Lower of Cost and Net Realizable Value (LCNRV) Rule

Like many other assets, inventory is recorded and reported at cost in accounting books following historical cost principle following a certain cost flow assumption either FIFO, LIFO, AVCO or other methods. Another way of measuring inventory value is based on net realizable value (NRV).



Under normal circumstances, cost of inventory is always lesser than the net amount business can earn by selling the inventory, called net realizable value (NRV). Common sense dictates that cost has to be lesser than NRV to make profit. But following a concept of conservatism, even if NRV is higher than cost, value of inventory is kept at cost and gain is not recognized until the inventory actually sells.

However, if NRV of inventory falls below the cost of inventory, following the same concept of conservatism, entity must write down the value of inventory to the amount that can be realized. Hence the recognition of loss to the extent expenditure on inventory are not expected to be recovered. It does not make sense to report an asset at any value higher than the amount it can recover and may overstate the assets materially. Therefore, entity must switch to NRV basis from historical cost basis of measurement if recoverable amount falls below cost of asset.

1 Reasons for lower NRV

NRV may falls below cost for two main reasons; either cost has increased or sales price has dropped. Some of the examples include:

  1. Goods are now obsolete. With newer products in the market offered at competitive rates, entity is unable to make sales or at least at profitable rate.
  2. Goods are damaged. Though price is good, but the cost to repair the goods renders recoverable or realisable amount lesser than the cost itself.
  3. Seasonal effects can alter prices significantly, though can be temporary.
  4. Wrong sales strategy of entity may cause oversaturation of goods in the market. This can cause prices to plummet below original cost. Entity has to maintain appropriate levels of supply against demand.
  5. If entity is minting profits, sooner or later competitors in the market will jump in as well offering similar products and it may be the case that they start offering products with same utility at prices lower than the production cost of entity.
  6. Production cost has increased. May be because of increase in raw material cost or other direct expenses such as royalty that is paid in foreign currency and exchange rate has fluctuated unfavorably for entity.
  7. It might be possible that entity can produce units at lower cost but has to spend a lot of carriage cost to move inventory to market before it can be sold.

Example – Lower of cost and NRV

By the end of the year entity had 100 units in warehouse of X-Pro. Units are so far reported at total cost of 10,000.

Recently fire broke out and damaged the outer casing of units. Engineers have confirmed that product can still fetch full selling price if outer cover is replaced. Currently X-Pro is selling for $110 per unit and cost of repair is estimated to be $5 per unit. Additionally entity will have to pay $2,000 in total towards the carriage cost to move repaired goods from workshop to warehouse.

Compute the value at which inventory should be reported in financial statements if LCNRV rule is followed?

Solution:

Total cost of units 10,000
Total sales price [100 x 110] 11,000
Less: Repair cost [100 x 5] Carriage cost 500
2000
(2,500) 8,500

NRV (8,500) < Cost (10,000) therefore, inventory will be valued at 8,500.

2 Applying Lower of Cost and NRV Rule

Application of LCNRV rule can be done individual item basis, group basis or on overall basis. What basis entity must use depends on the nature of inventory itself and management’s policy.

For example if product can be sold individually and its selling price and related costs and can be determined independently then for this product LCNRV rule will be applied on individual basis. If product is of such nature that its NRV cannot be determined on individual basis as it has to be sold with other products as a package then rule will be applied on group basis. And if entity manages inventory as a whole then rule will be applied on totality basis on all types of inventory taken together.

However, there is no restriction to apply LCNRV rule on different basis only if nature of product and sales is different. Entity may group similar types of products together and apply the rule on group basis even if items can be sold individually.

Example – Applying LCNRV Rule

Consider the following data. If entity applies LCNRV on individual basis then inventory value will be determined as follows:

ItemCostNRVInventory Value
Toys under 8 years
LEGO
Superhero Figurines
 
Toys over 8 years
Radio control cars
Friction cars
 
Indoor games
Scrabble
Othelo
Chess
Table tennis
 
Video Games
Parsec
Pacman
Space Invaders
 
252182
424958


130373
465086


230465
230291
394774
183567


168842
187179
142560
 
219389
368059


306738
209745


143697
306070
157454
497859


183760
164096
388188

219389
368059


130373
209745


143697
230291
157454
183567

 
168842
164096
142560

For the same set of data if entity applies LCNRV rule on group basis then inventory valuation will be as follows:

ItemCostNRVInventory Value
Toys under 8 years
LEGO
Superhero Figurines
 
252182
424958
 
219389
368059

Total under 8 years677140587448587448
Toys over 8 years
Radio control cars
Friction cars

130373
465086

306738
209745
Total Toys over 8 years595,459516,483516,483
Indoor games
Scrabble
Othelo
Chess
Table tennis

230465
230291
394774
183567

143697
306070
157454
497859
Total Indoor games1,039,0971,105,0801,039,097
Video Games
Parsec
Pacman
Space Invaders

168842
187179
142560

183760
164096
388188
Total Video Games498,581736,044498,581

And lastly if entity applied LCNRV rule inventory wide then measurement will be based on total cost and total NRV and then whichever, is lower will be used to value total inventory held:

ItemCostNRVInventory Value
Toys under 8 years
LEGO
Superhero Figurines
 
Toys over 8 years
Radio control cars
Friction cars
 
Indoor games
Scrabble
Othelo
Chess
Table tennis
 
Video Games
Parsec
Pacman
Space Invaders
 
252182
424958


130373
465086


230465
230291
394774
183567


168842
187179
142560
 
219389
368059


306738
209745


143697
306070
157454
497859


183760
164096
388188
Total2,810,2772,945,0552,810,277

3 Accounting for Lower of Cost and NRV (LCNRV)

To account for the the loss if NRV is lesser than the original cost, entity may choose one of the ways:

  1. Make adjustment in the inventory account directly to record the loss
  2. Make contra-asset account to record the loss

Jurisdiction and the applicable standards may also dictate the approach entity has to apply in this situation. For example International Accounting Standard (IAS) 2 requires loss to be adjusted directly in the inventory account.

