1

Study Unit Two

Measurement, Valuation, and Disclosure:

Assets -- Short-Term Items

2.1 Accounts Receivable ........................................................................................................ 2

2.2 Inventory -- Fundamentals ............................................................................................... 8
2.3 Inventory -- Cost Flow Methods ...................................................................................... 12
2.4 Measurement of Inventory Subsequent to Initial Recognition .......................................... 21

This study unit is the second of six on external financial reporting decisions. The relative weight
assigned to this major topic in Part 1 of the exam is 15%. The six study units are
● Study Unit 1: External Financial Statements
● Study Unit 2: Measurement, Valuation, and Disclosure: Assets -- Short-Term Items
● Study Unit 3: Measurement, Valuation, and Disclosure: Assets -- Long-Term Items
● Study Unit 4: Measurement, Valuation, and Disclosure: Liabilities
● Study Unit 5: Revenue and Impairment Recognition
● Study Unit 6: Integrated Reporting

This study unit discusses two current assets: accounts receivable and inventory. Topics covered in
this study unit include
● Accounting for accounts receivable, including

■ Transactions related to accounts receivable, including the timing of recognition

■ Credit losses
■ Types of factoring

● Accounting for inventory, including

■ Items to include in the counts of inventory

■ Cost flow assumption methods
■ Calculating cost of goods sold and ending inventory using different cost flow assumption methods
■ The effects of inventory errors
■ The lower of cost or market rule
■ The lower of cost or net realizable value rule

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2 SU 2: Measurement, Valuation, and Disclosure: Assets -- Short-Term Items

2.1 Accounts Receivable

Accounts receivable (trade receivables) are amounts owed to an entity by its customers resulting
from credit sales in the ordinary course of business that are due in customary trade terms.
● The recording of a receivable, which often coincides with revenue recognition, is consistent with
the accrual method of accounting.

Allowance for Credit Losses

The allowance for credit losses is a contra asset that reduces accounts receivable on the entity’s
balance sheet. This account is used to keep track of management’s estimate for the amount of
accounts receivable that the entity estimates it will not be able to collect.

Credit Loss Expense

Credit loss expense is the income statement account used to keep track of the expense related to
estimating credit losses.

Balance Sheet Presentation

Receivables should be separated into current and noncurrent portions.

● Most of the entity’s accounts receivable are classified as current assets because they are
expected to be collected within 1 year or the entity’s normal operating cycle.

● Current accounts receivable are reported in the balance sheet at net realizable value (NRV), i.e.,
net of allowance for credit losses (uncollectible accounts), allowance for sales returns, and billing
adjustments.

● Noncurrent receivables are measured at net present value of future cash flows expected to be
collected.

Allowance Method (Required under GAAP)

The allowance method attempts to match credit loss expense with the related revenue. This
method is required under GAAP.
● As specific accounts receivable are written off, they are charged to the allowance account.

■ Write-offs do not affect the carrying amount of the net accounts receivable balance because the
reductions of gross accounts receivable and the allowance are the same.
► The write-off of a particular account has no effect on expenses.

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 SU 2: Measurement, Valuation, and Disclosure: Assets -- Short-Term Items 3

● In the balance sheet, the carrying amount of accounts receivable is reported at the net amount
expected to be collected.

Balance Sheet:
Accounts receivable $X,XXX
Allowance for credit losses (X,XXX)
Accounts receivable, net $X,XXX

● Under the allowance method, the two approaches to calculating the amount charged to credit loss
expense are the income statement approach and the balance sheet approach.

Income Statement Approach (Percentage of Sales)

Under the income statement approach, the entity estimates the periodic credit loss expense as a
percentage of sales on credit.
● The ending balance of the allowance for credit losses is determined after all the activity in the
allowance account is recorded during the period.

Example 2-1 Income Statement Approach

Midburg Co. has the following unadjusted account balances at year end:

Cash $ 85,000
Accounts receivable 100,000
Allowance for credit losses 2,000
Sales on credit 500,000

Based on its experience, Midburg expects credit losses to average 2% of credit sales. Thus, the estimated
credit loss expense is $10,000 ($500,000 × 2%). The year-end adjusting entry is

Assets = Liabilities + Stockholders’ Equity

Allowance for credit losses $10,000 ↓ Credit loss expense $10,000 ↓

Since allowance for credit losses is a contra asset, this $10,000 entry reduces total assets but increases
the balance in the contra asset.

