CHAPTER 14

LOWER OF COST AND NET

REALIZABLE VALUE OF INVENTORIES
Ninia C. Pauig-Lumauan, MBA, CPA
2nd Semester 2020-2021
Lyceum of Aparri

Intermediate Accounting Part 1

 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.

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 NET REALIZABLE VALUE

• Net Realizable Value or 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.
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 NET REALIZABLE VALUE

b. The inventories have become wholly or

partially obsolete.
c. The selling prices have declined.
d. The estimated cost of completion or
the estimated cost of disposal have
increased.

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 NET REALIZABLE VALUE

• 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.
• Inventories are usually written down to
net realizable value on an item by item or
individual basis.
Intermediate Accounting Part 1
 DETERMINATION OF NET REALIZABLE VALUE

• 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.
• Materials and other supplies held for use in
production are not written down below
cost if the finished products in which they
will be incorporated are to be expected to
be sold at or above cost.
Intermediate Accounting Part 1
DETERMINATION OF NET REALIZABLE VALUE

• 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 replenishment
cost of materials may be the best
evidence of their net realizable value.
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 ACCOUNTING FOR INVENTORY WRITE
DOWN
• If the cost is lower than net realizable
value, there is no accounting problem
because the inventory is stated at cost
and the increase in value is not
recognized.
• If the net realizable value is lower than
cost, the inventory is measured at net
realizable value.
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 ACCOUNTING FOR INVENTORY
WRITEDOWN
• In this case, the problem is the proper
treatment of the write down of the
inventory to net realizable value.
• There are two (2) methods of accounting
for the inventory write down, namely:
1. Direct method or cost of goods sold
method.
2. Allowance method or loss method.
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 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 write down is not accounted
for separately but “buried” in the cost of
goods sold.

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 ALLOWANCE METHOD

• The inventory is recorded at cost and any

loss on inventory write down is
accounted for separately.
• This method is also known as “loss
method” because a loss account “loss on
inventory write down” is debited and a
valuation account “allowance for
inventory account” is credited.

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 ALLOWANCE METHOD

• In subsequent years, the 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 write down is
recorded.
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 ALLOWANCE METHOD
• 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 write down and
reversal of write down can be clearly
identified.
• As a matter of fact, PAS 2, paragraph 36,
requires disclosure of the amount of any
inventory write down and the amount of
any reversal of inventory write down.
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 ILLUSTRATION
(a) (b) (c) (a x b) (a x c) Lower
Units Unit NRV Total NRV
Cost Cost
Materials:
No. 1 1,000 11 10 11,000 10,000 10,000
No. 2 3,000 23 25 69,000 75,000 69,000
No. 3 2,000 30 32 60,000 64,000 60,000
Goods in Process:
X 5,000 40 38 200,000 190,000 190,000
Y 3,000 50 52 150,000 156,000 150,000
Finished Goods:
A 2,000 75 73 150,000 146,000 146,000
B 2,000 80 83 160,000 169,000 160,000
TOTAL 800,000 810,000 785,000

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 ILLUSTRATION
• The measurement of the inventory at
LCRNV is applied on an item by item or
individual basis or P 785,000.
• If the LCRNV is applied by total, the
measurement of the inventory is the
total cost of P 800,000 which is lower
than the total NRV of P 810,000.

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 ILLUSTRATION

DIRECT METHOD
• The inventory is recorded at the lower of
cost of NRV.
Inventory Dec, 31, 2019 785,000
Income Summary 785,000
• The loss on inventory write down of P
15,000 is not accounted for separately.
The entry will have the effect of
increasing cost of goods sold because the
NRV is lower than cost.
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 ILLUSTRATION
ALLOWANCE METHOD
• The inventory on December 31, 2019 is
recorded at cost.
Inventory Dec, 31, 2019 800,000
Income Summary 800,000
• The loss on inventory write down is
accounted for separately.
Loss on Inventory Write down 15,000
Allowance for Inventory Write down 15,000

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 ILLUSTRATION
• The loss on inventory write down is
included in the computation of cost of
goods sold.
• The allowance for inventory write down is
presented as a deduction from the
inventory:
Inventory – Dec. 31, 2019 at cost 800,000
Allowance for Inventory Write down ( 15,000)
Net Realizable Value 785,000
=======
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 CONTINUING ILLUSTRATION

