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Chapter 3.2® - Example of Net Realizable Value less a Normal Profit Margin, Market equals = Net Realizable value or Market equals net realizable value minus a normal Profit Margin

Let’s consider an example where we lower the carrying value of inventory using the net realizable value less a normal profit margin method. Consider a sporting goods company owns shoes worth \$13,500 at December 31st, 2009; these shoes have a selling value of \$15,000. The estimated cost of bringing these shoes to its stores for resale is \$300 and a normal profit margin is 20%. How do we determine “market” in such a case?

 Sales value of Inventory \$15,000 Less: Estimated cost of bringing shoes to stores (\$300) Net Realizable Value \$14,700 Less: Normal profit margin (10% x \$15,000) (\$1,500) Net realizable value less a normal profit margin \$13,200 This pie graph shows a break down of the sales value of inventory less estimated costs of bringing the shoe inventory to stores & the net realizable value. A normal profit margin is deducted of the net realizable value to arrive at 'net realizable value less a normal profit margin.'

Let's consider 2 scenarios where in i) Market equals Net Realizable value and ii) Market equals net realizable value minus a normal profit margin.

i) Market equals = Net Realizable value

If market equals the net realizable value alone, then we see that with an original purchasing cost of \$13,500, there will be a \$1,200 gain reported on the income statement, in the form of reduced cost of goods sold (\$13,500 - \$14,700) because instead of reporting Cost of Goods Sold of \$14,700 which is the market, we will recognize the original purchasing cost of \$13,500 as COGS and deduct this from Net Sales. In 2011, when we record \$13,500 as the cost of inventory (due to lower of cost or market with cost being lower at \$13,500), we will realize a gain of \$1,200 on the shoes inventory after deducting the cost of resale of \$300.

 Inventory Value December 31st, 2010 Balance Sheet Profit / Loss Recognition on the Income Statement a) If Market = NRV In 2010 In 2011 Cost = \$13,500 Market = \$14,700 LCM = \$13,500 \$13,500 Effect on 2010 Income Statement (\$13,500 - \$14,700) \$1,200 Profit Effect on 2011 Income Statement (when Inventory is sold) Revenue ----> \$15,000 Cost of Inventory > (\$13,500) Cost of Resale ---> (\$300) Profit --------> \$1,200

ii) Market equals = Net Realizable Value minus a Normal Profit Margin

In the second example where market equals the net realizable value minus a profit margin, there will be a \$300 loss reported on the income statement in 2010 because we are using the lower of cost (\$13,500) or market (\$13,200), thus we are using the market. Notice however that we benefit in 2011 because when subtracting this \$13,200 market from revenue, we derive a profit of \$1,500. If we had used the higher cost of \$13,500, we would be short \$300 profit because the calculations would look like:

 Inventory Value December 31st, 2010 Balance Sheet Profit / Loss Recognition on the Income Statement b) If Market = NRV minus a normal profit margin In 2010 In 2011 Cost = \$13,500 Market = \$13,200 LCM = \$13,200 \$13,200 Effect on 2010 Income Statement (\$13,500 - \$13,200) \$300 Loss Effect on 2011 Income Statement (when Inventory is sold) Revenue ----> \$15,000 Cost of Inventory > (\$13,200) Cost of Resale ---> (\$300) Profit --------> \$1,500