The year-end adjusted balance of allowance for credit losses is $12,000 ($10,000 + $2,000).

Balance sheet presentation:

Accounts receivable $100,000
Allowance for credit losses (12,000)
Accounts receivable, net $ 88,000

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4 SU 2: Measurement, Valuation, and Disclosure: Assets -- Short-Term Items

Balance Sheet Approach (Percentage of Receivables)

Under this approach, the ending balance of the allowance for credit losses is a percentage of the
ending balance of accounts receivable.
● Credit loss expense reflects the adjustment of the allowance to its correct ending balance.

Example 2-2 Balance Sheet Approach

Using the data from Example 2-1, assume that, based on Midburg’s experience, 6% of accounts
receivable are determined to be uncollectible. The ending balance of the allowance for credit losses needs
to be $6,000 ($100,000 × 6%). Because the allowance currently has a balance of $2,000, the following
entry is required:

Assets = Liabilities + Stockholders’ Equity

Allowance for credit losses $4,000 ↓ Credit loss expense $4,000 ↓

Balance sheet presentation:

Accounts receivable $100,000
Allowance for credit losses (6,000)
Accounts receivable, net $ 94,000

An entity rarely experiences a single rate of uncollectibility on all its accounts. For this reason,
entities using the balance sheet approach to estimate expected credit losses for accounts receivable
generally prepare an aging schedule.

Example 2-3 Balance Sheet Approach with Aging Schedule

Midburg prepares the following aging schedule of its accounts receivable:

Less than 31-60 61-90 Over 90 Total

Balance Range 30 Days Days Days Days Balances
$0 - $100 $ 5,000 $ 200 $ 100 $ 100 $ 5,400
$100 - $1,000 8,000 3,800 11,800
$1,000 - $5,000 20,000 2,000 1,900 23,900
$5,000 - $10,000 38,000 8,000 900 46,900
Over $10,000 12,000 12,000
Totals $71,000 $18,000 $10,000 $1,000 $100,000

-- Continued on next page --

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 SU 2: Measurement, Valuation, and Disclosure: Assets -- Short-Term Items 5

Example 2-3 -- Continued

Midburg then applies an appropriate percentage to each stratum based on experience.

Estimated Ending
Aging Intervals Balance Uncollectible Allowance
Less than 30 days $ 71,000 2% $1,420
30-60 days 18,000 12% 2,160
61-90 days 10,000 15% 1,500
Over 90 days 1,000 20% 200
Total $100,000 $5,280

Because the allowance currently has a balance of $2,000, the following entry is required to establish the
proper measurement:

Assets = Liabilities + Stockholders’ Equity

Allowance for credit losses $3,280 ↓ Credit loss expense $3,280 ↓

Balance sheet presentation:

Accounts receivable $100,000
Allowance for credit losses (5,280)
Accounts receivable, net $ 94,720

Reconciliation Summaries
The following equation illustrates the reconciliation of the beginning and ending balances of gross
accounts receivable (accounts receivable before adjustment for allowance for credit losses):

Beginning accounts receivable

+ Credit sales during the period
– Cash collected on credit sales during the period
– Accounts receivable written-off during the period
= Ending accounts receivable

The following equation illustrates the reconciliation of the beginning and ending balances of the
allowance for credit losses:

Beginning allowance for credit losses

+ Credit loss expense recognized for the period
– Accounts receivable written off
+ Collection of accounts receivable previously written off
= Ending allowance for credit losses

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6 SU 2: Measurement, Valuation, and Disclosure: Assets -- Short-Term Items

Allowance for Customers’ Right of Sales Return

When a right of return exists, an entity may recognize revenue from a sale of goods at the time of
sale only if the amount of future returns can be reliably estimated. A provision must be made for the
return of merchandise because of product defects, customer dissatisfaction, etc.

