7.3.3: The Problem of Overvaluation

Overvaluation can occur when inventory is reported at a higher value than the ultimate amount that can be recovered. This happens with changes in market conditions or consumer tastes, or it happens for other reasons. If a particular product loses favour with the market and must be severely discounted or even disposed of, it would not be appropriate to continue to carry that item on the balance sheet at its cost when that cost is not recoverable. To avoid this problem, the lower of cost and net realizable value (LCNRV) needs to be applied. Under this approach, inventory values are reduced to their recoverable amounts in order to ensure that current assets are not stated at an amount greater than the ultimate amount of cash that will be realized from their sale. This also results in recording an expense equal to the loss in value of the asset, which achieves the effect of matching the cost to the period in which the loss actually occurs. For example, if an inventory item has a reported cost of $1,000 but a net realizable value of only $800, the company should record the following journal entry:

Most companies will simply report the loss as part of the cost of goods sold account on the income statement. Separate disclosure may be appropriate, however, if the amount is considered material or unusual in nature.

What Is Net Realizable Value?

When determining the loss in inventory value, it is important to have a clear understanding of the concept of net realizable value (NRV). Net realizable value is an estimate based on the expected selling price of the goods in the ordinary course of business, less any estimated costs required to complete and sell the goods. It thus represents the net cash flow that will ultimately be generated by the sale of the product. Because the net realizable value is an estimate, it can be affected by management estimation bias and by changes in economic circumstances. As a result, write-downs of inventories need to be reviewed carefully and frequently by accountants to ensure the reported amounts are reasonable.

How Is the Lower of Cost and Net Realizable Test Applied?

In general, the lower of cost and net realizable test should be applied to the most detailed level possible. This would normally be considered to be individual inventory items. However, in some situations, it may be appropriate to group inventory items together and apply the test at the group level. This would be appropriate only when items relate to the same product line, have similar end uses, are produced and marketed in the same geographic area, and cannot be segregated from other items in the product line in a reasonable or cost-effective way. If grouping is appropriate, the amount of inventory write-downs will be less than if the test is applied on an individual-item basis. This occurs because grouping allows for some offsetting of over- and undervalued items.

Biological Assets

One interesting exception to the lower of cost and net realizable value rule is accounting for biological assets. Although ASPE does not specifically address these types of assets, IFRS does present a separate standard: IAS 41 Agriculture. This standard covers raising and harvesting living plants and animals. The biological assets are considered the original source of the commercial activity, such as the fruit tree that produces apples, the sheep that produces wool, or the dairy cow that produces milk. The detailed accounting for these specialized assets goes beyond the scope of this course. Generally, the product of the biological asset would fall under the normal rules for inventory accounting, but the biological asset itself is accounted for at its fair value, less selling costs. This means that every year, the value of the biological-asset must be determined, and an adjustment to the assets carrying value must be made. This adjustment would result in an unrealized gain or loss. As the inventory is produced, it is transferred from the biological-asset account to an inventory account at its fair value less selling costs at the point of harvest. This value now becomes the inventory's cost. When inventory is sold, the sale amount is transferred from the unrealized account to realized revenue.

Conceptually, these types of assets are similar in nature to a capital asset, but they are also different in that they grow and obtain value independent of the inventory they produce. This unique nature is the reason IFRS presents a separate standard for the accounting and disclosure of biological assets.