STUDY UNIT TWO

MEASUREMENT, VALUATION, AND

DISCLOSURE:
INVESTMENTS AND SHORT-TERM
ITEMS

Sameh Ellithy,CMA,CIA

2.4 Measurement of Inventory Subsequent to

Initial Recognition

9-1
 LOWER-OF-COST-OR-NET REALIZABLE
VALUE

A company abandons the historical cost principle when the

future utility (revenue-producing ability) of the asset drops
below its original cost.

Definition of Net Realizable Value

 Net realizable value (NRV) is the estimated selling
price in the ordinary course of business, less reasonably
predictable costs of completion, disposal, and
transportation.

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 Definition of Net Realizable Value

Illustration: Assume that Mander Corp. has unfinished inventory

with a cost of $950, a sales value of $1,000, estimated cost of
completion of $50, and estimated selling costs of $200. Mander’s
net realizable value is computed as follows.

ILLUSTRATION 9-1
Computation of Net Realizable Value

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 Definition of Net Realizable Value
ILLUSTRATION 9-1

 Mander reports inventory on its balance sheet at $750.

 In its income statement, Mander reports a Loss Due to
Decline of Inventory to NRV of $200 ($950 − $750).
ILLUSTRATION 9-2
LCNRV Disclosures

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 Illustration of LCNRV

Regner Foods computes its inventory at LCNRV, as

ILLUSTRATION 9-3
shown in Illustration 9-3 (amounts in thousands). Determining Final
Inventory Value

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 Methods of Applying LCNRV

ILLUSTRATION 9-4
Alternative Applications of LCNRV

Companies usually price inventory on an item-by-item basis.

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 Recording NRV Instead of Cost

The following inventory data is for Ricardo Company.

Ending inventory (cost) $ 82,000

Ending inventory (at NRV) 70,000
Adjustment to LCNRV $ 12,000

Loss
Loss Loss Due to Decline in Inventory 12,000
Method
Method Inventory

12,000
COGS
COGS Cost of Goods Sold 12,000
Method
Method Inventory

9-7 12,000 LO 1
 LOWER-OF-COST-OR-MARKET

The use of the lower-of-cost-or-net realizable value method

works well to measure the decline in value of a company’s
inventory for most companies.
The FASB decided to grant an exception to the LCNRV approach
for companies that use the LIFO or retail inventory methods.
 Rather than comparing cost to net realizable value, under
the alternative approach, companies compare a
“designated market value” of the inventory to cost.
 The approach is commonly referred to as lower-of-cost-or-
market (LCM).

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 LOWER-OF-COST-OR-MARKET

This approach begins with replacement cost, then applies two

additional limitations to value ending inventory.
 Net realizable value (ceiling) and
 net realizable value less a normal profit margin (floor).

Net realizable value (NRV) is the estimated selling price in the

ordinary course of business, less reasonably predictable costs of
completion and disposal.

A company values inventory at the lower-of-cost-or-market, with

market limited to an amount that is not more than net realizable
value or less than net realizable value less a normal profit margin.
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 LOWER-OF-COST-OR-MARKET ILLUSTRATION 9-10
Inventory Valuation—
Lower-of-Cost-or-Market

What is the rationale for the

Ceiling = NRV
Ceiling and Floor limitations?
Not
>

Replacement
Cost Market Cost
Cost Market
Not
<

Floor =
GAAP
GAAP NRV less Normal
LCM
LCM Profit Margin

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 LOWER-OF-COST-OR-MARKET

What is the rationale for the Ceiling and Floor limitations?

 Ceiling – prevents overstatement of the value of obsolete,
damaged, or shopworn inventories.
 Floor – deters understatement of inventory and
overstatement of the loss in the current period.

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 How Lower-of-Cost-or-Market Works
ILLUSTRATION 9-12
Determining Final Inventory Value

$65,000

Regner makes the following entry (using the loss method) to record the decline in
value.
Loss Due to Decline of Inventory to Market 65,000
Allowance to Reduce Inventory to Market 65,000
A reversal of a write-down of inventory recognized in the annual financial statements is
prohibited in subsequent periods. Once inventory is written down below cost, the reduced
9-12 amount is the new cost basis. LO 2
 Methods of Applying Lower-of-Cost-or-
Market

ILLUSTRATION 9-13
Alternative Applications of Lower-of-Cost-or-Market, Applying the LCM rule to each item of inventory produces
the lowest amount for each item and therefore the lowest and most conservative measurement for the
total inventory.

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9-14
9-15
9-16
 OTHER VALUATION APPOACHES

Purchase Commitments—A Special Problem

► Generally seller retains title to the merchandise.

► Buyer recognizes no asset or liability.

 A commitment to acquire goods in the future is not recorded at the
time of the agreement.
 The goods are recognized as inventory when they are received.

► If material, the buyer should disclose contract details in

note in the financial statements.

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 OTHER VALUATION APPOACHES

Purchase Commitments—A Special Problem

 But a loss is recognized on a firm’s noncancelable purchase
commitment if the current market price of the goods is less than the
commitment price.
 An example of such an agreement is a take-or-pay contract that requires one party
to purchase a certain number of goods from the other party or else pay a penalty.

 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 losses
in the period during which such declines in
market prices take place.

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 OTHER VALUATION APPOACHES

Illustration: St. Regis Paper Co. signed timber-cutting contracts

to be executed in 2018 at a price of $10,000,000. Assume further
that the market price of the timber cutting rights on December
31, 2017, dropped to $7,000,000. St. Regis would make the
following entry on December 31, 2017.

Unrealized Holding Gain or Loss—Income 3,000,000

Estimated Liability on Purchase Commitment 3,000,000

Other expenses and losses in the Income statement.

Current liabilities on the balance sheet.

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  Material losses expected on purchase commitments are
measured in the same way as inventory losses, recognized, and
separately disclosed.
 The reason for current loss recognition is the same as that for
inventory. A decrease (not an increase) in its future benefits
should be recognized when it occurs even if the contract is
unperformed on both sides.
 The nature and the term of the contract (obligation) must be
described in the notes to the financial statements.

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