To be consistent with the matching principle (recognition of revenue and related expense in the
same accounting period), the revenue from the sale of goods and the expense for the estimated sales
returns must be recognized in the same period.
● An allowance for sales returns should be established.

Factoring of Accounts Receivable

Factoring is a transfer of receivables to a third party (a factor) who assumes the responsibility of
collection.

Factoring discounts receivables on a nonrecourse, notification basis. Thus, payments by the debtors
on the transferred assets are made to the factor. If the transferor (seller) surrenders control, the
transaction is a sale.
● If a sale is without recourse, the transferee (credit agency) assumes the risks and receives the
rewards of collection. This sale is final, and the seller has no further liabilities to the transferee.
Accordingly, the receivables are no longer reported on the seller’s financial statements.

● If a sale is with recourse, the transferor (seller) may be required to make payments to the
transferee or to buy back receivables in specified circumstances.
■ In this circumstance, the transfer might not qualify as a sale. The parties account for the
transaction as a secured borrowing with a pledge of noncash collateral.
■ The receivables are still on the seller’s financial statements and it must recognize a liability for
the amount of cash received.

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 SU 2: Measurement, Valuation, and Disclosure: Assets -- Short-Term Items 7

Example 2-4 Factoring of Accounts Receivable

A factor charges a 2% fee plus an interest rate of 18% on all cash advanced to a transferor of accounts
receivable. Monthly sales are $100,000, and the factor advances 90% of the receivables submitted after
deducting the 2% fee and the interest. Credit terms are net 60 days. What is the cost to the transferor of
this arrangement?

Amount of receivables submitted $100,000

Minus: 10% reserve (10,000)
Minus: 2% factor’s fee (2,000)
Amount accruing to the transferor $ 88,000
Minus: 18% interest for 60 days (2,640) [$88,000 × 18% × (60 ÷ 360)]
Amount to be received immediately $ 85,360

The transferor also will receive the $10,000 reserve at the end of the 60-day period if it has not been
absorbed by sales returns and allowances. Thus, the total cost to the transferor to factor the receivables
for the month is $4,640 ($2,000 factor fee + interest of $2,640). Assuming that the factor has approved the
customers’ credit in advance (the sale is without recourse), the transferor will not absorb any bad debts.

The main reasons for factoring transactions are:

● The factor often operates more efficiently than its clients because of the specialized nature of its
services.

● An entity (seller) that uses a factor tries to speed up its collections.

■ The entity can eliminate its credit department and accounts receivable staff.
■ Credit losses are eliminated from the financial statements.

These reductions in costs can offset the fee charged by the factor.

Credit card sales are a common form of factoring. The retailer benefits by prompt receipt of cash and
avoidance of bad debts and other costs. In return, the credit card company charges a fee.

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8 SU 2: Measurement, Valuation, and Disclosure: Assets -- Short-Term Items

2.2 Inventory -- Fundamentals

Inventory is the total of tangible personal property

● Held for sale in the ordinary course of business,
● In the form of work-in-process to be completed and sold in the ordinary course of business, or
● To be used up currently in producing goods or services for sale.

■ Inventory does not include long-term assets subject to depreciation.

Financial Statement Presentation

Inventories are generally classified as current assets in the financial statements. They are expected
to be realized in cash or sold or consumed during the normal operating cycle of the business.

Inventory Accounts

The inventories of a retailer (trading entity) consist of goods purchased to be resold without
substantial modification.

The inventories of a manufacturer consist of

● Goods to be consumed in production (materials),
● Goods in the process of production (work-in-process), and
● Finished goods.

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 SU 2: Measurement, Valuation, and Disclosure: Assets -- Short-Term Items 9

Cost Basis of Inventory -- Initial Measurement

The cost of inventory includes all costs incurred in bringing the inventories to their existing location
and ready-to-use condition.

The cost of purchased inventories includes

● The price paid or consideration given to acquire the inventory (net of trade discounts, rebates, and
other similar items)

● Import duties and other unrecoverable taxes

● Handling, insurance, freight-in, and other costs directly attributable to

■ Acquiring finished goods and materials

■ Bringing them to their present location and condition (salable or usable condition)

Inventory Accounting Systems

A perpetual inventory system updates inventory accounts after each purchase or sale.
● This system is generally more suitable for entities that sell relatively expensive and heterogeneous
items and requires continuous monitoring of inventory and cost of goods sold accounts.

