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Accounting for Inventory: Lower of Cost or Market and Capitalizing Costs, Study notes of Software Development

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

2021/2022

Uploaded on 09/12/2022

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Lower of Cost or Market
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.
Obsolescence
Deterioration
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.
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Lower of Cost or Market

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.

  • Obsolescence
  • Deterioration

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.

Determining the "Market" Value of

Inventory

  • The market value is not defined as the current sales price of the inventory.
  • Market value is generally equal to the inventory's current replacement cost (how much it would cost to replace the inventory).
  • Except:
    • Market value cannot exceed the "net realizable value"
    • Market value cannot be less than the net realizable value less a normal profit margin.

Net realizable value is the selling price less any additional costs to complete or sell the inventory.

Journal Entries

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.

Example from Text, Page 384

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

Which Costs should be Capitalized?

Why is this important?

General Rule: All costs that are reasonable and necessary to prepare the asset for use.

  • Freight and transportation
  • Installation
  • Testing

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.

Special Considerations

  • Land: The basic rules apply, however the issues are more significant.
    • Lump-sum purchases are common (land and buildings)
    • Costs of preparation are large (removal of old building, etc.)
    • You do not depreciate land.
  • Interest: Can be capitalized if the loans are used to finance the construction of an asset.
    • You do not capitalize interest if the loan is used to finance the purchase of the asset.
    • Loans can be specifically dedicated to the project, or can be general long-term financing.
    • Issues that arise include the determination of an interest rate and the allocation to construction costs.

R&D Special issues

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.

Software Development Costs

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.

  • Technological feasibility: You have established that the product can be produced to meet its design specifications.
  • Costs incurred between technological feasibility and the start of commercial production are capitalized as an intangible asset and amortized.

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?

Required for Tuesday, October 31

E10-23; C10-

Financial Statements:

  • Determine the amount of R&D expense for your company. Compute R&D as a proportion of sales.
  • Did your company undertake any significant acquisitions during the year? If so, what is the proportion of the purchase price that was allocated to "in-process" R&D?
  • Does your company have a substantial amount of "Goodwill" on its balance sheet? If so, what policy does your firm follow to amortize the goodwill? How much goodwill amortization did the company record?