What is the reason for the inventory measurement at lower of cost and net realizable value?

Learning Outcomes

• Compare methods of computing lower of cost or net realizable value

Net realizable value (NRV) sounds complicated, and a lot of accountants may still use the old term: Lower of Cost of Market (LCM).

However, in July 2015, the Financial Accounting Standards Board (FASB) adopted ASU 2015-11, FASB’s Accounting Standards Codification (ASC) Topic 330, Inventory, that replaced LCM with LCNRV.

Lower of cost or market (old rule)

The old rule (that still applies to entities that use LIFO or a retail method of inventory measurement) required entities to measure inventory at the LCM. The term market referred to either replacement cost, net realizable value (commonly called “the ceiling”), or net realizable value (NRV) less an approximately normal profit margin (commonly called “the floor”).

In other words, market was the price at which you could currently buy it from your suppliers. Except, when you were doing the LCM calculation, if that market price was higher than net realizable value (NRV), you had to use NRV. If the market price was lower than NRV minus a normal profit margin, you had to use NRV minus a normal profit margin.

Lower of cost or NRV (new rule)

The new rule, LCNRV, was designed to simplify this calculation. NRV is the estimated selling price in the ordinary course of business, minus costs of completion, disposal, and transportation.

Say Geyer Co. bought 200 Rel 5 HQ Speakers five years ago for $110 each and sold 90 right off the bat, but has only sold 10 more in the past two years for $70. There are still a hundred on hand, costs using FIFO, but the speakers are obsolete and management feels they can sell them with some slight modifications to each one that cost $20 each.

So, the NRV is:

Let’s say the Geyer Co. looked at the HQ Speakers product # Rel 5 and determined that the current wholesale price was $60. There are a bunch on the shelf at the end of the year, 100 in fact, that using FIFO, are assigned a cost of $110.00. These speakers are antiquated and just aren’t selling, so even though they are on the books at FIFO (which means the cost is based on the most recent purchases, regardless of how old the actual speakers are), they are a couple of years old and could be purchased today for a lot less, if Geyer even wanted them.

• Cost: $110.00
• Replacement Cost: $60
• NRV: $50

So under the old rule of LCM, replacement cost (what our wholesale distributor sells to them to us for) would be the ceiling. Let’s also say we would normally mark them up and expect to make about $20 on the sale, so the floor, the lowest we could adjust them to, would be $30. If we lowered the cost to $30 on our books and sold them for $70 minus the $20 it takes to make them saleable, we’d make a normal profit.

Under the old rule that still applies to LIFO and retail inventory methods, the item could be written down to market because it is lower than the historical cost of $110. Market is somewhere between the ceiling and the floor: between $50 and $30. Since the replacement cost is over the ceiling, we’d use the $50 NRV for market.

If the replacement cost had been $20, the most we could write the inventory down to would be the floor of $30.

If the replacement cost had been $45, we would write the inventory down to $45.

Under the new rule, which Geyer would be using because it is using FIFO cost flow assumption, the calculation is actually simpler: NRV. So, $50.

As a result of our analysis, we would write down the cost of Rel 5 HQ Speakers, highlighted below in yellow, by $6,000 so the new cost on our books is $50 each.

In the next section, we’ll look at how to adjust total inventory, but first to review:

From ASU 2015-11:

330-10-35-1B Inventory measured using any method other than LIFO or the retail inventory method (for example, inventory measured using first-in, first-out (FIFO) or average cost) shall be measured at the lower of cost and net realizable value. When evidence exists that the net realizable value of inventory is lower than its cost, the difference shall be recognized as a loss in earnings in the period in which it occurs. That loss may be required, for example, due to damage, physical deterioration, obsolescence, changes in price levels, or other causes.

By adjusting the inventory down, the balance sheet value of the asset, Merchandise Inventory, is restated at a more conservative number. Notice that we never adjust inventory up to fair market value, only downward.

One final note: ASU 2015-11, FASB’s Accounting Standards Codification (ASC) Topic 330 carved out an exception to the new rule for LIFO and retail inventory methods. One of the simplest versions of the retail inventory method calculates ending inventory by totaling the value of goods that are available for sale, which includes beginning inventory and any new purchases of inventory. Total sales are multiplied by the cost-to-retail ratio (or the percentage by which goods are marked up from their wholesale purchase price to their retail sales price) in order to get an estimate of COGS.

Using the formula:

[latex]\text{Beginning inventory}+\text{purchases}-\text{ending inventory}=\text{COGS}[/latex]

Modified slightly:

[latex]\text{Beginning inventory}+\text{purchases}-\text{COGS}=\text{ending inventory}[/latex]

A large company like Home Depot that has a consistent mark-up can reasonably estimate ending inventory. Home Depot undoubtedly uses a more sophisticated version of this calculation, but the basic idea would be the same.

Because the estimated cost of ending inventory is based on current prices, this method approximates FIFO at LCM.

Let’s see how companies apply this conservative rule to inventories.

Under IFRS, inventories are reported at the lower of cost or net realizable value (NRV).

• If inventory declines in value below its original cost for whatever reason (obsolescence, price-level changes, damaged goods, etc.), the inventory should be written down to reflect this. If the NRV is lower than the cost, the ending inventory is written down to the NRV. The loss then is charged against revenues as an expense in the period in which the loss occurs, not in the period in which it is sold. However, if the NRV is higher than the cost, nothing is done. The increases in the value of the inventory are recognized only at the point of sale.
• A reversal (up to the amount of original write-down) is required if the inventory value goes up later.
• The amount of any reversal is recognized as a reduction in the cost of sales.
• This rule can be applied either directly to each inventory item, to each category, or to the total of the inventory. The most common practice is to price inventory on an item-by-item basis.

• Net realizable value: Estimated selling price less estimated costs of completion necessary to make the sale.
• Historical cost: The cash equivalent price of goods or services at the date of acquisition.
• Market value (Replacement cost): The cost that would be required to replace an existing asset.
• Fair value: The amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm's length transaction.

Net realizable value: $4,000 - $1,000 = $3,000

• Inventory Valuation under IFRS: $3,000 (the lower of historical cost and NRV).
• Inventory Valuation under U.S. GAAP: $2,000 (the lower of historical cost and market cost).

• Under IFRS, $1,000 of original write-down may be recovered to bring NRV up from $3,000 to $4,000. Note that reversals are limited to the amount of the original write-down ($2,000).
• Under U.S. GAAP, the value of inventory is $2,000 even though the new market value is $3,000. No adjustment is made and reversal is prohibited.

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