Chapter 3.1® - Inventory Valuation & Estimation – Lower of Cost or Market, Example & Illustration of Net Realizable Value, Market Replacement Cost
We already know that inventory is initially recorded at original cost (the cost at which the inventory was bought at or acquired). However, the historical cost principle is pushed aside if inventory declines in value below its original cost, thus causing impairment in its value. The reason for such a decline could be among many including obsolescence, damaged inventory, inventory destroyed by natural disaster/fire/earthquake, price-level changes, etc. If any of these factors occur, then the general rule is that the historical cost principle is adjusted when the asset’s future utility (its ability to generate future cash flows) is no longer as great as its original cost. Inventories that decline in value or utility should thus be recorded at lower of cost or market, instead of the original acquisition/buying cost (as the historical cost principle suggests).
A departure from historical cost principle can be justified for two main reasons. One of them is that investors reading the financial statements assume the current assets reported on the balance sheet can be converted in to at least as much cash as the value reported for them on the balance sheet. Thus if the total value of the inventory is $28 million, then investors will assume that inventory can be sold for $28 million or around the number. The second reason is that the matching principle requires that a loss of utility be charged against revenues in the period in which the loss occurs, not in the period in which the inventory is sold. Also, the lower of cost or market is a conservative approach to inventory valuation in such circumstances, and that is the topic of this chapter. Lower of cost or market valuation method assumes that if there is a doubt about an asset’s value, it is preferable to undervalue it, rather than overvalue it.
What is the meaning of “Lower of Cost or Market”?
Cost refers to the acquisition price of inventory calculated using one of the historical cost principle methods such as specific identification, LIFO/FIFO or Average cost. The term market however refers to other more complicated terms including Net realizable value (NRV), replacement cost, etc. Net realizable value (NRV) is the inventory’s estimated selling price in the ordinary operations of the business minus reasonable predictable costs to complete and dispose of the item.
Example & Illustration of Net Realizable Value
Sometimes in calculating LCM, a net realizable value (NRV) minus a normal profit margin can be used. The formula used is:
Consider a video retailer bought some DVDs for resale for $20 each (historical cost). However, the supplier’s catalogue price has now dropped to $15 per DVD – this therefore becomes the current ‘replacement cost.’ Replacement cost refers to the cost at which the retailer can buy more DVDs in the current market environment. Say the profit margin expected to be realized from the sale of these DVDs is 40%, what is the market?
So what would be the cost of inventory reported for these DVDs in the following cases?
So you can see there can be very many variations of the
term “market” including replacement cost, net realizable value
or net realizable value less a normal profit margin. Given the many variations,
what should be used when determining the lower of cost or market? There
is no set answer provided by the CICA, however net realizable value (NRV)
is the most common method of determining market.