Measurement of Inventory at the Lower of Cost and Net Realisable Value

Under IFRS, inventories may be measured and carried on the balance sheet at a lower cost and net realizable value. US GAAP, on the other hand, specifies the lower cost or market to value inventories. Market value, for this purpose, is defined as the current replacement cost subject to upper and lower limits.

The net realizable value is defined as the estimated selling price in the ordinary course of business less the estimated costs necessary to make the sale and estimated costs to get the inventory in condition for sale.

Measurement of Inventory at Lower of Cost and Net Realizable Value

The assessment of net realizable value under IFRS is typically done either item by item or by groups of similar or related items. If the value of inventory declines below the carrying amount on the balance sheet, the inventory carrying amount must be written down to its net realizable value. In addition, the loss should be recognized as an expense on the income statement. This expense can be included as part of the cost of sales or reported separately.

A new assessment of net realizable value should be made in each subsequent period. Reversal, which is limited to the amount of the original write-down, is required for a subsequent increase in the value of inventory that was previously written down. The reversal of any write-down of inventories is recognized as a reduction in the cost of sales.

US GAAP, although broadly consistent with IFRS, prohibits the reversal of write-downs. The market value cannot exceed the net realizable value given the fact that the lower limit is the net realizable value less a normal profit margin.

Question 1

Which of the following statements is least accurate?

1. The reversal of write-downs is prohibited under US GAAP.
2. The assessment of net realizable value is usually done either item by item or by groups of similar or related items.
3. The lower of cost method refers to the estimated selling price in the ordinary course of business less the estimated costs necessary to make the sale and estimated costs to get the inventory in condition for sale.

Solution

The correct answer is C.

The net realizable value, not the lower of cost method, refers to the estimated selling price in the ordinary course of business less the estimated costs necessary to make the sale and estimated costs to get the inventory in condition for sale.

Options A and B provide accurate statements.

Question 2

To find the net realizable value of a company’s inventory, which of the following items ought to be deducted from the inventory’s expected selling price?

1. Selling costs.
2. Costs required to convert inventory into a sellable condition.
3. Both selling costs and costs required to convert inventory into a sellable condition.

Solution

The correct answer is C.

The net realizable value of a company’s inventory could be figured out using the following equation:

Net realizable value = Selling price in an arm’s length transaction – Cost of sales – Cost required to convert inventory to sellable condition