CHAPTER 12

LOWER 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 m realizable value is now known as LCNRV.

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.

Determination of net realizable value

Inventories are usually written down to net realizable value on an item by item or individual basis.

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 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 is
not accounted for separately, but “buried” m 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 December 31, 2019

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 2,0000 1,900,000 1,900,000
E 1,500,000 4,560,000 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 individual 7,850,000
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 7,690,000
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, 2019 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,

Inventory - December 31, 2019 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 cost.

Allowance method

The inventory on December 31, 2019 is recorded at cost.

Inventory December 31, 2019 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 4 December 31, 2019, at cost 8,000,000

Allowance for inventory writedown ( 150,000)

Net realizable value 7,850,000

Continuing illustration

Assume on December 81, 2020, the total cost of the inventory is P8,500,000 and the net realizable value
is P8,400,000.

Direct method

Again, under this method, the inventory is simply recorded at the lower amount.

Thus, the journal entry to record the inventory on December 91, 2020 is;

Inventory December 31, 2020 8,400,000

Income summary 8,400,000

Allowance method

Cost December 31, 2020 8,500,000

Net realizable value 8,400,000

Required allowance -December 31, 2020 100,000

Less: Allowance balance December 31, 2019 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.

PAS 2, paragraph 34, provides that the amount of any reversal of any writedown of inventory arising
from an increase in net realizable value shall be recognized as a reduction m the amount of inventory
recognized as an expense in the period m which the reversal occurs.

The amount of inventory recognized as an expense of the period is actually the cost of goods sold during
the period.

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 5,000,000

Net purchases 20,000,000

Goods available for sale 25,000,000

Inventory – December 31 ( 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 1 500,000

Increase in allowance – loss on writedown 200,000

Note that whether direct 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
find price and fund quantity

Actually a purchase contract has already been made for future delivery of goods fixed in price and in
quantity.

Where the purchase commitments are significant or unusual, disclosure is required in the accompanying
notes to financial statements.

Any losses which are expected to arise from firm and non-cancelable commitments shall be recognized.

If there is a decline in purchase price after a purchase commitment has been made, a loss is recorded m
the period of the price decline.

Note that a purchase commitment must be non-cancelable in order that a loss purchase commitment
can be recognized.

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.

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 price 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 record 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 purchase is recorded at P500,000 because the purchase commitment of P500,000 is lower than the
replacement cost at P600,000.

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

The purchase is recorded at P480,000 only because the replacement cost is lower than the purchase
commitment P500, 000.

The gain on purchase commitment is the increase in market price from P450,000 at year-end to
P480,000 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.

b. The total carrying amount of inventories and the carrying amount in classification 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.

d. The amount of inventories recognized as an expense during the period.

e. The amount of any writedown of inventories recognized as an expense during the period.

f. The amount of reversal of writedown that is recognized as income.

g. The circumstances or events that led to reversal of a, writedown of inventories.

h. The carrying amount of inventories pledged as security for liabilities.

Agricultural, forest and mineral product

PAS 2, paragraph 4, provides that inventories of agricultural, forest and mineral products are measured
at net realizable value at certain stages of production.

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 homogeneous market exists and there is a negligible risk of failure to sell.

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 of an asset as the price that would be received to sell the asset
in an orderly transaction between market participants.

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-trader’s margin.

PROBLEMS

PROBLEM 1
Winter Company provided the following inventory data at year-end:
 Cost NRV
Skis 2,200,000 2,500,000

Boots 1,700,000 1,500,000

Ski equipment 700,000 800,000

Ski apparel 400,000 500,000

What amount should be reported as inventory at year-end?

a 5,000,000
b. 5,300,000
c. 4,800,000
d. 5,200,000

Solution Answer c
Cost NRV LCNRV
Skis 2,200,000 2,500,000 2,200,000
Boots 1,700,000 1,500,000 1,500,000
Ski equipment 700,000 800,000 700,000
Ski apparel 400,000 500,000 400,000
5,000,000 5,300,000 4,800,000

Inventories shall be measured at the lower of cost and net realizable Invent value applied by individual
item.

