CHAPTER 9

INVENTORIES:
ADDITIONAL VALUATION ISSUES

Intermediate Accounting
IFRS Edition
Kieso, Weygandt, and Warfield

9-1
 Lower-of-Cost-or-Net
Lower-of-Cost-or-Net Realizable
Realizable Value
Value

LCNRV
A company abandons the historical cost principle
when the future utility (revenue-producing ability)
of the asset drops below its original cost.

9-2 LO 1 Describe and apply the lower-of-cost-or-net realizable value rule.

 Lower-of-Cost-or-Net
Lower-of-Cost-or-Net Realizable
Realizable Value
Value

Net Realizable Value

Estimated selling price in the normal course of
business less estimated costs to complete and
estimated costs to make a sale.
Illustration 9-1

9-3 LO 1 Describe and apply the lower-of-cost-or-net realizable value rule.

 Lower-of-Cost-or-Net
Lower-of-Cost-or-Net Realizable
Realizable Value
Value

Net Realizable Value Illustration 9-2

LCNRV Disclosures

9-4 LO 1 Describe and apply the lower-of-cost-or-net realizable value rule.

 Lower-of-Cost-or-Net
Lower-of-Cost-or-Net Realizable
Realizable Value
Value

Methods of Applying LCNRV

► In most situations, companies price inventory on an
item-by-item basis.

► Tax rules in some countries require that companies use

an individual-item basis.

► Individual-item approach gives the lowest valuation for

statement of financial position purposes.

► Method should be applied consistently from one period

to another.

9-5 LO 1 Describe and apply the lower-of-cost-or-net realizable value rule.

 Lower-of-Cost-or-Net
Lower-of-Cost-or-Net Realizable
Realizable Value
Value
Recording Net Realizable Value Instead of Cost

Cost of goods sold (before adj. to NRV) $ 108,000

Ending inventory (cost) 82,000
Ending inventory (at NRV) 70,000

Loss
Loss Loss due to decline to NRV 12,000
Method
Method Inventory 12,000

COGS
COGS Cost of goods sold 12,000
Method
Method Inventory 12,000

9-6 LO 1 Describe and apply the lower-of-cost-or-net realizable value rule.

 Lower-of-Cost-or-Net
Lower-of-Cost-or-Net Realizable
Realizable Value
Value

Statement of Financial Position Presentation

Partial Statement COGS Loss
Method Method
Current assets:
Inventory $ 70,000 $ 70,000
Prepaids 20,000 20,000
Accounts receivable 350,000 350,000
Cash 100,000 100,000
Total current assets 540,000 540,000

9-7 LO 1 Describe and apply the lower-of-cost-or-net realizable value rule.

 Lower-of-Cost-or-Net
Lower-of-Cost-or-Net Realizable
Realizable Value
Value
Income Statement Presentation COGS Loss
Method Method
Sales $ 200,000 $ 200,000
Cost of goods sold 108,000 120,000
Gross profit 92,000 80,000
Operating expenses:
Selling 45,000 45,000
General and administrative 20,000 20,000
Total operating expenses 65,000 65,000
Other income and expense:
Loss due to NRV on inventory 12,000 -
Interest income 5,000 5,000
Total other (7,000) 5,000
Income from operations 20,000 20,000
Income tax expense 6,000 6,000
Net income $ 14,000 $ 14,000
9-8 LO 1
 Lower-of-Cost-or-Net
Lower-of-Cost-or-Net Realizable
Realizable Value
Value

Use of an Allowance
Instead of crediting the Inventory account for net realizable
value adjustments, companies generally use an
allowance account.

Loss
Loss Loss due to decline to NRV 12,000
Method
Method Allowance to reduce
inventory to NRV 12,000

9-9 LO 1 Describe and apply the lower-of-cost-or-net realizable value rule.

 Lower-of-Cost-or-Net
Lower-of-Cost-or-Net Realizable
Realizable Value
Value

Statement of Financial Position Presentation

Partial Statement COGS Loss
Method Method
Current assets:
Inventory $ 70,000 $ 82,000
Allowance to reduce inventory (12,000)
Inventory at NRV 70,000
Prepaids 20,000 20,000
Accounts receivable 350,000 350,000
Cash 100,000 100,000
Total current assets 540,000 540,000

9-10 LO 1 Describe and apply the lower-of-cost-or-net realizable value rule.

 Lower-of-Cost-or-Net
Lower-of-Cost-or-Net Realizable
Realizable Value
Value

Recovery of Inventory Loss

►Amount of write-down is reversed.

►Reversal limited to amount of original write-down.

Continuing the Ricardo example, assume the net realizable

value increases to $74,000 (an increase of $4,000). Ricardo
makes the following entry, using the loss method.

Allowance to reduce inventory to NRV 4,000

Recovery of inventory loss 4,000

9-11 LO 1 Describe and apply the lower-of-cost-or-net realizable value rule.

 Lower-of-Cost-or-Net
Lower-of-Cost-or-Net Realizable
Realizable Value
Value

Recovery of Inventory Loss

Allowance account is adjusted in subsequent periods,
such that inventory is reported at the LCNRV.
Illustration 9-8

Inventory should not be reported at a value above original cost.

