 and welcome to the session in which you would look at lower of cost or market. This method is used to measure the decline in inventory. Matter of fact, this method sounds very much like LCM or net realizable value to measure the decline in inventory that we looked at in the prior previous session. Well, why did we have LCM or NRV, the previous session? The reason why FASB introduced this is to simplify and reduce the cost and complexity of reducing inventory. However, what FASB found out later that there are difficulties in applying LCM or NRV to companies that were using LIFO or the retail inventory method. The cost of transition was high and the transition did not apply as smoothly as other methods such as FIFO, the average method. Therefore, what they said, they said companies that are using LIFO or retail method can use LCM lower of cost or market. So how does LCM works? Well, this topic is covered in an intermediate accounting course as well as your CPA exam. Whether you are an accounting student or a CPA candidate, I strongly suggest you take a look at my website, farhatlectures.com. I don't replace your CPA review course nor your accounting course. I'm a useful addition to your CPA review course. I can help you understand the material better. I explain the material differently. I provide you more examples. I'll show you the theory behind the concept. Your risk with me is one month of subscription, whatever that subscription is. Your potential gain is passing the exam. If you're not happy, cancel, just give it a try. It's an additional resource. If not for anything, take a look at my website to find out how well or not well your university doing your university doing on the CPA exam. My course catalog include intermediate accounting, managerial accounting, cost accounting, advance, governmental, so on and so forth. I have resources such as lectures, multiple choice, through false questions. My CPA supplemental resources are aligned with your Wiley, Becker, Roger, Gleam. So it's very easy to go back and forth between my material and your CPA review course. And I do give you access to 1500 previously AI CPA released questions in addition to thousands of questions to practice for the exam. If you have not connected with me on LinkedIn, please do so. Take a look at my LinkedIn recommendation like this recording. Share it with other connect with me on Instagram, Facebook, Twitter and Reddit. So it's very important to understand LCM. So what is LCM? Well, LCM stands for lower of cost or market. That's it. You're comparing two figures. That's how simple it is to explain it. You're comparing the cost to the market. Now, what do we mean by market? Now we're going to start to introducing some complexity. Market is the replacement cost. What is the replacement cost? For example, you purchased something for $12. That was your cost. How much can you buy it today? What is your replacement cost? If you want to buy the same asset, the same piece of inventory. How much does it cost? Is it 11? Is it 10? Is it 13? Is it 15? What happened to that cost? Did it lose its utility? Did it lose its value? And the reason is we have to report inventory at lower. Notice the key lower LCM. Lower of cost or market. Lower. Why lower? Two reasons. Just like LCM or NRV. One is not to overstate inventory. Two is to have a matching principle. Report the decline in our inventory. Report that loss of utility in the inventory in the period in which that decline occurs. Now, when it comes to replacement cost, we're going to add two additional limitations. So you might say, well, replacement cost is 11. Can we use 11? No. You have to look at two additional limitations. And we're going to explain why on the next slide. The two limitations are we're going to have a ceiling called net realizable value. Just like in NRV, net realizable values, we compute it by taking the sales amount minus cost the sale. And this is going to give us the ceiling. So we're going to have a ceiling called NRV. And we're going to have a floor called floor. And the floor equal to NRV. We computed first minus normal profit allowance for profit. Now we're going to explain this in numbers on the next slide. So simply put, what's going to happen is this, we're going to have our cost, which is we know our cost is 12. Then we're going to have our replacement cost, which is let's assume it's 11. We're not done. Then we have to find our NRV. And we have to find our floor. There's no reason to put the pluses here. We have to find what is our NRV and what's the floor. How do you find NRV? You'll take the sales minus cost the sale and NRV is in the floor is NRV less normal profit. Then we're going to have two figures. Guess what? If replacement cost is above NRV, if replacement cost is here, we're going to take NRV as the market. If replacement cost is below NRV, we're going to take the floor as the market cost. If replacement cost is in the middle, then replacement cost will be compared to cost. The best way to illustrate this concept is to look at an example. Let's assume Adam has a copier with a sales value of $500 and