● Under this system, inventory and cost of goods sold are adjusted as sales occur.

● An advantage of the perpetual inventory system is that the amount of inventory on hand and the
cost of goods sold can be determined at any time.

● A disadvantage of the perpetual inventory system is that the bookkeeping is more complex and
expensive.

In the periodic inventory system, inventory and cost of goods sold are updated at specific intervals,
such as quarterly or annually, based on the results of a physical count.
● Bookkeeping is simpler under this system. It is generally used by entities with relatively
inexpensive and homogeneous items that have no need to continuously monitor their inventory
and cost of goods sold.

● Under the periodic system, changes in inventory and cost of goods sold are recorded only at the
end of the period, based on the physical count.

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10 SU 2: Measurement, Valuation, and Disclosure: Assets -- Short-Term Items

Inventory Period-End Physical Count

An annual period-end inventory physical count is necessary under both the perpetual and periodic
inventory accounting systems. The amount of inventory reported in the annual financial statements
should be based on a physical count.
● Under the perpetual system, a physical count helps to detect misstatements in the records and
thefts of inventory.

● Under the periodic system, the amounts of inventory and cost of goods sold can be determined
based only on the results of a physical count.

For a physical count to be accurate, the entity must count all items considered to be inventory and
eliminate all items that are not. Items to be counted as inventory include the following:
● Goods in transit – Items in transit are inventories that on the physical count date (1) are not on
the entity’s premises and are on the way to the desired location and (2) whose legal title is held by
the entity; i.e., the entity bears the risk of loss on inventory in transit.
■ The following are the most common shipping terms:

► FOB shipping point – Legal title and risk of loss pass to the buyer when the seller delivers
the goods to the carrier.
● The buyer must include the goods in inventory during shipping.

► FOB destination – Legal title and risk of loss pass to the buyer when the seller delivers the
goods to a specified destination.
● The seller must include the goods in inventory during shipping.

● Goods out on consignment – A consignment sale is an arrangement between the owner of

goods (consignor) and the sales agent (consignee). Consigned goods are not sold but rather
transferred to an agent for possible sale. The consignor records sales only when the goods are
sold to third parties by the consignee.
■ Goods out on consignment are included in the consignor’s inventory at cost.

► Costs of transporting goods to the consignee are inventoriable costs, not selling expenses.

■ The consignee never records the consigned goods as an asset.

Inventory Errors
Inventory errors impact many elements of the entity’s financial statements.
● Affected elements of the balance sheet include current assets, working capital (Current assets –
Current liabilities), and ending stockholders’ equity.

● Affected elements of the income statement include cost of goods sold and net income.

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 SU 2: Measurement, Valuation, and Disclosure: Assets -- Short-Term Items 11

A common error is inappropriate timing of the recognition of transactions.

● If a purchase on account is not recorded and the goods are not included in ending inventory, cost
of goods sold and net income are unaffected. Current assets and current liabilities are understated.
● If purchases and beginning inventory are properly recorded but items are excluded from ending
inventory, cost of goods sold is overstated. Net income, inventory, retained earnings, and working
capital are understated.
● Errors arising from transactions recorded in the wrong period may reverse in the subsequent period.

■ If ending inventory is overstated, the overstatement of net income will be offset by the
understatement in the following year that results from the overstatement of beginning inventory.

An overstatement error in year-end inventory of the current year affects the financial statements of
2 different years.

The first year’s effects may be depicted as follows:

Figure 2-1

At the end of the second year, retained earnings is correctly stated as follows:

Figure 2-2

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12 SU 2: Measurement, Valuation, and Disclosure: Assets -- Short-Term Items

2.3 Inventory -- Cost Flow Methods

Specific Identification Method

Specific identification requires determining which specific items are sold and therefore reflects the
actual physical flow of goods. This system is appropriate for
● Items that are not ordinarily interchangeable

● Items that are segregated for a specific project

● Blocks of investment securities or special inventory items, such as automobiles or heavy

equipment
■ Any item that has a serial number on it is a candidate for the specific identification method.

