Chapter 12 – Lower of Cost and Net Realizable Value

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, which is also known as LCNRV
Net realizable value
 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 price 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 is lower than net realizable value, there is no accounting problems because the inventory is
measured at cost and the increases 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 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 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 decreases, a gain on reversal 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 wirtedown
and the amount of any reversal of inventory writedown

Illustration page 359 – 362

Purchase commitments
 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 form firm and noncancelable 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 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: page 363

LCNRV Adaptation
 The recognition of a loss on purchase commitment is and adaptation of the measurement at the lower
of cost or net realizable value
 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 purchase commitment previously
recorded

Illustration: page 364

Disclosures
 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 classification appropriate to
the entity. 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 a writedown of inventories
h. The carrying amount of inventories pledge 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 guarantees
b. When a homogeneous 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 at 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