estimated cost to complete the sale and disposal of $100. Adam earns a normal profit of 10% of sales and Adam paid $500 for this copier and can replace it for $3.75 today. So we bought it a while ago. Now the Adam can sell it for $500. If he wants to buy a new one, it will cost him $3.75. This is what we have. First, what is our cost? So let's keep it simple. Cost is simple. Cost here is how much we paid for the asset. We paid $500. So we're going to comparing everything versus this $500 and pick the lower of the cost or whatever we're going to determine the LCM. Let's find the ceiling and the floor. How do we compute the ceiling, which is the net realizable value? The ceiling, well, $500, which is the selling price. Notice there's $2,500. This is the selling sales value. Be careful. I should have changed this number here, but this is the $500 that belongs to the cost and this is the $500 that belongs to the sales value. It happens to be the same. Then we deduct less estimated cost of completion and disposal, which is $100 given here. Now we have the NRV, net realizable value of $400. Then from the net realizable value, we are going to deduct the allowance for normal profit, which is 10% of sales. 10% of $500, sales is $50. Then we got to the floor. The floor is $350. Now we have a ceiling of $400, a floor of $400. We know the floor and we know the ceiling. Now we need to kind of, where does the replacement cost fits? The replacement cost $375 happened to fit here. Now it's easy. We're going to compare $500 because the replacement cost is in between the floor and the ceiling versus $375 and we are going to report the inventory at $375. We're going to take a reduction allowance in our inventory of $125. Now the question is, why do we use a ceiling? Why do we use a floor? Let me explain why do we use a ceiling and why do we use a floor? Why the ceiling? Well, the reason for the ceiling is to prevent overstatement of inventory. Simply put, if we use the ceiling, our inventory will be overstated by $25. If we use the ceiling, what happens if our number is above the ceiling? Well, if it's above the ceiling, then we have to reduce it to the ceiling, but we'll talk about that in a moment. If replacement cost is above NRV, above the ceilings, let's assume the replacement cost was $425. Don't use the replacement cost. Use the ceiling. Why use the ceiling? Because now you are overstating inventory. You are overstating inventory and understating cost. So that's why you overstate inventory understate cost if it's above the ceiling. So what we're saying here, what happened if this was $425? If this was $425, you're really overstating your inventory now. Don't overstate it. NRV is a good figure. Why use a floor? So why don't go below the floor? Well, the reason is, how do we compute the floor? It's not to be less. Basically, you cannot be less NRV minus a normal profit. You cannot be below the floor. In our example, $350. Make no sense to report the inventory below the floor. Let's assume replacement cost was $325. Well, why would you report it below the floor if you can sell it for $350? Because you can sell it, have an allowance for profit, and it should be reported at $350. Don't bring it below the floor. It's a deter you from understating your inventory. And what happened in some years, you want to understate your inventory and overstate the loss. And they don't want you to do that. They want you to the floor is a reasonable figure because you can get rid of it. With a normal profit of $350, that's a reasonable amount. That's why you have a ceiling and a floor. Now, we're going to go back to the original example and say, remember, we're going to choose $375. What do we have to do with this $375? Well, we have to make an adjustment to adjust the inventory. Well, the adjustment, we're going to do a journal entry the same as we did in LCM or net realizable value. If you did not view this one, you better go back and view it, which is we're going to debit a loss to the client to inventory to the loss due to decline in inventory to that V an inventory 125 credit, the allowance to reduce inventory of 125. Now, make sure this allowance of to reduce inventory is a Contra. This is a Contra asset. And what does that mean? It means it's going to change from year to year. Again, I'm going to refer you back to see in the previous recording on what happened that changes from year to year. Also, to really understand this concept, you have to view examples and work multiple choice. And this is what I'm going to invite you to visit my website, farhatlectures.com for additional resources. This is what I do. Make sure you do that if you want to learn more. Again, at the end of this recording, I'm going to invite you to visit my website once again, farhatlectures.com. I don't replace your CPA review course. I'm going to give you more detailed information, more examples, more explanation that's going to help you understand your CPA review course better, which will help you pass your exam. Invest in yourself, invest in your career. The CPA exam is worth it. Study hard, good luck, and stay safe.