Page 302 - Accounting Principles (A Business Perspective)

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Assume that the Cost of Goods Sold account had a balance of USD 200,000 by year-end when it is closed to
Income Summary. There are no other purchase-related accounts to be closed. The entry to close the Cost of Goods
Sold account is:

Dec. 31 Income Summary 200,000
Cost of Goods Sold 200,000
To close Cost of Goods Sold account to Income
Summary at the end of the year.
Departures from cost basis of inventory measurement
Generally, companies should use historical cost to value inventories and cost of goods sold. However, some
circumstances justify departures from historical cost. One of these circumstances is when the utility or value of
inventory items is less than their cost. A decline in the selling price of the goods or their replacement cost may

indicate such a loss of utility. This section explains how accountants handle some of these departures from the cost
basis of inventory measurement.
Companies should not carry goods in inventory at more than their net realizable value. Net realizable value is
the estimated selling price of an item less the estimated costs that the company incurs in preparing the item for sale
and selling it. Damaged, obsolete, or shopworn goods often have a net realizable value lower than their historical
cost and must be written down to their net realizable value. However, goods do not have to be damaged, obsolete,
or shopworn for this situation to occur. Technological changes and increased competition have caused significant

reductions in selling prices for such products as computers, TVs, DVD players, and digital cameras.
To illustrate a necessary write-down in the cost of inventory, assume that an automobile dealer has a
demonstrator on hand. The dealer acquired the auto at a cost of USD 18,000. The auto had an original selling price
of USD 19,600. Since the dealer used the auto as a demonstrator and the new models are coming in, the auto now
has an estimated selling price of only USD 18,100. However, the dealer can get the USD 18,100 only if the
demonstrator receives some scheduled maintenance, including a tune-up and some paint damage repairs. This
work and the sales commission cost USD 300. The net realizable value of the demonstrator, then, is USD 17,800
(selling price of USD 18,100 less costs of USD 300). For inventory purposes, the required journal entry is:
Loss Due to the Decline in Market Value of Inventory (-SE) 200
Merchandise Inventory (-A) 200
To write down inventory to net realizable value ($18,000 -
$17,800)
This entry treats the USD 200 inventory decline as a loss in the period in which the decline in utility occurred.
Such an entry is necessary only when the net realizable value is less than cost. If net realizable value declines but
still exceeds cost, the dealer would continue to carry the item at cost.
The lower-of-cost-or-market (LCM) method is an inventory costing method that values inventory at the

lower of its historical cost or its current market (replacement) cost. The term cost refers to historical cost of
inventory as determined under the specific identification, FIFO, LIFO, or weighted-average inventory method.
Market generally refers to a merchandise item's replacement cost in the quantity usually purchased. The basic
assumption of the LCM method is that if the purchase price of an item has fallen, its selling price also has fallen or
will fall. The LCM method has long been accepted in accounting.
Under LCM, inventory items are written down to market value when the market value is less than the cost of the
items. For example, assume that the market value of the inventory is USD 39,600 and its cost is USD 40,000. Then,

the company would record a USD 400 loss because the inventory has lost some of its revenue-generating ability.

Accounting Principles: A Business Perspective 303 A Global Text