Subject 4. Inventory adjustments

Under IAS 2, inventories are reported at the lower of cost or net realizable value (NRV).

  • If inventory declines in value below its original cost for whatever reason (obsolescence, price-level changes, damaged goods, etc.), the inventory should be written down to reflect this. If the NRV is lower than the cost, the ending inventory is written down to the NRV. The loss then is charged against revenues as an expense in the period in which the loss occurs, not in the period in which it is sold. However, if the NRV is higher than the cost, nothing is done. The increases in the value of the inventory are recognized only at the point of sale.
  • A reversal (up to the amount of original write-down) is required if the inventory value goes up later.
  • The amount of any reversal is recognized as a reduction in cost of sales.
  • This rule can be applied either directly to each inventory item, to each category, or to the total of the inventory. The most common practice is to price the inventory on an item-by-item basis.

IAS 2 does not apply to the measurement of inventories held by producers of agricultural and forest products, mineral products, commodity brokers and dealers. Their inventories are measured at net realizable value (above or below cost) in accordance with well-established practices in those industries.

Similarly, GAAP requires the use of the lower-of-cost-or-market valuation basis (LCM) for inventories, with market value defined as replacement cost. Reversal is prohibited, however. The LCM valuation basis follows the principle of conservatism (on both the balance sheet and income statement) since it recognizes losses or declines in market value as they occur, where increases are reported only when inventory is sold.

Here are some relevant terms:

  • Net realizable value: Estimated Selling Price less estimated costs of completion and necessary to make the sale.
  • Historical cost: The cash equivalent price of goods or services at the date of acquisition.
  • Market value (Replacement cost): The cost that would be required to replace an existing asset.
  • Fair value: The amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm's length transaction.

Example

Historical cost: $5,000.
Market cost: $2,000.
Estimated selling price: 4,000.
Estimated costs to complete sale: 1,000.
Net realizable value: 4,000 - 1,000 = $3,000.

  • Inventory Valuation under IAS 2: $3,000 (the lower of historical cost and NRV).
  • Inventory Valuation under U.S. GAAP: $2,000 (the lower of historical cost and market cost).

Now assume NRV increases from $3,000 to $4,000, and the market cost increases from $2,000 to $3,000.

  • Under IAS 2, $1,000 of original write-down may be recovered to bring NRV up from $3,000 to $4,000. Note that reversals are limited to the amount of the original write-down ($2,000).
  • Under U.S. GAAP, the value of inventory is $2,000 even though the new market value is $3,000. No adjustment is made and reversal is prohibited.

Practice Question 1

"Valuation of inventory at the lower of cost or market" abandons which of the following accounting principle?

A. historical cost.
B. consistency.
C. conservatism.
Correct Answer: A

The general rule is that the historical cost principle is abandoned when the future utility (revenue-producing ability) of the asset is no longer as great as its original cost.

Practice Question 2

If a company uses FIFO and is experiencing declining inventory replacement prices, it should (under GAAP):

A. use specific identification method to track the declining inventory unit values.
B. change to LIFO to show a lower COGS and higher net income.
C. lower the inventory values to reflect the lower replacement market price.
Correct Answer: C

This is the application of lower-of-cost-or-market rule. Inventory should reflect the cost to replace the product when prices are decreasing and not necessarily the historical cost.

Practice Question 3

A firm uses FIFO to account for its inventory. Recently it found out the market price (of its inventory goods) has gone up by 10%. To reflect the future utility (revenue-producing ability) of the inventory the firm should:

A. adjust inventory 10% higher to reflect the current market prices.
B. adjust COGS 10% higher to reflect the current market prices.
C. change to LIFO to take advantage of tax savings.
D. make no adjustments.
Correct Answer: D

According to the lower-of-cost-or-market theory, the firm should not make any adjustments when the replacement market prices are higher than the current value for inventory.