PROBLEM 2

Harris Company provided the following information for an inventorv. year-end:,

Historical cost 1,200,000
Estimated selling price 1,300,000
Estimated completion and selling cost 150,000
Replacement cost 1 100,000

What amount should be reported as inventory at year-end?

a. 1,100,000
b. 1,150,000
C. 1,200,000
d. 1,300,000

Solution Answer b

Historical cost 1,200,000

Net realizable value (1,300,000-150,000) 1,150,000
LCNRV 1,150,000
PROBLEM 3

Aloha Company determined the following information for an inventory at year-end:

Historical cost 2,000,000
Current replacement cost 1,400,000
Net realizable value 1,800,000
Net realizable value less a normal profit margin1,700,000
Fair value 1,900,000

What amount should be reported as inventory at year-end?

a. 1,400,000
b. 1,700,000
C. 1,800,000
d. 1,900,000

Solution Answer c
Historical cost 2,000,000
Net realizable value 1,800,000
LCNRV 1,800,000

PROBLEM 4

Based on a physical inventory taken at year-end, Chewy Company determined the chocolate inventory
on a FFO basis at P5,200,000 with a replacement cost of P4,000,000.
The entity estimated that after further processing costs of P2,400,000, the chocolate could be sold as
finished candy bars for P8,000,000. The normal profit margin is 10% of sales.

Using the measurement at the lower of cost and net realizable value, what amount should be reported
as chocolate inventory at year-end?

a. 5,600,000
b. 4,000,000
c. 5,200,000
d. 4,800,000

Solution Answer c
Estimated sales price 8,000,000
Cost to complete processing cost (2,400,000)
Net realizable value 5,600,000

FIFO cost 5,200,000

Net realizable value 5,600,000
LCNRV 5,200,000

The FIFO cost of P 5,200,000 is the inventory valuation because it is lower than the net realizable value.

PROBLEM 5
Greece Company provided the following data for the current year
Inventory- January 1:
Cost 3,000,000
Net realizable value 2,800,000
Net purchases 8,000,000
Inventory December 31:
Cost 4,000,000
Net realizable value 3,700,000

What amount should be reported as cost of goods sold?

a. 7,000,000
b.7,100,000
c. 7,300,000
d.7,200,000

Solution Answer b
Inventory --January 1, at cost 3,000,000
Net purchases 8,000,000
Goods available for sale 11,000,000
Inventory - December 31, at cost (4,000,000)
Cost of goods sold before inventory writedown 7,000,000
Loss on inventory writedown 100,000
Cost of goods sold after inventory writedown 7,100,000

Required allowance December 31

4,000,000-3,700,000) 300,000
Allowance for inventory writedown - January 1
(3,000,000-2,800,000) Loss on inventory writedown 200,000
100,000
The amount of any inventory writedown to net realizable value and al losses on inventory shall be
included in cost of goods sold.
The amount of any reversal of inventory writedown shall be deducted from cost of goods sold.

PROBLEM 6

Uptown Company used the perpetual method to record inventory transactions for the current year.
Inventory 1,900,000
Sales 6,500,000
Sales return 150,000
Cost of goods sold 4,600,000
Inventory losses120,000

In the latter part of the year, the entity recorded a P150,000 credit sale of goods costing P100,000.

These goods were sold on FOB destination terms and were in transit at year-end. The goods were
included in the physical count.
The inventory at year-end determined by physical count had a cost of P2,000,000 and a net realizable
value of Pl,700,000.
Any inventory writedown is not yet recorded.

