Lower of cost and net realizable value (and write-down reversals)

What does “lower of cost and net realizable value” mean?

Inventory sits on the balance sheet at its cost, unless it can no longer be sold for that much. Then it is carried at the lower figure. Net realizable value (NRV) is what the goods are expected to sell for in the ordinary course of business, minus what it still costs to finish and sell them.

$$NRV = \text{Selling price} - \text{Costs to complete} - \text{Costs to sell}$$

The rule, lower of cost and net realizable value , compares cost with NRV. It is applied item by item, or to groups of similar or related items. If NRV is below cost, the inventory is written down to NRV. The loss is an expense in that period, usually inside cost of sales, though it may be shown separately. This is an inventory write-down .

$$\text{Write-down} = \text{Cost} - NRV \quad (\text{only if } NRV < \text{Cost})$$

Exam items turn this formula around. They give the write-down or the NRV and ask for the selling price or the costs to sell. It is one relationship, solved from any side.

When can a write-down be reversed?

Under IFRS, always, if the value recovers. Under US GAAP, never. A reversal of a write-down lowers cost of sales, so profit goes up in the year of the recovery.

Each period the company reassesses NRV. Under IFRS, if NRV has risen for inventory that was previously written down, the write-down is reversed. The reversal is limited to the amount of the original write-down, so the carrying amount can climb back to cost but never beyond it. Under US GAAP, the written-down amount becomes the new cost basis and a recovery is ignored.

$$\text{Reversal} = \min\bigl(NRV_{new} - \text{Carrying amount},\ \text{Original write-down}\bigr)$$

Exam tip If an IFRS carrying amount in an answer exceeds cost, it is wrong. If a US GAAP answer shows a reversal, it is wrong.

What is “market” under US GAAP for LIFO and retail inventories?

It is replacement cost, squeezed between a ceiling and a floor. The ceiling is NRV. The floor is NRV minus a normal profit margin. Inventory is then carried at the lower of cost and market.

US GAAP moved most inventories to lower of cost and NRV for fiscal years beginning after 15 December 2016, which is broadly the IFRS rule. The old lower of cost or market test survives only for inventories measured with LIFO or the retail method. There, market is built from replacement cost , the amount it would cost to buy or make the same goods now, and a normal profit margin .

$$\text{Market} = \text{middle value of } \bigl(NRV - m,\ RC,\ NRV\bigr)$$

Where replacement cost falls	Market is
Above the ceiling (NRV)	NRV
Between floor and ceiling	Replacement cost
Below the floor (NRV less margin)	The floor

Go deeper Why market survives only for LIFO and retail

The ceiling stops inventory being carried above what it can be sold for, and the floor stops a write-down so deep that the next sale is guaranteed to show a normal profit. The Financial Accounting Standards Board (FASB) simplified inventory measurement in 2015 (effective for fiscal years beginning after 15 December 2016) and kept the old market test only for LIFO and the retail method. For the exam, only the rule matters: if the question says LIFO or retail under US GAAP, do the ceiling-and-floor test. Otherwise use NRV.

Which inventories are exempt from the rule?

Producers of agricultural, forest and mineral products, and commodity broker-traders, may carry inventory at NRV even above cost. IFRS (International Accounting Standard, IAS, 2) does not apply the lower-of-cost rule to agricultural and mineral inventories or to commodity broker-traders . They measure at NRV (fair value less costs to sell) under well-established industry practice, and changes in value, up or down, go through profit in the period they occur. US GAAP is similar for agricultural and forest products and mineral ores, and it allows bullion at market.

So a recovery for these inventories is a gain, with no cap at the original cost. If a question says the inventory is wheat or copper ore and the price has risen, the carrying amount can exceed historical cost.

Inventory carrying amountstart from cost, then test against what the goods can be sold for

• IFRS Memorize
  • Lower of cost and NRV all cost formulas
  • Reversal required up to the original write-down, so never above cost
• US GAAP Memorize
  • FIFO and average cost: lower of cost and NRV no reversal
  • LIFO and retail: lower of cost or market market between NRV less margin and NRV; no reversal
• Exceptions under both Know the idea
  • Agricultural, forest and mineral producers NRV or fair value less costs to sell
  • Commodity broker-traders changes in value go to profit

What does a write-down do to the statements and ratios?

It lowers profit and assets now, and it makes activity ratios look better. The write-down is an expense. It also shrinks inventory, so everything built on inventory, assets and equity falls.

Memorize

Item	Effect in the write-down year
Inventory, current assets, total assets	Lower
Gross and net profit	Lower (unless the loss is shown below gross profit)
Equity	Lower
Current ratio	Lower
Inventory turnover, total asset turnover	Higher (smaller denominator, and larger cost of sales for inventory turnover)
Debt-to-equity	Higher
Later years	Lower inventory cost flows into cost of sales, so future margins look better

Inventory write-downexpensed in the year, usually inside cost of sales

• Falls Memorize
  • Inventory, current assets, total assets, equity
  • Gross profit, net income and margins
  • Current ratio
• Rises Memorize
  • Inventory turnover and total asset turnover smaller denominator
  • Debt-to-equity smaller equity
  • Later-year gross margin a lower cost flows to cost of sales

The cost formula changes how exposed a company is. When costs have been climbing, a LIFO balance sheet still holds the cheapest, oldest layers, so there is a wide cushion before NRV drops below them. FIFO (first in, first out), weighted average and specific identification inventories sit near current cost, with little cushion, so they get written down more often and by more. Watch two situations closely: a borrower near a covenant limit on the current ratio or leverage, and a business whose products date quickly, such as electronics or fashion. A string of write-downs year after year points to weak forecasting or products that no longer sell.

Go deeper Write-downs and the ratio you see in the notes

A company that records an allowance for obsolescence (rather than writing inventory down directly) still reports inventory net of the allowance on the balance sheet. Adding the allowance back gives gross inventory at cost, and subtracting the change in the allowance from cost of sales shows what profit and turnover would have been without the write-down. In a year with a net write-down, reworking the ratios that way makes turnover lower and gross margin slightly higher, which is the mirror of the table above. A reversal works the other way: it lowers cost of sales in the year of the recovery, so that year’s margin benefits from an expense taken in an earlier year.