Specific identification is the most accurate method because it identifies each item of inventory.
However, it requires detailed records and may not be feasible or cost effective.

When the inventory items purchased or produced are identical and interchangeable, specific
identification is not appropriate. In such circumstances, several assumptions about the flow of cost,
such as average, FIFO, or LIFO, may be appropriate for the measurement of periodic income. The
method selected should be the one that, under the circumstances, most clearly reflects periodic
income.

Average Method
The average method assumes that goods are indistinguishable and are therefore measured at an
average of the costs incurred. The average may be calculated on the periodic basis or as each
additional purchase occurs (perpetual basis).
● The moving-average method is used under the perpetual inventory accounting system. It
requires determination of a new weighted-average inventory cost after each purchase. This cost is
used for every sale until the next purchase.

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 SU 2: Measurement, Valuation, and Disclosure: Assets -- Short-Term Items 13

Example 2-5 Moving-Average Method

The following data relate to Entity A’s Year 1 activities:

Number Purchase price Sale price

Date Transaction of units per unit ($) per unit ($)
January 1 Beginning balance 100 20
March 1 Purchase 20 32
April 1 Sale 70 40
June 1 Purchase 30 14
October 1 Sale 40 24

Under the moving-average method, the year-end inventory and Year 1 cost of goods sold are calculated
as follows:

Date Cost of inventory On-hand Cost per unit

Activity Units Price Inventory total balance
purchased/sold units

Jan. 1 Beg. bal. 100 $20 $2,000 (100 × 20) 100 $20

Mar. 1 Purchase 20 $32 $640 = 20 × $32 $2,640 (2,000 + 640) 120 $22 ($2,640 ÷ 120)

Apr. 1 Sale 70 $22 ($1,540) = 70 × $22 $1,100 (2,640 – 1,540) 50 $22 ($1,100 ÷ 50)

Jun. 1 Purchase 30 $14 $420 = 30 × $14 $1,520 (1,100 + 420) 80 $19 ($1,520 ÷ 80)

Oct. 1 Sale 40 $19 ($760) = 40 × $19 $760 (1,520 – 760) 40 $19 ($760 ÷ 40)

The cost of inventory on December 31, Year 1, is $760. The Year 1 cost of goods sold is $2,300.

Beginning inventory $2,000

Purchases ($640 + $420) 1,060
Ending inventory (760)
Cost of goods sold ($1,540 + $760) $2,300

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14 SU 2: Measurement, Valuation, and Disclosure: Assets -- Short-Term Items

● The weighted-average method is used under the periodic inventory accounting system. The
average cost is determined only at the end of the period. The weighted-average cost per unit is
used to determine the ending inventory and the cost of goods sold for the period. It is calculated as
follows:

Cost of beginning inventory ($) + Cost of purchases during the period ($)
Units in beginning inventory + Number of units purchased during the period

Example 2-6 Weighted-Average Method

Under the weighted-average method, Entity A’s ending inventory and Year 1 cost of goods sold are
determined as follows:

First, the weighted-average cost per unit is calculated.

Cost of beginning inventory + Cost of purchases during the period $2,000 + $1,060
= = $20.40
Units in beginning inventory + Number of units purchased 100 + 20 + 30

Second, the ending inventory and Year 1 cost of goods sold are calculated using the weighted-average
cost per unit (WACPU).

Beginning inventory $2,000

Purchases 1,060
Ending inventory (816) (40 × $20.40) = (WACPU × Units in ending inventory)
Cost of goods sold $2,244 (110 × $20.40) = (WACPU × Units sold during the period)

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 SU 2: Measurement, Valuation, and Disclosure: Assets -- Short-Term Items 15

First-in, First-out (FIFO)

This method assumes that the first goods purchased are the first sold. Ending inventory consists of
the latest purchases. Cost of goods sold includes the earliest goods purchased.

Under the FIFO method, year-end inventory and cost of goods sold for the period are the same
regardless of whether the perpetual or the periodic inventory accounting system is used.