What amount should be reported as cost of goods sold for the current year?
a. 5,020,000
b. 4,500,000
C. 4,720,000
d. 4,920,000

Solution Answer d
Physical inventory 2,000,000
Net realizable value 1,700,000
Inventory writedown 300,000
Cost of goods sold per book 4,600,000
Cost of goods incorrectly recorded as sold (100,000)
Inventory losses 120,000
Loss on inventory writedown 300,000
Adjusted cost of goods sold 4,920,000

PROBLEM 7

Altis Company reported the following information for the current year:
Sales (100,000 units at P150) 15,000,000
Sales discount 1,000,000
Purchases 9,300,000
Purchase discount 400,000
The inventory purchases during the year were as follows:
Units Unit cost Total cost
Beginning inventory, January 1 20,000 60 1,200,000
Purchases, quarter ended March 31 30,000 65 1,950,000
Purchases, quarter ended June 30 40,000 70 2,800,000
Purchases, quarter ended Sept. 30 50,000 75 3,750,000
Purchases, quarter ended Dec. 31 10,000 80 800,000
150,000 10,500,000
The accounting policy is to report inventory in the financial statements at the lower of cost and net
realizable value.

Cost is determined under the first-in, first-out method.

At year-end, the entity has determined that the replacement cost of inventory was P70 per unit and the
net realizable value was P72 per unit. The normal profit margin is P10 per unit.

What amount should be reported as cost of goods sold for the current year?
a. 6,500,000
b. 6,300,000
c. 6,700,000
d. 6,900,000

Solution Answer a

Allowance method

September 30 (40,000 x 75) 3,000,000

December 31 (10,000x 80) 800,000
FIFO cost 3,800,000
Net realizable value (50,000 x 72) 3,600,000
Inventory writedown 200,000
Inventory January 1 at cost 1,200,000
Purchases 9,300,000
Purchase discount (400,000)
Goods available for sale 10,100,000
Inventory- December 31 at cost (3,800,000)
Cost of goods sold before inventory writedown 6,300,000
Loss on inventory writedown 200,000
Cost of goods sold after inventory in writedown 6,500,000

Direct method

Goods available for sale 10,100,000

Inventory December 31 at NRV (3,600,000)
Cost of goods sold 6,500,000
Observe that the cost of goods sold is the same whether allowance method or direct method.

PROBLEM 8

2018, North Company experienced a decline in the value of inventory

resulting in a writedown from cost of P3,600,000 to net realizable value of P3,000,000.

The entity used the allowance method to record the necessary adjustment.

In 2019, market conditions have improved dramatically. Om December 31,2019, the inventory had a cost
of P5,000,000 and net realizable value of P4,600,000.

What is included in the adjusting entry on December 31, 2019?

a. Debit gain on reversal of inventory writedown P200,000
b. Credit gain on reversal of inventory writedown P400,000
c. Debit allowance for inventory writedown P200,000
d. Credit allowance for inventory writedown P400,000

Solution Answer c

2018 Loss on inventory writedown 600,000

Allowance for inventory writedown 600,000
Cost December 31, 2018 3,600.000
Net realizable value 3,000,000
Loss on inventory writedown 600,000
2019 Allowance for inventory writedown 200,000
Gain on reversal of inventory writedown 200,000
Cost December 31, 2019 5,000,000
Net realizable value 4,600,000
Required allowance- December 31, 2019 400,000
Allowance December 31, 2018 600 000
Reversal of inventory writedown (200,000)

PROBLEM 9-10
On January1,2018, Card Company signed a three-year, noncancelable purchase contract, which allows
Card to purchase up to 5,000 units of a computer part annually from Hart Company at P100 per unit and
guarantees a minimum annual purchase of 1,000 units.

During 2018, the part unexpectedly became obsolete. Card had 2,500 units of this inventory on
December 31,2018, and believed these parts can be sold as scrap for P20 per unit.

9. What amount of loss from the purchase commitment should be reported in the 2018 income
statement?
a. 240,000
b. 200,000
c. 160,000
d. 360,000
10. What amount should be recognized as loss on inventory writedown in 2018?
a. 360,000
b. 560,000
c. 200,000
d. 0

Solution
Question 9 Answer c
Remaining contract- 1,000 units each year
2019 (1,000 x P100) 100,000
2020 (1,000 x P100) 100,000
Total 200,000
Estimated realizable value (2,000x P20) 40,000
Loss on purchase commitment 160,000

Question 10 Answer c
Inventory- December 31, 2018, at cost
(2,500 units x P100) 250,000
Net realizable value (2,500 units x P20) 50,000
Loss on inventory writedown 200,000