this channel going and makes sure Terrance gets enough snacks so he doesn’t get hangry. Nobody likes a hangry T-Rex. 👹 Get Caroline’s books on Amazon: Strength in Numbers: Fast and Easy Accounting Basics for Business Owners https://www.amazon.com/gp/product/B09NWX3M7M
View Video Transcript
0:00
We're here today to break down the very strange concepts of ceilings and floors in inventory
0:12
write downs. This is part of our inventory write down playlist and I'll link the other videos in the description
0:20
so you can see the whole picture. Welcome to Accounting How To
0:24
I'm your host Carolyn Grimm and that's my sidekick Terence. here to put the fun in accounting fundamentals. Now when we're talking about inventory write-downs
0:35
it can get a little weird on us because we do talk about something called the ceiling and the
0:42
floor and replacement costs. So I'm going to jump into a spreadsheet with you and I'm going to walk
0:47
you through a typical problem that you might see in accounting class that deals with this ceiling
0:53
and floor issue. And I'm going to break it down in a way that hopefully is going to make things
0:58
things a lot easier for you to understand. Let's jump on over
1:04
Wow, that was a trip. So here's a pretty typical looking example
1:10
that you might see in your homework or on a test. So what we have here is a table
1:15
with a bunch of gobbledygook in it. And this gobbledygook is the thing that we're going to explain
1:20
so that you get a really good idea of what's going on here. So when we're talking about doing inventory write downs
1:27
there are some things that we need to understand. And there are two rules that we talk about
1:32
one being the lower of cost or market, and the other being lower of cost or net realizable value
1:39
And again, I'll link those videos below so that you can get that foundation under you
1:44
for what we're talking about in this video. So in this table, what we've got is we've got some items
1:50
and we've called those items A, B, C, D, E, and F, just to keep it simple
1:54
And then we've got a column for cost, a column for net realizable value minus normal profit, net realizable value, and replacement cost
2:06
Now, depending on what inventory method a business uses, we need different pieces of information from this chart
2:13
So let's break that down. So let's say that a company uses FIFO or average cost or specific ID method for their inventory
2:25
So this is the way a company values their inventory on their balance sheet
2:29
And remember that the idea with costing inventory is to always make sure that you have an accurate number on your balance sheet
2:38
You don't want to be overstating or understating your inventory. You want to be representing it at the true value
2:45
So under FIFO, first in, first out, or average cost, or specific ID, the two columns that we are concerned with are cost and net realizable value
2:59
So to review net realizable value is how much you can get for that item when you sell it to your customer So in this example the two columns that we are interested in for FIFO or Avco or specific ID methods is the cost and the net realizable value
3:19
So when we're doing an inventory write down and we have to make a determination as to what the cost is we'll use to value our inventory
3:29
we're going to be looking at the lower of cost or net realizable value
3:35
So let's just take a look at our first item, item A. So the cost is $3.40 and the net realizable
3:45
value, the most we think we can sell this for, is $4.14. So the lower of cost or net realizable
3:56
value is cost in this situation. We've got $3.40 for our cost and we think that our net
4:03
realizable value is $4.14. So if we're going to be doing a write down on our inventory for this item
4:10
then what we want to be looking at valuing this item at is the cost because it's lower
4:16
So if this is what our inventory is on our balance sheet as $3.40, we don't need to do
4:24
a write down because our cost is the lower of the two and our inventory is already recorded at cost
4:34
So let's look at item B. So item B cost us $36. Our net realizable value is $32.40. So our net
4:45
realizable value is lower than what we paid for it. We cannot sell this item for as much as we
4:52
paid for it. So in this case, because our net realizable value, what we can sell it for is
4:58
less than our cost, that means we need to do a write down on the inventory because our cost
5:06
is higher than our net realizable value. So when we're talking about FIFO, AVCO, or specific ID
5:13
methods, whichever is the lower is the cost that you want to use on your balance sheet
5:19
So if the cost, what we paid for it is lower, there's nothing that needs to happen
5:25
because we can still sell it for more than it's worth. It's when the net realizable value drops below the cost
5:32
that now we need to do a journal entry to make an adjustment to our inventory
5:38
Now, when we're talking about LIFO, last in first out as our inventory method, things change
5:45
So as far as this chart goes, we don't really care about cost quite yet. We'll get to that. But right now, we want to look at our
5:54
other columns here. So we've got net realizable value minus normal profit. We've got net realizable
6:01
value, and we've got replacement cost. So the first thing that we need to do here is we need
6:07
