Question

Question:Explain the rationale for the ceiling and floor in the lower-of-cost-or-market method of valuing inventories.

Short answer

The ceiling and the floor under the method of lower-of-cost or market value helps in preventing the overstatement or understatement in the value of inventory.

Step-by-step solution

Step-by-step-solutionStep1:

The ceiling is also known as the upper limit, which is the net realizable value of the inventory, whereas the Floor is also known as the lower limit, which is the difference of net realizable value and the profit margin.

Step 2:

The maximum limit wherein the inventory value cannot exceed the net realizable value, helps in preventing the overstatement of inventory. In the given situation, if the replacement cost is higher than the net realizable value, then it will be not recorded at replacement cost, and the business will only be able to realize the selling price of the inventory less any disposal cost.

If the inventories are reported at replacement cost, then it will overstate the value of the inventory and will understate the loss.

Step 3:

The lower limit, wherein the value of cannot be below the difference between net realizable value and the profit margin. It is the minimum level that measures the price of inventory at which it can be sold and also earns a normal profit. If floor value is used, it will understate the value of the inventory, and overstate the loss.