One of the requirements of the Generally Accepted Accounting Principles (GAAP) is that inventory should be recorded at LCM (lower cost or market) rule. According to the cost principle, a company’s assets are generally stated in the financial statements. When it comes to inventory, cost principle is deserted and lower of cost or market rule takes its place. The LCM says that inventory should be measured at the lower of cost or market value (Accounting Explained).
Market value basically means the replacement cost of the company’s inventory. This replacement cost can be in the form of a purchase cost or a manufacturing cost; simplified, market value is the amount a company would have to pay to acquire their inventory of the same quantity and quality through purchase or through manufacturing. There are upper limits as well as lower limits on the market value of inventory. These are fairly simple to figure.
The upper limit is the net realizable value (NRV) of a company’s inventory which equals the expected selling price minus the sum of the expected cost of completion and the expected cost necessary to make the sale. The lower limit is the net realizable value minus the normal profit margin on the inventory and can be applied to inventory on individual items basis, inventory class basis or to entire inventory. However, whatever the choice the company makes, the choice must be consistent.
Capitalizing Interest
In FASB 34, it states that companies must capitalize interest on all construction projects since to qualify for interest capitalization; assets must require a period of time to get them ready for their intended use (FASB). The importance of remembering that the company may only capitalize the actual amount of money spent, and the interest rate is the lower of actual interest costs or avoidable interest is very crucial. However, a company may only capitalize this interest while construction is underway (McBride).
The real objective of capitalizing interest are to accomplish a measure of attainment cost that reflects the full investment in the asset, and to charge the cost that relates to the acquisition of that asset against the revenues of the periods of benefit from use. According to FASB 34, the interest cost that is eligible for capitalization is the interest cost that is recognized on borrowings and other obligations.
The amount that is to be capitalized will be an allocation of the interest cost that is incurred during the period that is required to complete the building. The interest rate for capitalization purposes will be based on the rates of the company’s outstanding borrowings. If the company obtains a new borrowing with the building, the company may apply the rate on that borrowing as well to the appropriate portion of the expenditures for the asset. If there are expenditures that are not covered by the specific new borrowings, a weighted average of the rates is to be applied (FASB).
Recording Gain or Loss To dispose of a fixed asset is to withdrawal the fixed asset from use when the assets useful life is over or when it is not working up to standards. One of the things to consider when disposing of a fixed asset is if there is or is not a salvage value. In the rare situation where there is no salvage value of the fixed asset, there will be no terminal cash flow. However, if the asset does have a salvage value it is probable that the disposal will cause a gain or a loss. For example, if a fixed asset is sold at a price which is higher than it carrying amount at the date of the disposal, the excess of the sale proceeds over the carrying amount will be recognized as a gain.
At this time the equipment account and the related accumulated depreciation account will be written off in the process of the disposal and the gain would be reported in the income statement. Now, if a fixed asset is sold at a price that is lower than its current carrying amount at the date of disposal, a loss will be recognized which is