Example 2-7 FIFO

The number of units in Entity A’s ending inventory is 40. Under the FIFO method, the cost of these units is
the cost of the latest purchases ($740).

Price Total
Date of purchase Units per unit cost
June 1, Year 1 30 $14 $420
March 1, Year 1 10 32 320
Ending inventory 40 $740

The Year 1 cost of goods sold is $2,320.

Beginning inventory $2,000

Purchases ($640 + $420) 1,060
Ending inventory (740)
Cost of goods sold $2,320

NOTE: The results are the same under the periodic and perpetual systems.

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16 SU 2: Measurement, Valuation, and Disclosure: Assets -- Short-Term Items

Last-in, First-out (LIFO)

The LIFO (last-in, first-out) method assumes the newest items of inventory are sold first. Thus, the
items remaining in inventory are the oldest.
● Under the LIFO method, the perpetual and the periodic inventory accounting systems may result in
different values for year-end inventory and cost of goods sold.
■ Under the periodic inventory accounting system, the calculation of inventory and cost of goods
sold are made at the end of the period.

Example 2-8 LIFO Periodic -- Entity A

The number of units in Entity A’s ending inventory is 40. Under the LIFO method, the cost of those units
is the cost of the earliest purchases (beginning inventory) of $800 (40 units × $20). The Year 1 cost of
goods sold is $2,260.

Beginning inventory $2,000

Purchases ($640 + $420) 1,060
Ending inventory (800)
Cost of goods sold $2,260

For another example with different data, see Example 2-11.

■ Under the perpetual inventory accounting system, cost of goods sold is calculated every time a
sale occurs and consists of the most recent (latest) purchases.

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 SU 2: Measurement, Valuation, and Disclosure: Assets -- Short-Term Items 17

Example 2-9 LIFO Perpetual -- Entity A

Cost Cost of inventory Number

Date Activity Units Inventory total balance
per unit purchased/sold of units

Jan. 1 Beg. bal. 100 $20 100 × $20 = $2,000 100

Jan. 1, layer 100 × $20 = $2,000

Mar. 1 Purchase 20 $32 20 × $32 = $640 Mar. 1, layer 20 × $32 = 640 120
$2,640

20 × $32 = $ 640
Apr. 1 Sale 70 50 × $20 = 1,000 Jan. 1, layer 50 × $20 = $1,000 50
$(1,640)

Jan. 1, layer 50 × $20 = $1,000

Jun. 1 Purchase 30 $14 30 × $14 = $420 Jun. 1, layer 30 × $14 = 420 80
$1,420

30 × $14 = $ 420
Oct. 1 Sale 40 10 × $20 = 200 Jan. 1, layer 40 × $20 = $800 40
$(620)

Entity A’s cost of ending inventory is $800, and the Year 1 cost of goods sold is $2,260 ($1,640 + $620).

NOTE: The results of the LIFO method under the perpetual and periodic systems are the same in this
example but may differ in other situations.

For another example with different data, see Example 2-12.

LIFO is not permitted.

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18 SU 2: Measurement, Valuation, and Disclosure: Assets -- Short-Term Items

Retail Inventory Method

The retail inventory method is a very effective means of estimating inventory value. It is used for
● Interim and annual financial reporting in accordance with GAAP

● Federal income tax purposes

● Verifying year-end inventory and cost of goods sold data, e.g., as an analytical procedure by an
independent auditor

Cost Flow Methods -- Comparison

The cost flow model selected should be the one that most clearly reflects periodic income.

Example 2-10 Cost Flow Methods

The following are Entity A’s varying results under each of the five cost flow methods:

Ending Cost of
Inventory Goods Sold
Moving average $760 $2,300
Weighted average 816 2,244
FIFO 740 2,320
LIFO periodic 800 2,260
LIFO perpetual 800 2,260

In a time of rising prices (inflation), use of the LIFO method results in the lowest year-end inventory,
the highest cost of goods sold, and the lowest gross profit. LIFO assumes that the oldest (and
therefore the lowest-priced) goods purchased are in year-end inventory, and that cost of goods sold
consists of the latest (and therefore the highest-priced) goods purchased.

