LOWER OF COST AND NET
REALIZABLE VALUE
CHAPTER 12
OBJECTIVES
To know the measurement of inventory in the statement of
financial position
To explain the lower of cost and net realizable value basis of
measurement
To account for inventory writedown using allowance method
and direct method
To know the treatment of purchse commitments in relation to
lower of cost and net realizable measurement
Lower of cost and net realizable value
PAS 2, paragraph 9, provides that inventories shall be measured
at the lower of cost and net realizable value.
The measurement of inventory at the lower of cost and net realizable
value is known as LCNRV.
Net realizable value
Net realizable value or NRV is the estimated selling price in the
ordinary course of business less the estimated cost of
completion and the estimated cost of disposal.
The cost of inventories may not be recoverable under the
following circumstances:
a. The inventories are damaged
b. The inventories have become wholly or partially obsolete.
c. The selling prices have declined.
d. The estimated cost of completion or the estimated cost of
disposal has increased.
The practice of writing inventories down below cost to net
realizable value is consistent with the view that assets shall not be
carried in excess of amounts expected to be realized from their
sale or use.
Determination of net realizable value
Inventories are usually written down to net realizable value on
an item by item or individual basis.
It is not appropriate to write down inventories based on a
classification of inventory, for example, finished goods or all
inventories in a particular industry or geographical segment.
In some circumstances, however, it may be appropriate to
group similar or related items.
This may be the case with items of inventory relating to the
same product line that have similar purposes, are produced
and marketed in the same geographical area and cannot be
practically evaluated separately.
Materials held for use in production are not written down below
cost if the finished products in which they will be incorporated
are expected to be sold at or above cost.
However, when a decline in the price of materials indicated that
the cost of the finished products in which they will be
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evidence of net realizable value.
In such circumstances, the replacement cost of materials may
be the best evidence of net realizable value.
Accounting for inventory writedown
If the cost is lower than net realizable value, there is no
accounting problem because the inventory is measured at
cost and the increase in value is not recognized.
If the net realizable value is lower than cost, the inventory is
measured at net realizable value and the decrease in value is
recognized.
Methods of accounting for inventory writedown
a. Direct method or cost of goods sold method
b. Allowance method or loss method
Direct method
The inventory is recorded at the lower of cost or net realizable
value.
This method is also known as " cost of goods sold method"
because any loss on inventory writedown or gain on reversal of
inventory writedown is accounted for separately but buried in
the cost of goods sold.
Allowance method
The inventory is recorded at cost and any loss on inventory
writedown is accounted for separately.
This method is also known as " loss method" because a loss
account "loss for inventory writedown" is credited.
In subsequent years, this allowance account is adjusted upward
or downward depending on the difference between the cost and
the net realizable value of the inventory at year-end.
If the required allowance increases, an additional loss is
recognized.
If the recognized allowance decreases, a gain on reversal of
inventory writedown is recorded.
However, the gain is limited only to the extent of the allowance
balance.
Preferably, the allowance method is used in order that the effects of
writedown and reversal of writedown can be clearly identified.
PAS 2, paragraph 36, requires disclosure of the amount of any
inventory writedown and the amount of any reversal of inventory
writedown .
Purchases commitments
Purchase commitments are obligations of the entity to acquire
certain goods sometime in the future at a fixed price and fixed
quantity.
Any losses which are expected to arise from the firm and
noncancellable commitments shall be recognized.
If there is a decline in purchase price after a purchase
commitment has been made, a loss is recorded in the period of
the price decline.
Thus, if at the end of the reporting period, the purchase price falss
below the agreed price the difference is accounted for as a debit
to loss on purchase commitments and a credit to an estimated
liability.
LCNRV Adaptation
Actually, the recognition of a loss on purchase commitment is
an adaptation of the measurement at the lower of cost or net
realizable value.
Accordingly, if the market price rises by the time the entity
makes the purchase, a gain on purchase commitment would
be recorded.
However, the amount of gain to be recognized is limited to the loss
on purchases commitment previously recorded.
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