to determine what the middle value is for these three different columns for each one of our items
6:15
And that the part where we start to get into the ceiling and the floor thing in accounting So the ceiling is the most that you can sell an item for The floor is the most you can sell the item for
6:32
minus the normal profit on that item. And then the replacement cost is what you would pay
6:38
to get that merchandise at today's prices. So let's talk about the replacement cost first
6:46
So LIFO, last in, first out, is all about replacement costs. So when you use LIFO, last in, first out
6:56
as your inventory method, the costs that you are using first are the most recent costs
7:02
Whatever you bought yesterday is the cost you're using for your replacement cost
7:10
It's the cost that you're using to determine how much your inventory is worth
7:15
So LIFO is all about replacement cost. Now let's circle back to the ceiling and the floor thing
7:22
So the ceiling we said is the most that you can sell an item for
7:26
That's our net realizable value. So we're right back to our same column that we were using in our last example
7:35
But what we're looking at here is the most that we can get for this item
7:40
That's our ceiling. That's the highest we're going to get. Now, if you took your net realizable value and you subtracted your cost, it would give you your profit
7:50
So what the floor is all about is ensuring that you get your normal profit, that you're taking that into consideration for that item
7:58
Let me just break it down for you in a different way, the way that I understand it better
8:03
So what I do is I look at the ceiling minus the replacement costs equals the floor
8:14
And what that equates to me is you're taking your revenue, what you would sell this item for
8:20
you're subtracting your costs, your cost of goods sold, and that gives you your gross profit
8:26
So if you look at ceiling and floor and replacement costs within that context
8:32
It helps to understand better what's going on here. So if you take your ceiling, the most you can sell that for, minus your replacement costs
8:40
it's going to give you your profit number, right? Your gross profit
8:46
So let's jump into an example and see how this works. So let's look at our first item, item A
8:54
So we've got our net realizable value of $4.14. cents. We've got our net realizable minus normal profit of $2 and 79 cents. And then our replacement
9:07
cost is $4 and 65 cents. So what we want to do with this method is we want to find the middle
9:15
number. We want the middle ground. So if we go back to our table, now what we're looking to do
9:22
is we're looking to find what the middle number is for these three different numbers
9:29
that go along with this product. So for product A our net realizable value is Our net realizable value minus our normal profit is
9:41
And our replacement cost is $4.65. So it's going to cost us more to replace this than our net realizable value
9:50
So what we do in this case is we're going to find the number that's in the middle
9:55
In this case, it is the net realizable value of $4.14. So our replacement cost is the highest
10:04
our net realizable value is in the middle, and our net realizable value minus normal profit
10:10
is at the bottom. So we want the one in the middle. We want that net realizable value
10:16
And that's the point where we can now say, which is the lower of cost or market
10:23
So our market value is the number in the middle, in this case $4.14
10:30
Our cost is $3.40. So the lower of cost or market is $3.40
10:38
So our net realizable values, the number in the middle, $4.14. Our cost is $3.40
10:46
The lower of those two amounts is our cost. So in this case, we don't need to adjust our inventory because our cost is still lower than our net realizable value
10:59
Now let's take item B and take a look at that. So we have our NRV minus normal profit of $28.80
11:07
We have our net realizable value of $32.40. And we have our replacement cost of $27.60
11:13
So the number that's in the middle is $28.80, which in this case is our NRV minus normal profit number
11:22
So then we're going to take that number, the number in the middle, and we're going to compare that to cost and say which is lower
11:30
Well, the middle value is the market value of $28.80. Our cost is $36
11:36
So now our cost is higher than our middle number. So lower of cost or market in this case is the market value, the $2880
11:48
So with this particular item, we would be looking to do an inventory markdown to mark it down to the market cost
11:57
We're going to do that for each one of the items or categories in our inventory
12:02
We're going to look at those three different amounts, the net realizable value, the ceiling
12:06
the net realizable value minus normal profit, the floor, and the replacement cost
12:12
to see which one of those numbers is the middle number of those three amounts
12:17
And then we will compare that to cost and figure out which is the lower of cost or market value
12:24
And based on whether that number is higher or lower than cost, we'll determine whether we need to do an inventory markdown
12:31
So if that middle number is lower than our cost, we can't sell it for enough money
12:38
then we need to do an inventory right down. So I hope that has cleared things up a little bit for you
12:44
Until next time, stay balanced, my friends
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