Lesson 11

LOWER OF COST AND NET REALIZABLE VALUE

Learning Objectives
After studying the chapter, you should be able to
1. To know if the measurement of inventory in the statement of financial position.
2. To explain the lower of cost and net realizable value basis of measurement
3. To account for inventory writedown using allowance method and direct method.
4. To know the treatment of purchase commitments in relation to lower of cost and net realizable measurement.

Measurement of inventory
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 now 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 indicates that the cost of the finished products exceeds net realizable value, the materials are written down to 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 us 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 the 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 is not 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 on inventory writedown” is debited and a valuation account “allowance for inventory writedown” is credited.

In subsequent years, this allowance account is adjusted upward or downward depending on the difference between the cost and net realizable value of the inventory at year-end.

If the required allowance increases, an additional loss is recognized.

If the required 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.

As a matter of fact, PAS 2, paragraph 36, requires disclosure of the amount of any inventory writedown and the amount of any reversal of inventory writedown.

Illustration – Inventory data on December 31, 2019

Needless to say, LCNRV means to choose
Category 1 Cost NRV LCNRV between the LOWER of COST and NET
110,000 100,000 100,000 REALIZABLE VALUE
A
B 690,000 750,000 690,000
C 600,000 640,000 600,000
Subtotal 1,400,000 1,490,000

Category 2
D 2,000,000 1,900,000 1,900,000
E 1,500,000 1,560,000 1,500,000
Subtotal 3,500,000 3,460,000
 Category 3
F 1,500,000 1,460,000 1,460,000
G 1,600,000 1,690,000 1,600,000
Subtotal 3,100,000 3,150,000
Grand total 8,000,000 8,100,000 7,850,000

LCNRV item by item or individual 7,850,000

Cost NRV LCNRV

Category 1 1,400,000 1,490,000 1,400,000 Note: If Individual Basis is not given, then
Category 2 3,500,000 3,460,000 3,460,000 choose LCNRV by Category, then LCNRV by
Category 3 3,100,000 3,150,000 3,100,000 total
LCNRV by Category 7,960,000

LCNRV by Total 8,000,000 8,100,000 8,000,000

The inventory is measured at the lower of cost and net realizable applied on an item by item or individual basis.

Cost - December 31, 2019 8,000,000

Net Realizable Value 7,850,000
Inventory Writedown 150,000

Recording of Inventory Writedwon - Direct Writeoff and Allowance method

Transaction Event Direct Writeoff Method Allowance Method

Inventory - December 31, 2019 7,850,000 Inventory - December 31, 2019 7,850,000
Income Summary 7,850,000 Income Summary 7,850,000
The inventory on
December 31, 2019 is
The Loss on inventory writedown is accounted for seperately
recorded at cost Decreased in Ending Inventory will increase the cost of goods sold
Loss on inventory writedown (+ CGS) 150,000
Allowance for inventory writedown ( - Invty) 150,000

Assume on December 31, Inventory - December 31, 2020 8,400,000 Inventory - December 31, 2020 8,500,000
2020, the total cost of the Income Summary 8,400,000 Income Summary 8,500,000
inventory is P8,500,000
and the net realizable
value is P8,400,000 Decreased in Ending Inventory will increase the cost of goods sold Allowance for inventory writedown (+ Invty) 50,000
Gain on reversal of inventory writedown (- CGS) 50,000

Note that whether direct method or allowance method, the cost of goods sold must be the same.

PURCHASE COMMITMENTS

Purchase commitments are obligations of the entity to acquire certain goods sometime in the future at a fixed price and fixed quantity.

Actually, a purchase contract has already been made for future delivery of goods fixed in price and in quantity.

Where the purchase commitments are significant or unusual, disclosure is required in the accompanying notes to financial statements.

Any losses, which are expected to arise from firm and noncancelable commitments shall be recognized.

If there is a decline in purchase price after a purchase commitment has been made, a loss in recorded in the period of the price decline.

Note that a purchase commitment must be noncancelable in order that a loss purchase commitment can be recognized.

Thus, if at the end of the reporting period, the purchase price falls below the agreed price the difference is accounted for as a debit to loss on purchase commitments and a credit to an
estimated liability

ILLUSTRATION

Transaction Event Entries

The contract purchase price is P500,

50,000 The loss on purchase commitment is classified as other
000 and the replacement cost at year- Loss on Purchase Commitment
Estimated Liability for purchase Commitment 50,000 expense and the estimated liability for purchase
end is P450,000. The market decline
(500,000 - 450,000) commitment is classified as current liability.
of P50,000

Only 30,000 is recognized as loss in this period because it

Purchases 420,000
Actual price of inventory purchase is Loss on Purchase Commitment 30,000 was already partially recorded at previous year
420,000 Estimated Liability for purchase commitment 50,000
Accounts Payable 500,000 Estimated liability for Purchase commitment is close to
Accounts payable or Cash upon actual purchase
Purchases 500,000 Purchases/Inventory will be recorded only at contract price
LCNRV adaptation of 500,000 since it is LOWER than its actual price of 600,
Estimated Liability for purchase commitment 50,000
Actual price of inventory purchase is Accounts Payable 500,000 000,
gain on purchase commitment cannot exceed the
600,000 Gain on purchase Commitment 50,000
previously recorded Loss on Purchase Commitment

Purchases 480,000
LCNRV adaptation

Estimated Liability for purchase commitment 50,000 Purchases/inventory is recorded at actual amount/cost
Actual price of inventory purchase is Accounts Payable 500,000
30,000 since it is lower to its contract price of 500,000
480,000 Gain on purchase Commitment

Disclosure
With respect to inventories, the financial statements shall disclose the following:

a. The accounting policies adopted in measuring inventories, including the cost formula used.
b. The total carrying amount of inventories and the carrying amount in classifications appropriate to the entity.
Common classifications of inventories are merchandise, production supplies, goods in process and finished goods.
Common classifications of inventories are merchandise, production supplies, goods in process and finished goods.
c. The carrying amount of inventories carried at fair value less cost of disposal.
d. The amount of inventories recognized as an expense during the period.
e. The amount of any writedown of inventories recognized as an expense during the period.
f. The amount of reversal of writedown that is recognized as income.
g. The circumstances or events that led to reversal of writedown that is recognized as income.
h. The carrying amount of inventories pledged as security for liabilities.

Agricultural, forest and mineral products

PAS 2, paragraph 4, provides that inventories of agricultural, forest and mineral products are measured at net realizable value at certain stages of production.
Accordingly, agricultural crops that have been harvested or mineral products that have been extracted are measured at net realizable value:
a. When a sale is assured under a forward contract or government guarantee.
b. When a homogenous market exists and there is a negligible risk of failure to sell.

Commodities of broker-traders
PAS 2, paragraph 3, provides that commodities of broker-traders are measured at fair value less cost of disposal.

PFRS 13, paragraph 9, defines fair value of an asset as the price that would be received to sell the asset in an orderly transaction between market participants.

Broker-traders are those who buy and sell commodities for others or on their own account.

The inventories of broker-traders are principally acquired with the purpose of selling them in the near future and generating a profit from fluctuations in price or broker-traders’ margin.

END OF TOPIC