Practice Question 4

Today's Technology, Inc. manufactures personal computers. At the end of 2010, the cost of their computer parts inventory is $ 815,500 while the market value of the inventory $ 775,000. Expected selling related costs for the inventory amount are approximately 1% of cost or $ 8,155. Which of the following is the correct valuation of the inventory at the end of 2010?

A. $ 807,345
B. $ 775,000
C. None of the above- the inventory would be carried at its discounted present value
Correct Answer: B

At year end, if market prices are lower than historical costs, the inventory is carried at the current market price. This is an application of the conservatism principle.

Practice Question 5

The reporting of inventory values at the lower of cost or market reflects the accounting principle or convention of ______.

A. cost principle.
B. materiality.
C. conservatism.
Correct Answer: C

The reporting of inventory values at the lower of cost or market reflects the accounting convention of conservatism. Conservatism requires that a company be careful not to overstate assets or understate liabilities on the balance sheet.

Practice Question 6

The amount of the inventory write-down:

I. reduces net income.
II. reduces assets.
III. reduces stockholder's equity.
Correct Answer: I, II and III

Practice Question 7

In 2007 the book value of a company's inventory was $5 million before a $0.3 million write-down was recorded. In 2008, the fair value of the company's inventory was $0.5 million greater than the carrying value. Which of the following statements is (are) false (under IFRS)?

I. In 2007 the company's COGS would increase by $0.3 million due to the write-down.
II. In 2008 the company's COGS would decrease by $0.5 million due to the reversal.
III. In 2008 the company would record a $0.3 million recovery as a gain.
IV. In 2007 the company would record a $0.3 million loss due to the write-down.
Correct Answer: II only

The company is limited to a $0.3 million recovery as it's the original write-down.

Practice Question 8

Inventory can be written down to the lower of cost or market value if its value declines due to:
I. obsolescence.
II. price-level changes.
III. damage.
IV. any reason.

A. I and II only.
B. I and III only.
C. I, II, III, IV.
Correct Answer: C

The inventory should be written down to reflect the loss if its value declines below its original cost for whatever the reason.

Practice Question 9

Lower of cost or market rule can be applied directly to:

A. each inventory item/category only.
B. total inventory only.
C. all of them (item, category or total).
Correct Answer: C

The most common practice is to price the inventory on an item-by-item basis. Whichever method is selected, it should be applied consistently from one period to another.

Practice Question 10

An item of inventory with an invoice price of $80, on which 50% is added as markup, has a current replacement cost of $82. Under LCM, which amount should be used to determine the value of this item of inventory?

A. $123.
B. $80.
C. $82.
Correct Answer: B

Under LCM, the lower of cost or market is used. In this case, cost ($80) is lower than market ($82).

Practice Question 11

U.S. GAAP requires that inventories are:

A. stated at replacement value.
B. stated at lower of cost or market.
C. stated either at cost or market value, but the company must be consistent in which method they use.
Correct Answer: B

Inventories must be stated at lower of cost or market value. Market value is defined as replacement cost.

Practice Question 12

In 2007 the book value of a company's inventory was $5 million before a $0.3 million write-down was recorded. In 2008, the fair value of the company's inventory was $0.5 million greater than the carrying value. Which of the following statements is (are) correct (under the U.S. GAAP)?

I. In 2007 the company's COGS would increase by $0.3 million due to the write-down.
II. In 2008 the company's COGS would decrease by $0.5 million due to the reversal.
III. In 2008 the company would record a $0.3 million recovery as a gain.
IV. In 2007 the company would record a $0.3 million loss due to the write-down.

A. I, III and IV
B. I and IV
C. I and II
Correct Answer: B

Reversal of a write-down is prohibited under the U.S. GAAP.

Practice Question 13

Inventories valued using ______ are least likely to incur inventory write-downs.

A. FIFO.
B. LIFO.
C. Weighted average cost.
Correct Answer: B

The inventory carrying amounts under the LIFO method are already conservatively presented at the oldest and lowest costs (given increasing inventory costs).