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In the below question, my thought was that the replacement cost would the market cost. Because US GAAP is being used, inventory would be valued at the lower of market price and cost. Instead, the profit margin is used to calculate a range of replacement costs, which I have not seen before. Can anyone shed some light onto why this is done? Thanks in advance.
Pluto Corporation purchased inventory for $101,100. The company plans to sell it at $103,300, but estimates that it will incur selling costs of $3,300. The company also estimates that the replacement cost of its inventory is $95,000. Assuming a normal profit margin of $4,000 and that the company follows U.S. GAAP, the value of inventory it should report on its balance sheet is closest to:
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$95,000
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$96,000
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$97,800
Answer: B
Net realizable value = 103,300 – 3,300 = $100,000
Net realizable value – Normal profit margin = 100,000 – 4,000 = $96,000
Therefore, replacement cost must lie between $96,000 and $100,000.
As the replacement cost of $95,000 does not lie within the specified range, it must be written-up to $96,000.
The adjusted replacement cost of $96,000 is less than the original cost of $101,100. Therefore, inventory should be reported at $96,000.
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