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 SU 2: Measurement, Valuation, and Disclosure: Assets -- Short-Term Items 19

Example 2-11 LIFO Periodic -- Entity B

The following data relate to Entity B’s Year 1 activities:

Number Purchase price Sale price

Date Transaction of units per unit ($) per unit ($)
January 1 Beginning balance 15 6
March 1 Purchase 10 9
April 1 Sale 8 18
June 1 Purchase 20 10
October 1 Sale 14 21

The number of units in Entity B’s ending inventory is 23. Under the LIFO method, the cost of those units
is the cost of the earliest purchases of $162 [(15 units beginning inventory × $6) + (8 units from March
purchase × $9)]. The Year 1 cost of goods sold is $218.

Beginning inventory $ 90
Purchases ($90 + $200) 290
Ending inventory (162)
Cost of goods sold $218

Example 2-12 LIFO Perpetual -- Entity B

Cost Cost of inventory Number

Date Activity Units Inventory total balance
per unit purchased/sold of units

Jan. 1 Beg. bal. 15 $6 15 × $6 = $90 15

Jan. 1, layer 15 × $6 = $ 90
Mar. 1 Purchase 10 $9 10 × $9 = $90 Mar. 1, layer 10 × $9 = 90 25
$180

Jan. 1, layer 15 × $6 = $90

Apr. 1 Sale 8 8 × $9 = $72 Mar. 1, layer 2 × $9 = 18 17
$108

Jan. 1, layer 15 × $6 = $ 90
Mar. 1, layer 2 × $9 = 18
Jun. 1 Purchase 20 $10 20 × $10 = $200 Jun. 1, layer 20 × $10 = 200 37
$308

Jan. 1, layer 15 × $6 = $ 90
Mar. 1, layer 2 × $9 = 18
Oct. 1 Sale 14 14 × $10 = $140 60 23
Jun. 1, layer 6 × $10 =
$168

Entity B’s cost of ending inventory is $168, and the Year 1 cost of goods sold is $212 ($72 + $140).

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20 SU 2: Measurement, Valuation, and Disclosure: Assets -- Short-Term Items

The following table compares the results under FIFO and LIFO:

During a Period Gross Profit

Ending Inventory Cost of Goods Sold
of Inflation (Net Income)

LIFO Lowest Highest Lowest

FIFO Highest Lowest Highest

Advantages of FIFO:
● Ending inventory approximates current replacement cost
● In times of rising prices, results in highest net income
● Often matches the physical flow of inventory

Disadvantage of FIFO:
● Matches current revenues with older costs

Advantage of LIFO:
● Lower gross profit in periods of rising prices leads to lower taxable income

Disadvantages of LIFO:
● Management can manipulate net income with an end-of-period purchase that immediately alters
cost of goods sold

● Rarely matches physical flow of inventory

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 SU 2: Measurement, Valuation, and Disclosure: Assets -- Short-Term Items 21

2.4 Measurement of Inventory

Subsequent to Initial Recognition

The subsequent measurement of inventory depends on the cost method used.

● Inventory accounted for using LIFO or the retail inventory method is measured at the lower of
cost or market.

● Inventory accounted for using any other cost method (e.g., FIFO or average cost) is measured at
the lower of cost or net realizable value.

Loss on Write-Down of Inventory

A write-down of inventory below its cost may result from damage, deterioration, obsolescence,
changes in price levels, changes in demand, etc.
● The loss on write-down of inventory to market or net realizable value (NRV) generally is
presented as a component of cost of goods sold.
■ However, if the amount of loss is material, it should be presented as a separate line item in the
current-period income statement.

● A reversal of a write-down of inventory recognized in the annual financial statements is

prohibited in subsequent periods. Once inventory is written down below cost, the reduced amount
is the new cost basis.

● Depending on the nature of the inventory, the rules for write-down below cost may be applied
either directly to each item or to the total of the inventory (or in some cases, to the total of each
major category). The method should be the one that most clearly reflects periodic income.

