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The accounting principle of recording inventory at the lower of cost or market value, including the determination of market value and journal entries. It also covers the capitalization of costs for long-term assets and research and development expenditures.
Typology: Study notes
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Accounting "conservatism" requires inventory to be recorded at the lower of cost or market.
As a result, firms are required to "write-down" their inventory when the market value of their inventory substantially declines.
In order to make this determination, you need to know the "cost" and the "market" values of your inventory.
Cost is easy. It is the historical cost as determined by your inventory cost method.
Market is more difficult.
Net realizable value is the selling price less any additional costs to complete or sell the inventory.
The proper journal entry is:
Dr. Loss from write-down of inventory Cr. Inventory
If the amounts are relatively small, firms will instead record:
Dr. Cost of Goods Sold Cr. Inventory
The problem with the second entry is that it distorts cost of goods sold (because the sales revenue for the units has not been recorded) and gross profit margins.
The normal profit margin is 25% of the selling price Replacement Selling Disposal Product Cost Cost Price Costs 101 80,000 85,000 160,000 30, 102 175,000 160,000 200,000 25, 201 160,000 140,000 180,000 50, 202 45,000 20,000 60,000 22, (In $ thousands) 101 102 201 202 Historical cost 80 175 160 45 Replacement cost 85 160 140 20 Net realizable value 130 175 130 38 NRV - normal profit 90 125 85 23 "Market value" 90 160 130 23
If the firm uses two inventory categories, Category A ( & 102) and Category B (201 and 202): Category A Category B Cost 255 205 Market 250 153 Write-down 5 52
Why is this important?
General Rule: All costs that are reasonable and necessary to prepare the asset for use.
Note: Depreciation begins when the asset begins production. Subsequent costs are generally expensed. Exceptions include costs that substantially alter the asset or extend the asset's useful life (can be capitalized).
Allocation of Costs: Common costs are generally allocated based upon the relative fair market values.
R&D Limited Partnerships
Software Development Costs
Purchased R&D
R&D Limited Partnerships (Not in text): One way firms used to avoid the expensing of R&D was to form an R&D limited partnership. The sponsoring firm purchases an interest in the limited partnership with an option to purchase the results of the R&D. The investment in the limited partnership is treated as an asset. In SFAS #68, the FASB adjusted the accounting for such arrangements to substantially close this loophole.
This applies to software to be sold commercially. Costs to develop software for internal use are generally expensed. Software development costs are expensed until technological feasibility is established.
Example from the text: Technological feasibility: June 30, 2000 Commercial production: January, 2001 Costs: 1/1/00 - 6/30/00 = $1,200, 7/1/00 - 12/31/00 = $800, % of estimated total revenue in 2001: 30% % of estimated economic life of the product in 2001: 25% Expense recognized in 2001: 30% x $800,000 = $240,000.
Example: In 1995 IBM paid $2.9 billion to acquire Lotus. The fair value of the tangible assets was determined to be $325 million. The fair value of the intangible assets was determined to be $735 million. The value of in-process R&D was valued at $1.84 billion.
Most of the $1.84 billion was allocated to a product called "WordSpeak". WordSpeak was a technology to convert oral communications into editable (typed) documents. The technology was in the preliminary development stage and was not expected to be marketable until the year 2000.
What is the rationale behind the accounting treatment for "in-process R&D?"
What are management's incentives with regard to the accounting for an acquisition?
Why is the accounting treatment for in-process R&D controversial?
Financial Statements:
