| LO3 – Explain and calculate lower of cost and net realizable value inventory adjustments. |
In addition to the adjusting entry to record the shrinkage of merchandize inventory (discussed in Chapter 5), there is an additional adjusting entry to be considered at the end of the accounting period when calculating cost of goods sold and ending inventory values for the financial statements. Generally accepted accounting principles require that inventory be valued at the lesser amount of its laid-down cost and the amount for which it can likely be sold—its net realizable value(NRV). This concept is known as the lower of cost and net realizable value, or LCNRV. Laid-down cost includes the invoice price of the goods (less any purchase discounts) plus transportation in, insurance while in transit, and any other expenditure made by the purchaser to get the merchandize to the place of business and ready for sale.
As an example of LCNRV, a change in consumer demand may mean that inventories become obsolete and need to be reduced in value below the purchase cost. This often occurs in the electronics industry as new and more popular products are introduced.
The lower of cost and net realizable value can be applied to individual inventory items or groups of similar items. Assume two types of inventory for a paper supply company, as shown in Figure 6.15 below.
Depending on the calculation used, the valuation of ending inventory will be either $2,600 or $2,650. Under the unit basis, the lower of cost and net realizable value is selected for each item: $1,200 for white paper and $1,400 for coloured paper, for a total LCNRV of $2,600. Because the LCNRV is lower than cost, an adjusting entry must be recorded as follows.
The purpose of the adjusting entry is to ensure that inventory is not overstated on the balance sheet and that income is not overstated on the income statement.
If white paper and coloured paper are considered a similar group, the calculations in Figure 6.15 above show they have a combined cost of $2,650 and a combined net realizable value of $2,700. LCNRV would therefore be $2,650. In this case, the cost is equal to the LCNRV so no adjusting entry would be required if applying LCNRV on a group basis.
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