Inventory valuation

Inventory is first recorded at cost, and that cost moves to cost of goods sold when the goods are sold. If inventory becomes damaged or obsolete, the company may expect to collect less than its cost. U.S. GAAP then requires the loss to be recognized right away by writing the inventory down on 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 and net realizable value (LCNRV)	FIFO, Average method, Moving average method, Specific identification	The lower of: Cost Net realizable value (NRV)
Method 2: Lower of cost or market (LCM)	LIFO, Retail inventory method **	The lower of: 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. The mechanics of the retail method are beyond this chapter; just remember that inventory costed with it is valued at lower of cost or market.

When the NRV (Method 1) or market value (Method 2) is below recorded cost, the inventory is written down by debiting a loss on inventory write-down (or cost of goods sold, depending on company policy) and crediting inventory.

When comparing US GAAP to IFRS for inventory valuation:

Pitfall: IFRS uses lower of cost and NRV for all inventory (LIFO isn’t allowed under IFRS), and a prior write-down can be reversed if the inventory’s value recovers. US GAAP uses LCM only for inventory costed under LIFO or the retail method, and a write-down is never reversed, no matter which method was used.

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.

Definitions

Market value

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

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

Replacement cost

Or the cost to purchase the inventory currently.

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.

Product	Cost (in $)	NRV	Replacement cost	NRV less profit margin	Designated market value	LCM
Item 1	180	170	160	140	160 (replacement cost)	160
Item 2	250	280	270	250	270 (replacement cost)	250
Item 3	400	430	380	330	380 (replacement cost)	380
Item 4	320	300	315	265	300 (NRV)	300
Item 5	210	230	190	205	205 (NRV less profit margin)	205
Total	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.