In this video, we walk through 5 FAR practice questions teaching about calculating lower of cost and NRV and lower of cost or market. These questions are from FAR content area 2 on the AICPA CPA exam blueprints: Select Balance Sheet Accounts.
The best way to use this video is to pause each time we get to a new question in the video, and then make your own attempt at the question before watching us go through it.
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Calculating the Carrying Amount of Inventory Using Lower of Cost and NRV and Lower of Cost or Market
Inventory valuation is crucial for financial reporting as it directly affects both the balance sheet and the income statement. Two primary methods for inventory valuation in accordance with GAAP and IFRS are the lower of cost and net realizable value (NRV) and the lower of cost or market (LCM). Each method is used to ensure that inventory is not overstated on financial statements.
Lower of Cost and Net Realizable Value (NRV) Method
The lower of cost and NRV method requires the inventory to be reported at the lower of its historical cost or its net realizable value (NRV).
- Net Realizable Value (NRV):
Net realizable value is defined as the expected selling price of the inventory minus any estimated costs to complete and sell the item. This value reflects the actual cash flow expected from selling the inventory, making it a conservative measure to avoid overvaluation. - Example:
Imagine a company has an inventory item recorded at a historical cost of $100,000. The company expects to sell the item for $130,000 but will incur $20,000 in costs to complete and sell the item. In this case:- NRV Calculation:
NRV = Selling Price – Costs to Complete and Sell
NRV = $130,000 – $20,000 = $110,000 - Carrying Amount:
Since the NRV ($110,000) is higher than the historical cost ($100,000), the inventory is carried at the lower historical cost of $100,000 on the balance sheet.
- NRV Calculation:
Lower of Cost or Market (LCM) Method
The lower of cost or market (LCM) method is slightly more complex because it introduces the concept of market value, which must be compared to a ceiling and a floor to determine the appropriate carrying amount.
- Market Value Definition:
Under LCM, “market value” is defined as the middle value of three values:- Replacement Cost: The cost to purchase or replace the inventory item.
- Ceiling (NRV): The net realizable value, calculated as expected selling price minus the costs to complete and sell.
- Floor: The NRV minus the normal profit margin. This value ensures the inventory is not reported at a value too low to recover its cost.
- Example:
Let’s say a company has the following data for an inventory item:- Historical Cost: $200,000
- Replacement Cost: $175,000
- Expected Selling Price: $250,000
- Estimated Costs to Complete and Sell: $30,000
- Normal Profit Margin: 15%
- Step 1: Calculate Net Realizable Value (NRV)
NRV = Selling Price – Costs to Complete and Sell
NRV = $250,000 – $30,000 = $220,000 - Step 2: Calculate Market Floor
Floor = NRV – (Expected Selling Price * Normal Profit Margin)
Floor = $220,000 – ($250,000 * 15%)
Floor = $220,000 – $37,500 = $182,500 - Step 3: Determine Market Value
Market Value is the middle value of Replacement Cost ($175,000), Ceiling (NRV = $220,000), and Floor ($182,500). In this case, the middle value is $182,500. - Step 4: Compare Market Value to Historical Cost
- Historical Cost: $200,000
- Market Value: $182,500
Choosing Between Lower of Cost and NRV vs. Lower of Cost or Market
The appropriate method depends on the company’s accounting policy and the inventory costing method it uses:
- Lower of Cost and NRV:
Used for FIFO and weighted-average methods under GAAP and all inventory under IFRS. This method simplifies the comparison by focusing only on historical cost and NRV. - Lower of Cost or Market (LCM):
Required for LIFO and retail inventory methods under GAAP. The LCM approach introduces more complexity with the ceiling and floor calculations to ensure that inventory is neither overvalued nor undervalued.
Key Differences Between the Two Methods
- Ceiling and Floor:
LCM introduces the concepts of a market ceiling (NRV) and a market floor (NRV less profit margin), while the lower of cost and NRV method does not require these additional calculations. - Application:
Lower of cost and NRV is more straightforward and typically results in lower reported values compared to LCM, making it the preferred method for conservatism in international reporting.
Conclusion
Both methods aim to ensure that inventory is reported at a conservative, realistic value, but the calculations differ based on accounting standards and inventory costing methods. Whether using the simpler lower of cost and NRV approach or the more detailed lower of cost or market method, the goal remains the same: preventing overstatement of inventory values, which could otherwise mislead stakeholders.
