Inventory valuation

The previous sections of the inventory chapter discuss the costs included in inventory.

In summary, the inventory account should initially be valued at cost. If there are no special circumstances affecting the value of the inventory that the company is holding, the inventory will continue to be valued at cost and when they are sold, this cost value will go to the cost of goods sold.

However, at certain instances, inventories can be damaged or obsolete. In this case, the company is not anymore able to sell the inventory in the intended original state resulting in expected revenues from selling the inventories to be lower than its cost. When this happens, it is important to recognize this loss as it happens by reducing the value of inventories in the balance sheet.

This process is called inventory valuation, which is part of the subsequent measurement of inventories under US GAAP.

The rules for inventory valuation depend on which cost flow assumption is used by the company:

Method	Applicable for cost flow assumptions	Valuation method
Method 1: Lower of cost or net realizable value (LCNRV)	FIFO, Average method, Moving average method, Specific identification	The lower of between the: Cost Net realizable value (NRV) (NRV = selling price less costs to complete and sell)
Method 2: Lower of cost or market (LCM)	LIFO, Retail inventory method **	The lower between the: Cost Market value. The market value is further defined as the median of: NRV Replacement cost NRV less normal profit margin

** The retail inventory method is a method of costing inventories used by department stores that tracks inventory costs using the retail value and applying the cost/retail ratio. This is not covered by the CMA exams so it is not discussed in detail.

When the NRV (from Method 1) or market value (from Method 2) is lower than the recorded cost of the inventory, the inventory should be written down to avoid overstating the assets of the company. The journal entry to record the write-down the inventory is as follows:

Account	Debit	Credit	Financial statement element
Loss on inventory write-down	XXX		Loss
Inventory		XXX	Asset
To record inventory write-down

It is also acceptable to debit the write-down to cost of goods sold (COGS). It depends on the policy of the company.

When comparing US GAAP versus IFRS, the following should be noted:

• The “lower of cost or market value method” is only used in US GAAP and not under IFRS. This makes sense because LIFO is not allowed under IFRS. Only lower of cost or NRV is being used for inventory valuation under IFRS
• Impairments of inventory in the previous periods can be recovered (i.e., reversed) under IFRS. However, this is prohibited in US GAAP.

Sample situation

An example situation is provided below. We need to determine the inventory value using the two different methods discussed.

The ending inventory of Achievable Co. is composed of the following:

Product	Selling price (in $)	Profit margin (in %)	Profit margin (in $)	Cost (in $)	Replacement cost (in $)	Selling cost (in $)
Item 1	200	15%	30	180	160	30
Item 2	300	10%	30	250	270	20
Item 3	500	20%	100	400	380	70
Item 4	350	10%	35	320	315	50
Item 5	250	10%	25	210	190	20

Method 1: Lower of cost and net realizable value (LCNRV)

If the company is using cost flow assumptions other than LIFO or the retail method, the LCNRV method should be used.

Definitions

Net realizable value (NRV)

This term means the selling price less costs to complete and sell.

Under the LCNRV, the only relevant inputs are the following:

• Cost
• Selling price
• Costs to complete
• Costs to sell

In this example, there are no costs to complete the inventory. All other inputs should be ignored.

The analysis can be done on the inventory as a whole or per inventory item. When done per inventory item, this will result in the lowest amount of inventory since there is no possible offsetting of impacts. We will present the solution by analyzing the valuation per inventory item which is the recommended way to do it when the problem is silent in the CMA exam.

Product	Selling price (in $)	Selling cost (in $)	NRV (SP - SC)	Cost (in $)	Lower amount	Cost to record
1	200	30	170	180	NRV	170
2	300	20	280	250	Cost	250
3	500	70	430	400	Cost	400
4	350	50	300	320	NRV	300
5	250	20	230	210	Cost	210
			1,410	1,360		1,330

The total inventory should be valued at $1,330 based on the LCNRV method applied per inventory item. Since the total cost is at $1,360, inventory should be written down by $30. The write-down is recorded as follows:

Account	Debit	Credit	Financial statement element
Loss on inventory write-down	$30		Loss
Inventory		$30	Asset
To record inventory write-down

You should notice that if we apply the LCNRV to the total of the inventory items, there should be no inventory write-down because of the offsetting impacts.

Method 2: Lower of cost or market (LCM)

If the company is using LIFO or the retail method, the LCM method should be used. For this method, the following inputs are needed:

• Cost
• NRV
• Replacement cost
• NRV less normal profit margin

Definitions

Market value

For purposes of inventory valuation, this term means the median of:

• NRV
• Replacement cost, and
• NRV less profit margin

Net realizable value (NRV)

Selling price less costs to complete and sell. This is the same definition as LCNRV. Under LCM method, the NRV becomes the maximum amount of designated market value.

Replacement cost

Or the cost to purchase the inventory currently.

NRV less normal profit margin

Under LCM method, this becomes the minimum amount of designated market value.

As with LCNRV, the LCM analysis can be done per inventory item or on the inventory as a whole; we’ll again analyze it per item, since that’s the recommended approach when the problem is silent.

Steps in the LCM method

Step 1:

Calculate the designated market value as the middle value of the three amounts:

• NRV (the “ceiling”)
• Replacement cost
• NRV less normal profit margin (the “floor”)

The amount selected must be the exact amount in between and not the average of the three. See example solution below.

Step 2:

Compare the designated market value to the cost. Any amounts lower than cost require a write-down.

Pitfall: Don’t default to replacement cost as the designated market value. Replacement cost is only used when it falls between the ceiling (NRV) and the floor (NRV less normal profit margin). If replacement cost falls outside that range, the designated market value is whichever of the ceiling or floor is closer - see Item 5 below, where replacement cost ($190) falls below the floor ($205), so the floor itself becomes the designated market value.

					LCM inputs			Designated market value
Product	Cost (in $)	Selling price (in $)	Selling cost (in $)	Profit margin (in $)	NRV (SP - SC) (in $)	Replacement cost	NRV less profit margin	Designated MV (Median)	Designated MV (in $)	LCM
Item 1	180	200	30	30	170	160	140	Replacement cost	160	160
Item 2	250	300	20	30	280	270	250	Replacement cost	270	250
Item 3	400	500	70	100	430	380	330	Replacement cost	380	380
Item 4	320	350	50	35	300	315	265	NRV	300	300
Item 5	210	250	20	25	230	190	205	NRV less profit margin	205	205
	1,360								1,315	1,295

Based on the above (see last column), the inventory should be valued at $1,295, while the cost recorded (see second column) in the books is $1,360. This means that the inventory should be written down by $65. The following journal entry is required to record the write-down:

Account	Debit	Credit	Financial statement element
Loss on inventory write-down	$65		Loss
Inventory		$65	Asset
To record inventory write-down

You should notice that if we apply the LCM to the total of the inventory items, the offsetting impacts shrink the write-down but do not eliminate it: the total cost of $1,360 still exceeds the total designated market value of $1,315, giving a $45 write-down rather than the $65 computed item by item.