• Assume on December 31, 2020, the total

cost of the inventory is P 1,000,000 and
the net realizable value is P 990,000.
DIRECT METHOD
• Again, under this method, the inventory
is simply recorded at the lower amount.
Inventory Dec, 31, 2020 990,000
Income Summary 990,000

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 CONTINUING ILLUSTRATION
ALLOWANCE METHOD
Cost 1,000,000
Net Realizable Value 990,000
Required Allowance – December 31, 2020 10,000
Less: Allowance balance – December 31, 15,000
2019
Decrease in Allowance (5,000)
vvvvvv

• The decrease in allowance is a reversal of

the previous inventory write down and
recorded as follows:
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 CONTINUING ILLUSTRATION
Allowance for Inventory Write down 5,000
Gain on reversal of Inventory Write down 5,000
• The gain on reversal of inventory write
down is presented as a deduction from
cost of goods sold.
• PAS 2, paragraph 34, provides that “the
amount of any reversal of any write down
of inventory arising from an increase in net
realizable value shall be recognized as a
reduction in the amount of inventory
recognized as an expense in the period in
which the reversal occurs.”
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 PURCHASE COMMITMENTS

• Purchase commitments are 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 quantity.
• Where the commitments are significant or
unusual, disclosure is required in the
accompanying notes to financial statements.
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 PURCHASE COMMITMENTS

• Any losses which are expected to arise

from firm and non-cancellable
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 the purchase commitment must
be non-cancellable in order that a loss
purchase commitment can be recognized.
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 PURCHASE COMMITMENTS

• 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 price is P 500,000 and the
replacement cost at year end is P 450,000.
The market decline of P 50,000 is recorded
as follows: Intermediate Accounting Part 1
 ILLUSTRATION
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.
• When the actual purchase is made in the
subsequent period and the current
replacement cost drops further to P
420,000, the journal entry is:
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 ILLUSTRATION
Purchases 420,000
Loss on Purchase Commitment 30,000
Estimated Liability for Purchase Commitment 50,000
Accounts Payable 500,000

• 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 price rises by
the time the entity makes the
purchase, a gain on purchase
commitments would be recorded.
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 ILLUSTRATION
• However, the amount of gain to be
recognized is limited to the loss on
purchase commitments previously
recorded.
• Thus, in the preceding illustration, if the
replacement cost of the purchase
commitment if P 600,000 when the
actual purchase is made, the journal
entry to record the actual purchase is:

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 ILLUSTRATION
Purchases 500,000
Estimated Liability for Purchase Commitment 50,000
Accounts Payable 500,000
Gain on Purchase Commitment 50,000

• The purchase is recorded at P 500,000

because the purchase commitment of P
500,000 is lower than the replacement
cost of P 600,000.
• The gain on purchase commitment is
classified as other income.

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 ILLUSTRATION
• If the replacement cost of the purchase
commitment is P 480,000 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

• The purchase is recorded at P 480,00 only

because the replacement cost is lower than
the purchase commitment of P 500,000.
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 ILLUSTRATION
• The gain on purchase commitment is the
increase in market price from P 450,000
at year-end to P 480,000 on the date of
actual purchase.
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.
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 DISCLOSURES

b. The total carrying amount of

inventories and the carrying amount in
classifications 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.
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 DISCLOSURES

d. The amount of inventories recognized

as an expense during the period.
e. The amount of any write down of
inventories recognized as an expense
during the period.
f. The amount of reversal of write down
that is recognized as income.
g. The circumstances or events that let to
reversal or a write down of inventories.
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 DISCLOSURES

h. The carrying amount of inventories

pledged 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.
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 AGRICULTURAL, FOREST AND MINERAL
PRODUCTS
• 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 guarantee.
b. When a homogenous market exists and
there is negligible risk of failure to sell.
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 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 as
“the price that would be received to sell
an asset or paid to transfer a liability in an
orderly transaction between market
participants.”

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 COMMODITIES OF BROKER-TRADERS
• 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.

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