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22 SU 2: Measurement, Valuation, and Disclosure: Assets -- Short-Term Items

Measurement of Inventory at the Lower of Cost or Market (LCM)

Inventory accounted for using the LIFO or retail inventory method must be written down to market
if its utility is no longer as great as its cost. The excess of cost over market is recognized as a loss on
write-down in the income statement.

Market is the current cost to replace inventory, subject to certain limitations. Market should not
(1) exceed a ceiling equal to NRV or (2) be less than a floor equal to NRV reduced by an allowance
for an approximately normal profit margin.
● NRV is the estimated selling price in the ordinary course of business minus reasonably predictable
costs of completion, disposal, and transportation.

● Current replacement cost (CRC) is not to be greater than NRV or less than NRV minus a normal
profit (NRV – P).

Figure 2-3

● The excess of cost over market is recognized as a loss on write-down in the income statement.

Example 2-13 Calculating LCM

The following information is related to a company’s year-end inventories:

Cost per inventory unit Item A Item B Item C

Estimated selling price $80 $70 $44
Minus: Cost of completion (20) -- (3)
Minus: Cost of disposal (6) (5) (2)
NRV (ceiling) $54 $65 $39
Minus: Normal profit margin (3) (7) (4)
NRV – NPM (floor) $51 $58 $35
Current replacement cost (CRC) $53 $55 $40
(a) Market $53 Ceiling > CRC > Floor $58 Floor > CRC $39 CRC > Ceiling
(b) Historical cost per unit $50 $60 $45
Lower of cost (b) or market (a) $50 Cost < Market $58 Market < Cost $39 Market < Cost

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 SU 2: Measurement, Valuation, and Disclosure: Assets -- Short-Term Items 23

Example 2-14 LIFO -- LCM

Lala Co. accounts for its inventory using the LIFO cost method. The following is its inventory information at
the end of the fiscal year:

Historical cost $100,000

Current replacement cost 82,000
Net realizable value (NRV) 90,000
Normal profit margin 5,000

Under the LIFO method, inventory is measured at the lower of cost or market (current replacement cost
subject to certain limitations). Market cannot be higher than NRV ($90,000) or lower than NRV reduced by
a normal profit margin ($90,000 – $5,000 = $85,000). Thus, market is $85,000. (The current replacement
cost of $82,000 is below the floor.) Because market is lower than cost, the inventory is reported in the
balance sheet at market of $85,000. The write-down of inventory of $15,000 ($100,000 – $85,000) is
recognized as a loss in the income statement.

Inventories are measured at the lower of cost or net realizable value (NRV) regardless
of the cost method used. NRV is the estimated selling price less the estimated costs of
completion and disposal. NRV is assessed each period. Accordingly, a write-down may be
reversed but not above original cost. The write-down and reversal are recognized in profit
or loss.
A list of IFRS differences can be found in Appendix B.

Measurement of Inventory at the Lower of Cost or NRV (LCNRV)

Inventory measured using any method other than LIFO or retail (e.g., FIFO or average cost), must
be measured at the lower of cost or net realizable value.
● NRV is the estimated selling price in the ordinary course of business minus reasonably predictable
costs of completion, disposal, and transportation.

● The excess of cost over NRV is recognized as a loss on write-down in the income statement.

Example 2-15 FIFO -- LCNRV

Using the data from Example 2-14, assume that Lala Co. accounts for its inventory using the FIFO cost
method.

Under the FIFO method (or any other method except for LIFO or retail), inventory is measured at the
lower of cost or net realizable value. NRV of $90,000 is lower than cost of $100,000. Thus, a loss on
write-down to NRV of $10,000 is recognized.

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24 SU 2: Measurement, Valuation, and Disclosure: Assets -- Short-Term Items

Inventory Measurement at Interim Dates

A write-down of inventory below cost (to market for LIFO and retail and to NRV for all other methods)
may be deferred in the interim financial statements if no loss is reasonably anticipated for the
year.
● But inventory losses from a nontemporary decline below cost must be recognized at the interim
date.

● If the loss is recovered in another quarter, it is recognized as a gain and treated as a change in
estimate. The amount recovered is limited to the losses previously recognized.

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