9-12 LO 1 Describe and apply the lower-of-cost-or-net realizable value rule.

 Lower-of-Cost-or-Net
Lower-of-Cost-or-Net Realizable
Realizable Value
Value
Evaluation of LCM Rule
Some Deficiencies:
 Decreases in the value of the asset and the charge to expense are
recognized in the period in which the loss in utility occurs—not in the
period of sale.
 Increases in the value of the asset (in excess of original cost)
recognized only at the point of sale.
 Inconsistency because a company may value inventory at cost in one
year and at net realizable value in the next year.
 LCNRV values inventory conservatively. Net income for the year in
which a company takes the loss is definitely lower. Net income of the
subsequent period may be higher than normal if the expected
reductions in sales price do not materialize.

9-13 LO 1 Describe and apply the lower-of-cost-or-net realizable value rule.

 Valuation
Valuation Bases
Bases

Special Valuation Situations

Departure from LCNRV rule may be justified in situations when
► cost is difficult to determine,

► items are readily marketable at quoted market prices, and

► units of product are interchangeable.

Two common situations in which NRV is the general rule:

► Agricultural assets

► Commodities held by broker-traders.

9-14 LO 2 Explain when companies value inventories at net realizable value.

 Valuation
Valuation Bases
Bases

Agricultural Inventory NRV

Biological asset (classified as a non-current asset) is a
living animal or plant, such as sheep, cows, fruit trees, or
cotton plants.

► Biological assets are measured on initial recognition

and at the end of each reporting period at fair value
less costs to sell (NRV).

► Companies record gain or loss due to changes in NRV

of biological assets in income when it arises.

9-15 LO 2 Explain when companies value inventories at net realizable value.

 Valuation
Valuation Bases
Bases

Agricultural Inventory NRV

Agricultural produce is the harvested product of a
biological asset, such as wool from a sheep, milk from a
dairy cow, picked fruit from a fruit tree, or cotton from a
cotton plant.

► Agricultural produce are measured at fair value less

costs to sell (NRV) at the point of harvest.

► Once harvested, the NRV becomes cost.

9-16 LO 2 Explain when companies value inventories at net realizable value.

 Valuation
Valuation Bases
Bases

Illustration: Bancroft Dairy produces milk for sale to local cheese-

makers. Bancroft began operations on January 1, 2011, by
purchasing 420 milking cows for €460,000. Bancroft provides the
following information related to the milking cows.
Illustration 9-9

9-17 LO 2 Explain when companies value inventories at net realizable value.

 Valuation
Valuation Bases
Bases
Illustration 9-9

Bancroft makes the following entry to record the change in

carrying value of the milking cows.

Biological Asset—Milking Cows 33,800

Unrealized Holding Gain or Loss—Income 33,800

9-18 LO 2 Explain when companies value inventories at net realizable value.

 Valuation
Valuation Bases
Bases

Biological Asset—Milking Cows 33,800

Unrealized Holding Gain or Loss—Income 33,800

Reported in statement of financial position reports the

Biological Asset—Milking Cows as a non-current asset at
fair value less costs to sell (net realizable value).

Reported as “Other income and expense” on the income

statement.

9-19 LO 2 Explain when companies value inventories at net realizable value.

 Valuation
Valuation Bases
Bases
Illustration: Bancroft makes the following summary entry to record
the milk harvested for the month of January.

Milk Inventory 36,000

Unrealized Holding Gain or Loss—Income 36,000

Assuming the milk harvested in January was sold to a local cheese-

maker for €38,500, Bancroft records the sale as follows.

Cash 38,500
Sales 38,500

Cost of Goods Sold 36,000

Milk Inventory 36,000
9-20 LO 2
 Valuation
Valuation Bases
Bases

Commodity Broker-Traders NRV

Generally measure their inventories at fair value less costs to
sell (NRV), with changes in NRV recognized in income in the
period of the change.

► Buy or sell commodities (such as harvested corn, wheat,

precious metals, heating oil).

► Primary purpose is to sell the commodities in the near

term and generate a profit from fluctuations in price.

9-21 LO 2 Explain when companies value inventories at net realizable value.

 Valuation
Valuation Bases
Bases

Valuation Using Relative Sales Value

Permitted by GAAP under the following conditions:
(1) a controlled market with a quoted price applicable to all
quantities, and
(2) no significant costs of disposal (rare metals and
agricultural products)

or
(3) too difficult to obtain cost figures (meatpacking).

LO 3 Explain when companies use the relative

9-22
sales value method to value inventories.
 Valuation
Valuation Bases
Bases

Purchase Commitments—A Special Problem

► Generally seller retains title to the merchandise.

► Buyer recognizes no asset or liability.

► If material, the buyer should disclose contract details in

footnote.
► If the contract price is greater than the market price, and
the buyer expects that losses will occur when the
purchase is effected, the buyer should recognize a liability
and a corresponding loss in the period during which such
declines in market prices take place.

