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CHAPTER 9
Inventories: Additional Valuation Issues
LEARNING OBJECTIVES
1. Describe and apply the lower-of-cost-or-net realizable value rule.
2. Identify other inventory valuation issues.
CHAPTER REVIEW
1. Chapter 9 concludes the discussion of inventories by addressing certain unique valuation
Lower-of-Cost-or-Net Realizable Value (LCNRV)
2. (L.O. 1) When the future revenue-producing ability associated with inventory is below its
original cost, the inventory should be written down to reflect this loss. Thus, the historical
3. The term “net realizable value” is the difference between the estimated selling price of
4. For example, consider the following illustration:
Historical cost .............................................. €190
5. The LCNRV rule may be applied (a) on an item-by-item basis, (b) on a group basis,
6. Two methods may be used to record inventory at net realizable value. The two methods
are the cost-of-goods-sold method and the loss method. The cost-of-goods-sold
7. Instead of crediting the inventory account for net realizable adjustments, companies
generally use an allowance account, Allowance to Reduce Inventory to Net Realizable
8. In periods following a write-down, the net realizable value of inventory previously written
9. The LCNRV rule suffers some conceptual deficiencies: (a) the decrease in the value of
the inventory and the loss are recognized in the period of the loss, not the period of sale.
Valuation Bases
10. There are some situations where companies depart from the LCNRV rule. Such treatment
may be justified in situations where cost is difficult to determine, the items are readily
11. Under IFRS net realizable value measurement is used for inventory when the inventory is
12. Biological assets are measured at initial recognition and at the end of each reporting
13. Agricultural produce (which is harvested from biological assets) is measured at NRV
(fair value less cost to sell) at the point of harvest. The NRV debited to an inventory account
14. Commodity broker-traders buy and sell commodities (e.g., grains, precious metals, oil,
etc.) for others or on their own account in order to generate profit from fluctuations in
Other Inventory Valuation Issues
15. (L.O. 2) When a group of varying inventory items is purchased for a lump sum price,
16. Purchase commitments represent contracts for the purchase of inventory at
a specified price in a future period. If material, the details of the contract should be disclosed
The Gross Profit Method
17. (L.O. 3) The gross profit method is used to estimate the amount of ending inventory. Its
use is not appropriate for financial reporting purposes; however, it can serve a useful
purpose when an approximation of ending inventory is needed. Such approximations are
18. The major disadvantages of the gross profit method are: (a) it provides an estimate,
therefore companies must take a physical count to verify the inventory; (b) it uses past
19. (L.O. 4) The retail inventory method is an inventory estimation technique based upon
an observable pattern between cost and sales price that exists in most retail concerns.
20. Basically, the retail method requires the computation of the cost-to-retail ratio of inventory
available for sale. This ratio is computed by dividing the cost of the goods available for
sale by the retail value (selling price) of goods available for sale. Once the ratio is
21. To obtain the appropriate inventory figures under the retail inventory method, proper
22. When the cost-to-retail ratio is computed after net markups (markups less markup
cancellations) have been added, the retail inventory method approximates lower of cost
23. The retail inventory method becomes more complicated when such items as freight-in,
purchase returns and allowances, and purchase discounts are involved. In essence,
24. Other items that require careful consideration include transfers-in, normal shortages,
abnormal shortages, and employee discounts. Transfers-in from another department
25. The retail inventory method is widely used (a) to permit the computation of net income without
a physical count of inventory, (b) as a control measure in determining inventory shortages,
Presentation and Analysis
26. (L.O. 5) Inventories normally represent one of the most significant assets held by a
business entity. Therefore, the accounting profession has mandated certain disclosure
LECTURE OUTLINE
This chapter describes inventory valuation problems and estimation techniques. The chapter
can be covered in three to four class sessions.
Emphasize that the Chapter 9 inventory techniques do not represent complete departures from
the FIFO and average cost bases of valuing inventory. For example, the LCNRV rule results in
The following lecture outline is appropriate for this chapter.
