Question

Explain how net realizable value (NRV) is calculated and how the lower of cost of net realizable value rule (LCNRV) is applied to valuing inventory.

a) Definition of net realizable value

b) Alternative methods for applying the rule

c) Describe the two alternative methods for recording adjustments under the LCNRV method

d) Assume that a firm has an ending inventory valued at cost of $100,000 and at NRV at $85,000, record the journal entries for each of the two recording options discussed in the text using an allowance instead of booking directly to inventory.

e) If the firm had sales of $150,000 and cost of goods sold before adjustment of $90,000, show the income statement presentation for each of the two methods discussed in the text for recording NRV instead of cost.

f) Show how the balance sheet would present the application of the LCNRV rule given the above informationassuming the use of a valuation allowance.

g) The year following one for which data are presented above, the firm’s ending inventory was value at cost of $125,000 and NRV of $115,000, prepare the journal entries for the cost of goods sold and loss methods that the firm would make at the end of the second year also assuming the use of a valuation allowance account.

Answer 1

Solution

a) Definition of net realizable value

Net realizable value (NRV) is the value of an asset that can be realized upon the sale of the asset, less a reasonable estimate of the costs associated with the eventual sale or disposal of the asset. NRV is a common method used to evaluate an asset's value for inventory accounting. NRV is a valuation method used in both Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS).

b) Alternative methods for applying the LCNRV rule

The lower of cost or net realizable value (LCNRV) method states that when valuing a company's inventory, it is recorded on the balance sheet at either the historical cost or the net realizable value. Historical cost refers to the cost at which the inventory was purchased.

The lower of cost or net realizable value rule traditionally applies to companies whose products become obsolete. The rule also applies to products that lose value, due to a dwindled current market price, which is defined as the current cost of replacing outdated inventory, provided that the market price isn't larger or smaller than the net realizable value, which is essentially the projected selling price minus disposal fees.

c) Describe the two alternative methods for recording adjustments under the LCNRV method

i) Make adjustment in the inventory account directly to record the loss:

If entity choose to record written-down loss directly in inventory account then it has to be credited. However, which account is to be debited depends on the presentation of expenses in income statement and entity’s policy to record such losses. Entity may choose either of the following options:

1. Report the loss as cost of sales/cost of goods sold

2. Report the loss separately

ii) Make contra-asset account to record the loss

This way the original inventory value is kept in records and also lower of cost and NRV rule is achieved because inventory value is reported as a net of inventory account and contra-asset account in the financial statements.On the other hand, its up to entity whether it likes to record loss as part of cost of sales or separately in the income statement. So even in this approach its up to entity which account to debit.