Chapter 3.6® - Income Statement Presentation - Direct & Indirect Method and Advantages & Disadvantages of Using Lower of Cost and Market

Browse Accounting Lessons Here

Accounting Terms & Definitions

Accounting for Merchandising Activities

Debits and Credits (Double Entry Accounting)

Business Valuation Formulas

Time Value of Money & Present/Future Values

Complex Debt & Equity Instruments

Common Stock & Shareholder's Equity

Accounting & Finance Ratios

Valuing Common Stock

Corporate Income Taxes

Lower of Cost or Market (LCM) & Inventory Valuation

Chart of Accounts & Bookkeeping

Bonds Payable & Long Term Liabilities

Capital Assets

GAAP, Accrual & Cash Accounting, Information Commodity, Internal Controls & Materiality

What category of browser are you on this website?
Accounting student (homework help)
Finance professor (university research)
Accounting manager (at work)
Other

View results

Explore Careers in Accounting and Finance

Visit our section on Careers in Accounting & Finance to explore vast opportunities in this industry.

Chapter 3.6® - Income Statement Presentation - Direct & Indirect Method and Advantages & Disadvantages of Using Lower of Cost and Market

i) Income Statement Presentation - Direct Method

Kali Denali Corp. Income Statement For the year ended December 31st, 2009
Sales		$300,000
Cost of Goods Sold
Inventory, January 1st	$85,000
Purchases (assumed)	$120,000
Goods available for sale	$205,000
Inventory, December 31st (Market)	$90,000
Cost of Goods Sold		($115,000)
Gross profit on Sales		$185,000

i) Income Statement Presentation - Indirect Method

Kali Denali Corp. Income Statement For the year ended December 31st, 2009
Sales		$300,000
Cost of Goods Sold
Inventory, January 1st	$85,000
Purchases (assumed)	$120,000
Goods available for sale	$205,000
Inventory, December 31st (Market)	$97,000
Cost of Goods Sold		($108,000)
Gross profit on Sales		$192,000
Loss due to market decline of inventory (reported in other expenses & losses)		($7,000)
Net profit on Sales		$185,000

The second method (the indirect method) is preferable from an investor’s point of view because it clearly discloses the loss resulting from market decline of inventory prices instead of hiding the loss in cost of goods sold. Notice in the Direct method, we are claiming cost of goods sold of $115,000 which includes the hidden $7000 decline in market prices of inventory, while in the Indirect method, we are showing a Cost of Goods sold of $108,000 and showing a separate line called “Loss due to market decline of inventory” of $7000 which brings our gross profit on sales to $185,000 for the year.

Advantages & Disadvantages of Using Lower of Cost and Market

1) Decreases in value of inventory and the charge to expense are recognized in the period in which the loss of utility occurs, and not in the period of sale. On the other hand, increases in the value of inventory are recognized only at the point of sale, thus this type of accounting treatment creates inconsistency and can lead to distortions of data on the income statement.

2) A company’s inventory can be valued at cost one year, and market the next year, which leads to inconsistency in financial reporting.

3) Lower of cost and market can value the balance sheet inventory balances correctly, however the effects on the income statement can be skewed. For instance, net income for the year in which the loss occurs is lower; however net income of the subsequent period may be higher than normal if the expected reduction in sales price does not materialize.