LOWER OF COST AND NET

REALIZABLE VALUE
Chapter 10

Maria Jessalen B. Azul

LCNRV - the measurement of inventory at the Lower of Cost and Net Realizable
Value
Net realizable value or NRV =
estimated selling price – (estimated cost of completion + estimated cost of disposal)

The cost of inventories may not be recoverable when the inventories are
damaged or have become obsolete, when selling prices have decreased and
when the estimated cost of completion or estimated cost of disposal has
increased.
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.
Determination Of Net Realizable Value
Inventories are usually written down to net realizable value on an item by item or
individual basis.
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.
In some circumstances, however, it may be appropriate to group similar or related items.
This may be the case with items of inventory relating to the same product line that have
similar purposes, are produced and marketed in the same geographical area and cannot
be practically evaluated separately.
Materials held for use in production are not written down below cost if the finished
products in which the materials will be incorporated are expected to be sold at or above
cost.
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.
The direct method is also known as cost of goods sold method because any
loss on inventory writedown or gain on reversal of inventory writedown is not
accounted for separately but "buried" in the cost of goods sold.
Allowance method
The inventory is recorded at cost and any loss on inventory writedown is accounted for
separately.
The allowance method is also known as loss method because a loss on inventory
writedown is debited and an allowance for inventory writedown is credited.
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.
In other words, 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.
The standard does not prescribe or require any method.
However, preferably the allowance method is used in order that the effects of writedown
and reversal of writedown can be clearly identified.
Illustration - Inventory data on December 31, 2022
Category 1 Cost NRV LCNRV
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 2,000,000 1,900,000 1,900,000
E 1,500,000 1,560,000 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
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 7,960,000

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, 2022 8,000,000
Net realizable value - item by item 7,850,000
Inventory writedown 150,000
Direct method
The inventory is recorded at the lower of cost or NRV.
Inventory - December 31, 2022 7,850,000
Income summary 7,850,000
The loss on inventory writedown of P150,000 is not accounted for separately.
Allowance method
The inventory on December 31, 2022 is recorded at cost.
Inventory - December 31, 2022 8,000,000
Income summary 8,000,000

The loss on inventory write down is accounted for separately.

Loss on inventory write down 150,000
Allowance for inventory writedown 150,000
The loss on inventory write down is included in the computation of cost of goods sold.
The allowance for inventory writedown is presented as a deduction from the inventory.
Inventory - December 31, 2022, at cost 8,000,000
Allowance for inventory writedown (150,000)
Net realizable value 7,850,000
Inventory data on December 31, 2023

Continuing the illustration, the following inventory data on December 31, 2023
are provided:
Inventory - December 31, 2023 8,500,000
Net realizable value 8,400,000
Net purchases 30,000,000
Direct Method
Under this method, the inventory is simply recorded at the lower amount of
P8,400,000 on December 31, 2023.
Inventory - December 31, 2023 8,400,000
Income summary 8,400,000
Allowance method
The inventory on December 31, 2023 is recorded at cost of P8,500,000.
Inventory-December 31, 2023 8,500,000
Income summary 8,500,000

Cost-December 31, 2023 8,500,000

Net realizable value 8,400,000
Required allowance - December 31, 2023 100,000
Allowance balance - December 31, 2022 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 write down is presented as a deduction from
cost of goods sold. Direct Method Allowance Method
Inventory – Dec. 31, 2022 7,850,000 8,000,000
Net Purchase for 2023 30,000,000 30,000,000
Goods Available for Sale 37,850,000 38,000,000
Cost of Good sold before 29,450,000 29,500,000
reversal
Gain on reversal of writedown - (50,000)
Cost of good sold after reversal 29,450,000 29,450,000
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 – Jan . 1 4,500,000
Net Purchases 20,000,000
Goods Available for Sale 24,500,000
Inventory (5,300,000)
Cost of Good Sold 19,200,000

Note that under direct method, the inventory, whether beginning or ending, is
presented at the lower amount.
Allowance Method
Inventory – Jan . 1 at cost 5,000,000
Net Purchases 20,000,000
Goods Available for Sale 25,000,000
Inventory – Dec. 31 at cost (6,000,000)
Cost of Good Sold before inventory writedown 19,000,000
Loss on inventory writedown for the current year 200,000
Cost of goods sold after inventory writedown 19,200,000
Required Allowance – Dec. 31 (6,000,000-5,300,000) 700,000
Required allowance – Jan 1 (5,000,000 – 4,500,000 500,000
Increase in allowance – loss on inventory writedown 200,000
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 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 noncancelable 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 a purchase commitment must be noncancelable 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 loss on purchase commitment.
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 of P600,000.
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 of P500,000.
As a simple guide, the actual purchase is recorded at the lower between the amount of
purchase commitment and the current replacement cost or current market price.
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. The gain on purchase commitment is classified
as other income.
Disclosures about inventories
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
classifications appropriate to the entity.
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 write down that is recognized as income.
g. The carrying amount of inventories pledged as security for liabilities.
Agricultural, forest and mineral products
Inventories of agricultural, forest and mineral products are measured at net
realizable value at certain stages of production. 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
Commodities of broker-traders are measured at fair value less cost of disposal.
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.
Thank you!