A. (L.O. 1) Lower-of-Cost-or-Net Realizable Value (LCNRV)
1. The general rule is that the historical cost principle is abandoned when the future utility
of the asset is no longer as great as its original cost.
4. Companies may apply the LCNRV rule using one of three methods:
a. An item-by-item basis, which produces the lowest valuation, and is most often used.
5. There are two methods that can be used to record inventory at NRV.
a. The cost-of-goods-sold method, which records the loss directly to the Cost of
6. An allowance account, “Allowance to Reduce Inventory to Net Realizable Value” is
used instead of crediting the Inventory account for the write-down.
a. The entry to record the write-down is:
7. If NRV increases in subsequent periods, the amount of the write-down is reversed. The
journal entry is:
8. The LCNRV rule suffers some conceptual deficiencies:
a. The decrease in the value of the asset and the charges to expense are
recognized in the period in which the loss in value occurs, not the period of sale.
B. Other Inventory Valuation Bases.
1. Agricultural Inventory. Under IFRS, net realizable value measurement is used for
inventory related to agricultural activity.
2. Biological asset (a long-term asset) is a living animal or plant.
4. Commodity broker-traders buy and sell commodities for others and themselves to
generate a profit from fluctuations in price.
5. (L.O. 2) Valuation using the relative standalone sales value method—When several
6. Purchase Commitments.
b. Accounting for formal purchase orders for which a firm price has been
established:
(1) If the market price exceeds the contract price—disclose the existence of the
contract in the notes, if material.
(2) If the market price is less than the contract price—
(a) Debit a loss account and credit a liability account (Purchase Commitment
Liability).
C. (L.O. 3) The Gross Profit Method.
1. This method is used when an estimate of a firm’s inventory is required. The resulting
estimate is acceptable for interim reporting purposes but not generally for annual
reporting.
2. Point out that four items of information are sufficient to estimate the cost of ending
inventory:
3. Point out that in this context the terms “gross margin,” “gross profit,” and “markup” are
synonymous. Discuss the distinction between markup expressed as a percentage of
cost and markup expressed as a percentage of sales. Describe how the percentage
markup is computed.
4. Describe how to convert a markup on cost to a markup on sales.
a. From markup on cost to markup on sales.
b. From markup on sales to markup on cost.
5. Appraisal of the gross profit method.
D. (L.O. 4) The Retail Inventory Method.
1. Like the gross profit method, the retail inventory method provides an estimate of ending
2. More detailed records are required for the retail inventory method than for the gross
profit method. Under the retail inventory method, records must be kept of the following.
3. Variations of the retail inventory method:
(1) either of the major inventory cost flow assumptions: FIFO or Average.
4. The conventional method computes the cost-to-retail ratio after markups and markup
cancellations but before markdowns. It approximates the lower-of-average-cost-or-net
realizable value.
5. The cost method computes the cost-to-retail ratio after both net markups and net
markdowns. It approximates cost.
6. Special items related to computing the cost-to-retail ratio and ending inventory at retail
are as follows:
a. Freight costs are part of the purchase cost.
b. Purchase returns are deducted under both the cost and retail columns.
7. Point out that there are three basic steps in computing ending inventory using the retail
method.
a. Compute ending inventory at retail. This step is the same for either method.
8. Appraisal of the Retail Inventory Method.
a. The method permits:
(1) the computation of net income without a physical count of inventory.
b. The method has an averaging effect on varying rates of gross margin. Problems
may arise when the averages being used are not reflective of underlying conditions.
E. (L.O. 5) Presentation and Analysis
1. IFRS require the following disclosures:
a. The accounting policies adopted for measuring inventories.
b. The total carrying amount of inventories and the carrying amount in classifications.
2. There are two ratios related to inventory management.
a. Inventory turnover, which measures the number of times on average a
company, sells inventory during the period.
b. Average days to sell inventory represents the average number of days inventory
is held.