3.1 Recording loss directly in inventory account

If entity choose to record written-down loss directly in inventory account then it has to be credited. However, which account is to be debited depends on the presentation of expenses in income statement and entity’s policy to record such losses. Entity may choose either of the following options:

  1. Report the loss as cost of sales/cost of goods sold
  2. Report the loss separately

3.1.1 Recording LCNRV loss as cost of goods sold and directly in inventory

Under this method once the loss is determined, cost of goods sold account is debited and inventory account is credited to record the write-down loss on inventory.

3.1.2 Recording LCNRV loss as separate account and directly in inventory

Under this method instead of debiting the loss to cost of goods sold, a separate account with appropriate name is debited and then closed in profit and loss. Credit aspect is however, recorded in same inventory account.

Example – Accounting for LCNRV loss – directly in inventory

Ultar Inc. makes miniature models of Karakoram peaks for tourists. Cost of year-end inventory is 7,388. However, recent sales in southern market has seen fall in prices. Therefore, its NRV of inventory is 5,300 only.

Give the journal entry to record the write-down loss if entity is using:

  1. cost of sales method
  2. Separate account method

Solution:

1 cost of sales method:

Write-down loss is: 5300 – 7388 = -2088. The journal entry will be as following:

Cost of goods sold a/c 2088
Inventory a/c 2088

2 Separate account method:

In this method a separate account with appropriate title e.g. “Inventory written-down loss” will be used to record the loss which is later closed in profit and loss as follows:

Inventory written-down loss a/c 2088
Inventory a/c 2088

Closing entry will be:

Profit and loss a/c 2088
Inventory written-down loss a/c 2088

3.2 Recording loss in contra-asset account (Allowance account)

In the above method, we saw that recording LCNRV loss inventory account is credited or in simple words reduced to reflect NRV.

However, in some jurisdictions it is preferred that instead of altering inventory account, loss is recorded in separate contra-asset account. This way the original inventory value is kept in records and also lower of cost and NRV rule is achieved because inventory value is reported as a net of inventory account and contra-asset account in the financial statements.

On the other hand, its up to entity whether it likes to record loss as part of cost of sales or separately in the income statement. So even in this approach its up to entity which account to debit.

3.2.1 Recording LCNRV loss as cost of goods sold and contra-asset account

Under this method once the loss is determined, cost of goods sold account is debited and Allowance for NRV loss account is credited to record the write-down loss on inventory.

3.2.2 Recording LCNRV loss as separate account and contra-asset account

Under this method instead of debiting the loss to cost of goods sold, a separate account with appropriate title is debited and then closed in profit and loss. Credit aspect is however, recorded in contra-asset account with appropriate name e.g. Allowance for NRV loss account.

Example – Accounting for LCNRV loss – Allowance for LCNRV loss

Ultar Inc. makes miniature models of Karakoram peaks for tourists. Cost of year-end inventory is 7,388. However, recent sales in southern market has seen fall in prices. Therefore, its NRV of inventory is 5,300 only.

Give the journal entry to record the write-down loss if entity is using:

  1. cost of sales method
  2. Separate account method

Solution:

1 Cost of sales method

Cost of goods sold a/c 2088
Allowance for NRV loss a/c 2088

2 Separate account method

Inventory written-down loss a/c 2088
Allowance for NRV loss a/c 2088

Closing entry will be:

Profit and loss a/c 2088
Inventory written-down loss a/c 2088

4 Recovery of LCNRV loss

Though prices of inventory hardly rise again once fallen, however, in some cases inventory’s NRV may recover and rise. In such cases, entity is permitted to reverse the previously recognized loss.

The accounting treatment for such reversals again depends upon applicable rules, standards and the manner in which loss was recognized previously. In case of IFRSs, entity is required to reduce the amount of inventory recognized as expense on to account for reversal in NRV loss. And in other cases where allowance is used, then allowance is adjusted. However, one thing is common i.e. value of inventory cannot be more than the original cost of inventory. In other words, amount of reversal cannot be higher than original write-down loss.

Example – Recovery of LCNRV Loss

Ultar Inc. makes miniature models of Karakoram peaks for tourists. Cost of year-end inventory is 7,388. Last year, sales in southern market were not promising thus entity had to write down the inventory to then prevailing NRV of 5,300.

This year however, NRV has risen and determined at 8,500.

Give the journal entry to record the recovery of write-down loss.

Solution:

Although NRV has risen from 5,300 to 8,500 which is $3,200 increase but total recovery cannot be more than original write-down loss i.e. 2,088 (5,300 – 7,388) therefore, the maximum inventory value that can be achieved is the original cost of inventory.

If entity recognized loss in cost of sales and directly in inventory then recovery entry will be as follows:

Inventory a/c 2088
Cost of sales a/c 2088

If entity is maintaining Allowance account instead of adjusting the inventory directly then journal entry can be:

Allowance for NRV loss a/c 2088
Cost of sales a/c 2088

Remember, if entity is using a separate account instead of cost of sales then on recovery of NRV loss it will also be recorded separately instead of crediting cost of sales a/c

If entity is recording recovery directly in inventory a/c then entry will be:

Inventory a/c 2088
Recovery of NRV loss a/c 2088

Recovery of NRV loss a/c will be later closed in profit and loss.

If entity is recording recovery with allowance then:

Allowance for NRV loss a/c 2088
Recovery for NRV loss a/c 2088