Valuation of Inventories - Key Issues
Author: Daniel Wiranata Dayan
Inventory can be measured by several valuation methods, whether using the cost method or other valuation methods. Normally, at inception, inventories are measured at cost, in accordance with the historical cost principle. And subsequent valuation of inventory can use the Lower of Cost or Net Realizable Value / LCNRV Method [IAS 2], which was formerly the Lower of Cost or Market / LCM method [U.S. GAAP]. LCM term is better known as COMWIL (Cost or Market Price Whichever is Lower).
Although they look similar, LCM and LCNRV are different methods. In LCM, inventories are compared to market prices, where U.S. GAAP defines market prices as replacement cost subject to the constraints of net realizable value (the ceiling) and net realizable value less a normal markup (the floor) for inventories accounted for under LIFO or retail methods. Meanwhile, IFRS defines the market as net realizable value (NRV) and does not use a ceiling or a floor to determine the market (Kieso & Weygant, 2020).
What about other measurements besides Cost and LCNRV?
Inventories can also be measured at fair value less cost to sell (FV less cost to sell), relative standalone sales value, estimated inventory value based on certain gross margin, or estimated inventory value based on cost / retail ratio.
Example:
General Rule:
Under IAS 2 or PSAK 14, Inventory should be measured at the lower of cost or net realizable value. NRV is the estimated selling price in the ordinary/normal course of business less the estimated costs of completion and the estimated costs to sale.
From this definition, it shows that inventory that can be measured on the NRV does not only come from inventory of finished products, due to the term "estimated cost to complete". So that the inventory of work-in-process/WIP or raw materials [Unfinished Inventory] can be assessed to be measured at NRV, if the entity can determine the expected selling price dan cost to sell, and also inventory WIP/raw material can be sold.
Practical Consideration
For some inventories, it may be:
1. no alternative use for other customers,
2. limitations related to legal requirements,
3. For some WIP inventories, the entity has no intention that the inventories will be sold
And several other conditions that make inventories difficult to value by NRV.
Subsequent Measurement - LCNRV
In the subsequent measurement, inventory may be damaged, become obsolete, or have a significant decline in value; so that the inventory value has been write-down and measured at NRV.
How is this impairment recognized? Entities may recognize cost of sales or loss on impairement, which can have an impact on a decrease in profit for the year. IFRS does not specify a particular account to debit for the write-down, but based on the underlying concept, the loss method is more preferable because it clearly discloses the losses resulting from the write-down of inventories to the NRV.
QA1: Does inventory valuation based on NRV reduce the value of inventory measured based on cost?
This really depends on the accounting policies applied by the entity. If the entity uses the direct method, the value of the inventory at cost will decrease directly. But if the entity uses the indirect/allowance method, the value of the inventory at cost is not affected by the decrease to NRV but will be reduced net through the "allowance to reduce inventory to NRV" account.
Under U.S. GAAP, if inventory is written down under the LCM method, the new basis is now considered its cost. Under IFRS, the write-down may be reversed in a subsequent period up to the amount of the previous write-down.?
QA2: Can inventory increase in value after impairment?
Of course, this is also known as recovery/reversal, when the NRV value in the current year exceeds the cost of inventory. However, the increase in the recovery of inventory value is not possible to cause the inventory value to exceed its cost.
The profit loss (income statement) effect of this reversal is an increase in company profits, due to the recognition of other income or a decrease in inventory costs in the current year (depending on accounting standards in each country).