Los G and H requires us to:
g. describe the measurement of inventory at the lower of cost and net realizable value.
h. describe implications of valuing inventory at net realizable value for financial
statements and ratios.
a. As per the IFRS:
i. The inventory should be reported at a lower of cost or realizable value.
ii. The net realizable value is the selling price (i.e. the consideration receivable on sale) as reduced by the selling cost (it is the extra cost that is incurred in bringing the finished goods into the saleable condition, for example, commissions, extra packaging cost, delivery charges, etc.).
iii. If at any point in time, the net realizable value is less than the cost of goods, then the inventory should be written down. And the loss on writing down of the inventory should be recognized on the income statement either as cost of goods sold (this is acceptable under GAAP as well) or as a separate item of expense in the income statement.
iv. Under the IFRS, while writing down the inventory an ‘inventory valuation allowance account’ may also be created and used. The journal entry for writing down the value of inventory using this account would be:
|
Date |
Particulars |
LF |
Debit |
Credit |
|
xx-xx-xx |
Cost of goods sold |
xxx |
||
|
Inventory valuation allowance account |
xxx |
b. IFRS also allows the upward revaluation of inventory, if there is an increase in the value of inventory at a subsequent date. However, such revaluation is limited up to the amount lying in a credit of the inventory revaluation allowance account. The journal entry for such revaluation is:
|
Date |
Particulars |
LF |
Debit |
Credit |
|
xx-xx-xx |
Inventory valuation allowance account |
xxx |
||
|
Cost of goods sold |
xxx |
c. As per U. S. GAAP:
i. Inventory should be recognized at the lower of its cost or market value.
ii. The market value, as per the GAAP is the replacement cost lies in the range of ‘net realizable value’ and ‘net realizable value minus the normal profit margin’. That is, the market value cannot be higher than the ‘net realizable value of the inventory and it cannot be lower than the ‘net realizable value minus the normal profit margin’.
iii. If the value of the inventory goes beyond the range then it should be adjusted upwards or downwards to reach within range.
iv. If at any point in time, the market value is less than the market value it must be written down either as the cost of goods sold or as a separate expense item. The journal entry to write off the value of inventory is:
|
Date |
Particulars |
LF |
Debit |
Credit |
|
xx-xx-xx |
Cost of goods sold |
xxx |
||
|
Inventory |
xxx |
d. Inventory once written down cannot be reversed under GAAP.
e. The companies that are using specific identification methods, FIFO, or average cost methods are most likely to incur write-downs in comparison to the companies that are using the LIFO method. This is mainly because LIFO anyways uses the oldest inventory prices.
f. For certain specific types of businesses, such as agricultural products, precious metals, and mining products, etc., the inventories are always recognized at net realizable value and not at cost.
If there is an active market for the quoted price is considered as the net realizable value. Otherwise, the most recent market transaction price is considered as the realizable value.
The gains or losses on the valuation and revaluation of inventory should be recognized as profits or losses in the period of change.
|
Example Suppose in the year 20×1 the value of ending inventory (at cost) is $ 5,500,000. Its Net realizable value (NRV) is $ 5,100,000 and the replacement cost is $ 5,000,000. In the next year, the net realizable value exceeds the carrying value by $ 500,000. The treatment of inventory under IFRS would be: · In the year 20×1: o The value of ending inventory should be recognized at the lower of NRV or cost, which is a cost in this case ($ 5,100,000). It should, therefore, be written down by $ 400,000. o The journal entry for the write-down of inventory would be:
· In the next year, i.e. 20×2: o Since the NRV exceeds the carrying amount, the inventory should be revalued upwards. The difference between the carrying amount and the NRV is $ 500,000, but the amount of revaluation upwards is restricted up to the amount lying to the credit in the ‘inventory valuation allowance account’. Thus the revaluation would be by the amount of $ 400,000 only. o The journal entry for the revaluation upwards would be:
The treatment under U.S. GAAP would be: · In the year 20×1: o The inventory should be valued at a lower of cost or market value. o The market value would be the replacement cost if it lies in the range of: § NRV, which is $ 5,100,000; and § NRV minus profit margin, which is $ 4,700,000 (i.e. $ 5,100,000 – $ 400,000) Therefore, the market value is the replacement cost of $ 5,000,000 o Therefore the inventory would be written down by $ 500,000. And the journal entry for the same would be:
· Since the revaluation upwards is not permitted under U.S. GAAP, there would be no treatment for the rise in the value of inventory in the year 20×2. |
Effects of Inventory Write-Downs on Ratios & Financial Statements
a. Inventory write-down reduces the amounts of profits and the carrying amount of inventory.
b. Thus, the inventory write-down has a negative impact on:
i. the profitability ratios, as there is a drop in the amount of profits (which forms the numerator in these ratios, while the denominator remains unchanged),
ii. the liquidity ratios, as the amount of current assets decreases (which is usually the numerator in such ratios) and the liabilities side, remain unchanged (which is the denominator), and
iii. the solvency ratios, as the debt remains unchanged and the amount of equity drops.
c. There would, however, be a positive impact on the activity ratios, as there increase in the value of COGS (which is the numerator) and there is a fall in the value of assets (which is the denominator).