Inventory

Measurement of Inventories
Subsequent to Initial
Recognition
Measurement of Inventory

PAS 2, paragraph 9, provides that inventories shall be measured at the lower of cost and net realizable value
which measurement 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:
• The inventories are damaged.
• The inventories have become wholly or partially obsolete.
• The selling price have declined.
• 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 nit 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 material indicates that the cost of the finished products in which they will be
incorporated are expected to be sold or above cost.
• In such circumstances, the replacement cost of materials may be the best evidence of net realizable value.
Illustrative Example 1: To illustrate the lower of
cost and net realizable value
Assume the following information for different inventory items held by Song
Hye Kyo (SHK) Company at December 31, 2019:
 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.
• The amount of any write-down of inventories to net realizable value should be recognized as an expense in
the period the write down occurs.
• The write down of inventory cost to lower of cost and net realizable value may be recorded using direct
method or allowance 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 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.
• The gain on reversal of inventory writedown is presented as a deduction from cost of goods sold.
• PAS 2, paragraph 34, provides that the amount of any reversal of any writedown of inventory arising from
an increase in net realizable value shall be recognized as a reduction in the amount of inventory recognized
as an expense in the period in which the reversal occurs.
• Th amount of inventory recognized as an expense of the period is actually the cost of goods sold during the
period.
 Presentation in Profit or loss: Direct method and
Allowance Method
Direct method:
The beginning and ending inventory are reported directly
at the lower of cost and net realizable value; hence, the
decline in net realizable value is absorbed by the cost of
goods sold.
Allowance Method:
Both the beginning and ending inventories are measured at cost in
the computation of the cost of goods sold. The adjustment in the
balance of the allowance is presented as other income (recovery) or
other operating expenses (decline) in profit or loss.
Illustrative Example 2: Direct Method and
Allowance Method (Periodic Inventory System)
Assume the following data for Song Joong Ki (SJK)
company. The company uses periodic system and FIFO
method of cost allocation.
Illustrative Example 3: Direct Method and
Allowance Method (Perpetual Inventory System)
Assume the following data for Song
Joong Ki (SJK) company. The company
uses Perpetual Inventory System
Other Inventory Issues

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 non cancelable 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.
• Note that a purchase commitment must be noncancelable in order that a loss purchase commitment can be recognized.
• Thus, if at the ned 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.
• The loss on purchase commitment is classified as other expense and the estimated liability for purchase commitment is
classified as current liability.