9-23 LO 4 Discuss accounting issues related to purchase commitments.

 Gross
Gross Profit
Profit Method
Method of
of Estimating
Estimating Inventory
Inventory

Substitute Measure to Approximate Inventory

Relies on Three Assumptions:

(1) Beginning inventory plus purchases equal total goods to

be accounted for.

(2) Goods not sold must be on hand.

(3) The sales, reduced to cost, deducted from the sum of the
opening inventory plus purchases, equal ending
inventory.

9-24 LO 5 Determine ending inventory by applying the gross profit method.

 Gross
Gross Profit
Profit Method
Method

Evaluation
Disadvantages:

(1) Provides an estimate of ending inventory.

(2) Uses past percentages in calculation.

(3) A blanket gross profit rate may not be representative.

(4) Normally unacceptable for financial reporting purposes.

IFRS requires a physical inventory as additional
verification.

9-25 LO 5 Determine ending inventory by applying the gross profit method.

 Retail
Retail Inventory
Inventory Method
Method

A method used by retailers, to value inventory without a

physical count, by converting retail prices to cost.

Requires retailers to keep:

(1) Total cost and retail value of goods purchased.
(2) Total cost and retail value of the goods available for sale.
(3) Sales for the period.

Conventional Method or Cost Method

(based on LCNRV)

9-26 LO 6 Determine ending inventory by applying the retail inventory method.

 Retail
Retail Inventory
Inventory Method
Method

Special Items
 Freight costs
 Purchase returns
 Purchase discounts and allowances
 Transfers-in
 Normal spoilage
 Abnormal shortages
 Employee discounts

9-27 LO 6 Determine ending inventory by applying the retail inventory method.

 Retail
Retail Inventory
Inventory Method
Method

Evaluation
Widely used for the following reasons:
(1) To permit the computation of net income without a
physical count of inventory.
(2) Control measure in determining inventory shortages.
(3) Regulating quantities of merchandise on hand.
(4) Insurance information.

Some companies refine the retail method by computing inventory separately by

departments or class of merchandise with similar gross profits.

9-28 LO 6 Determine ending inventory by applying the retail inventory method.

 Presentation
Presentation and
and Analysis
Analysis

Presentation of Inventories
Accounting standards require disclosure of:
(1) Accounting policies adopted in measuring inventories,
including the cost formula used (weighted-average, FIFO).
(2) Total carrying amount of inventories and the carrying amount
in classifications (merchandise, production supplies, raw
materials, work in progress, and finished goods).
(3) Carrying amount of inventories carried at fair value less costs
to sell.
(4) Amount of inventories recognized as an expense during the
period.

9-29 LO 7 Explain how to report and analyze inventory.

 Presentation
Presentation and
and Analysis
Analysis

Presentation of Inventories
Accounting standards require disclosure of:
(5) Amount of any write-down of inventories recognized as an
expense in the period and the amount of any reversal of
write-downs recognized as a reduction of expense in the
period.
(6) Circumstances or events that led to the reversal of a write-
down of inventories.
(7) Carrying amount of inventories pledged as security for
liabilities, if any.

9-30 LO 7 Explain how to report and analyze inventory.

 Presentation
Presentation and
and Analysis
Analysis

Analysis of Inventories
Common ratios used in the management and evaluation of
inventory levels are inventory turnover and average days
to sell the inventory.

9-31 LO 7 Explain how to report and analyze inventory.

  The requirements for accounting for and reporting inventories are more
principles-based under IFRS. That is, U.S. GAAP provides more
detailed guidelines in inventory accounting.
 Who owns the goods—goods in transit, consigned goods, special sales
agreements—as well as the costs to include in inventory are essentially
accounted for the same under IFRS and U.S. GAAP.
 U.S. GAAP permits the use of LIFO for inventory valuation. IFRS
prohibits its use. FIFO and average cost are the only two acceptable
cost flow assumptions permitted under IFRS. Both sets of standards
permit specific identification where appropriate.
9-32
  In the lower-of-cost-or-market test for inventory valuation, IFRS defines
market as net realizable value. U.S. GAAP, on the other hand, defines
market as replacement cost subject to the constraints of net realizable
value (the ceiling) and net realizable value less a normal markup (the
floor). IFRS does not use a ceiling or a floor to determine market.
 Under U.S. GAAP, if inventory is written down under the LCM valuation,
the new basis is now considered its cost. As a result, the inventory may
not be written back up to its original cost in a subsequent period. Under
IFRS, the write-down may be reversed in a subsequent period up to the
amount of the previous write-down. Both the write-down and any
subsequent reversal should be reported on the income statement.
9-33
  Unlike property, plant, and equipment, IFRS does not permit the option
of valuing inventories at fair value. As indicated above, IFRS requires
inventory to be written down, but inventory cannot be written up above
its original cost.
 As indicated, IFRS requires both biological assets and agricultural
produce at the point of harvest to be reported to net realizable value.
U.S. GAAP does not require companies to account for all biological
assets in the same way. Furthermore, these assets generally are not
reported at net realizable value. Disclosure requirements also differ
between the two sets of standards.

9-34