LOWER OF COST AND

NET REALIZABLE VALUE

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 of 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:
1. The inventories are damaged
2. The inventories have become wholly or partially obsolete
3. The selling prices have declined
4. The estimated cost of completion or the estimated cost of completion and the
estimated cost of disposal.
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.
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 the 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 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.
 Illustration- Inventory data on Dec. 31, 2020
Cost NRV LCNRV
Category 1
A 110,000 100,000 100,000
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 7,850,000
individual
Cost NRV LCNRV
Category 1 1,400,000 1,490,000 1,400,000
Category 2 3,500,000 3,460,000 3,460,000
Category 3 3,100,000 3,150,000 3,100,000
LCNRV by category 7,960,000

Cost NRV LCNRV

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, 2020 8,000,000

Net realizable value 7,850,000
Inventory writedown 150,000
 Direct method
The inventory is recorded at the lower of cost or NRV.

Inventor - December 31, 2020 7,850,000

Income summary 7,850,000

The loss on inventory writedown of P150,000 is not accounted for separately.

The entry will have the effect of increasing cost of goods sold because the NRV
is lower than the cost.
 Allowance method
The inventory on December 31, 2020 is recorded at cost.
Inventory - December 31, 2020 8,000,000
Income summary 8,000,000

The loss on inventory writedown is accounted for separately

Loss on inventory writedown 150,000
Allowance for inventory writedown 150,000
The loss on inventory writedown is included in the computation of cost of goods sold.
The allowance for inventory writedown is presented as a deduction from the inventory.

Inventory - December 31, 2020, at cost 8,000,000

Allowance for inventory writedown (150,000)
Net realizable value 7,850,000
 Continuing illustration

Assume on December 31, 2021, the total cost of the inventory is

P8,500,000 and the net realizable value is P8,400,000.
 Direct method
Under this method, the inventory is simply recorded at the lower amount. Thus,
the journal entry to record the inventory on December 31, 2021 is:

Inventory - December 31, 2021 8,400,000

Income Summary 8,400,000
 Allowance method
Cost - December 31, 2021 8,500,000
Net realizable value 8,400,000
Required allowance - December 31, 2021 100,000
Less: Allowance balance - December 31, 2020 150,000
Decrease in allowance (50,000)

The decrease in allowance is a reversal of the previous inventory writedown and recorded as gain on reversal of
writedown.
Allowance for inventory writedown 50,000
Gain on reversal of inventory writedown 50,000

The gain on reversal of inventory writedown is presented as a deduction from cost of goods sold.
 Another illustration

Inventory - January 1:

Cost 5,000,000
Net realizable value 4,500,000
Net purchases 20,000,000

Inventory - December 31:

Cost 6,000,000
Net realizable value 5,300,000
 Direct method
Inventory - January 1 4,500,000
Net purchases 20,000,000
Goods available for sale 24,500,000
Inventory - December 31 (5,300,000)
Cost of goods sold 19,200,000

Note that under direct method, the inventory, whether beginning or ending, is
presented at the lower amount.
 Allowance method
Inventory - January 1, at cost 5,000,000
Net purchases 20,000,000
Goods available for sale 25,000,000
Inventory - December 31, at cost (6,000,000)
Cost of goods sold before inventory writedown 19,000,000
Loss on inventory writedown for current year 200,000
Cost of goods sold after inventory writedown 19,200,000

Required allowance - December 31(6,000,000 - 5,300,000) 700,000

Required allowance - January 1 (5,000,000 - 4,500,000) 500,000
Increase in allowance - loss on writedown 200,000
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.
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 is recorded in the period of the price decline.
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

The contract purchase price is P500,000 and the replacement cost at

year-end is P450,000. The market decline of P50,000 is recorded as
follows:

Loss on purchase commitment 50,000

Estimated liability for purchase commitment 50,000

The loss on purchase commitment is classified as other expense and the

estimated liability for purchase commitment is classified as current liability.
 Illustration

When the actual purchase is made in the subsequent period and the
current replacement cost drops further to P420,000, the journal
entry is:

Purchases 420,000
Loss on purchase commitment 30,000
Estimated liability for purchase commitment 50,000
Accounts payable 500,000
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 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.
Thus, in the preceding illustration, if the replacement cost of the purchase
commitment is P600,000 when the actual purchase is made, the journal entry to
recorded the actual purchase is:
Purchases 500,000
Estimated liability for purchase commitment 50,000
Accounts payable 500,000
Gain on purchase commitment 50,000

The gain on purchase commitment is classified as other income.

If the replacement cost of the purchase commitment is P480,000 when the
actual purchase is made, the journal entry to record the actual purchase is:

Purchases 480,000
Estimated liability for purchase commitment 50,000
Accounts payable 500,000
Gain on purchase commitment 30,000
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.
Commodities of broker-traders
PAS 2, paragraph 3, provides that commodities of broker-traders are
measured at fair value less cost of disposal.