CHAPTER 9

SOLUTIONS TO QUESTIONS

1. Where there is evidence that the utility of goods to be disposed of in the

ordinary course of business will be less than cost, the difference should
be recognized as a loss in the current period, and the inventory should be
stated at net realizable value in the financial statements.

2. The usual basis for carrying forward the inventory to the next period is
cost. Departure from cost is required; however, when the utility of the
goods included in the inventory is less than their cost. This loss in utility
should be recognized as a loss of the current period, the period in which
it occurred. Furthermore, the subsequent period should be charged for
goods at an amount that measures their expected contribution to that
period. In other words, the subsequent period should be charged for
inventory at prices no higher than those which would have been paid if
the inventory had been obtained at the beginning of that period.
(Historically, the lower-of-cost-or-net realizable value rule arose from the
accounting convention of providing for all losses and anticipating no
profits.)

In accordance with the foregoing reasoning, the rule of “cost or net

realizable value, whichever is lower” may be applied to each item in the
inventory, to the total of the components of each major category, or to
the total of the inventory, whichever most clearly reflects operations. The
rule is usually applied to each item, but if individual inventory items enter
into the same category or categories of finished product, alternative
procedures are suitable.

The arguments against the use of the lower-of-cost-or-net realizable

value method of valuing inventories include the following:

(a) The method requires the reporting of estimated losses (all or a

portion of the excess of actual cost over net realizable value) as
definite income charges even though the losses have not been
sustained to date and may never be sustained. Under a consistent
criterion of realization a drop in net realizable value below original
cost is no more a sustained loss than a rise above cost is a realized
gain.

(b) A price shrinkage is brought into the income statement before the
loss has been sustained through sale. Furthermore, if the charge for
the inventory write-downs is not made to a special loss account, the
cost figure for goods actually sold is inflated by the amount of the
estimated shrinkage in price of the unsold goods. The title “Cost of
Goods Sold” therefore becomes a misnomer.

(c) The method is inconsistent in application in a given year because it

recognizes the propriety of implied price reductions but gives no
recognition in the accounts or financial statements to the effect of
the price increases.
 (d) The method is also inconsistent in application in one year as opposed
to another because the inventory of a company may be valued at cost
in one year and at net realizable value in the next year.

(e) The lower-of-cost-or-net realizable value method values the inventory

in the statement of financial position conservatively. Its effect on the
income statement, however, may be the opposite. Although the
income statement for the year in which the unsustained loss is taken
is stated conservatively, the net income on the income statement of
the subsequent period may be distorted if the expected reductions in
sales prices do not materialize.

3. The lower-of-cost-or-net realizable value rule may be applied directly to

each item or to the total of the inventory (or in some cases, to the total of
the components of each major category). The method should be the one
that most clearly reflects income. The most common practice is to price
the inventory on an item-by-item basis. Companies favor the individual
item approach because tax requirements in some countries require that
an individual item basis be used unless it involves practical difficulties.
In addition, the individual item approach gives the most conservative
valuation for balance sheet purposes.

4. (1) $12.80.

(2) $16.10.

(3) $13.00.

(4) $9.20.

(5) $15.90.

5. One approach is to record the inventory at cost and then reduce it to net
realizable value, thereby reflecting a loss in the current period (often
referred to as the loss method). The loss would then be shown as a
separate item in the income statement and the cost of goods sold for the
year would not be distorted by its inclusion. An objection to this method
of valuation is that an inconsistency is created between the income
statement and balance sheet. Companies may record the adjustment
either directly to the Inventory account or use the Allowance to Reduce
Inventory to Market which is a contra account against inventory on the
statement of financial position.

Another approach is merely to substitute market for cost when pricing

the new inventory (often referred to as the cost of goods sold method).
Such a procedure increases cost of goods sold by the amount of the loss
and fails to reflect this loss separately. For this reason, many theoretical
objections can be raised against this procedure.

6. An exception to the normal recognition rule occurs where the inventory

consists of (1) agricultural assets, and (2) commodities held by broker-
traders. Some minerals and minerals products may be valued at NRV.
7. (a) Biological assets are measured on initial recognition and at the end
of each reporting period at fair value less costs to sell (NRV).
Companies record a gain or loss due to changes in the NRV of
biological assets in income when it arises.
(b) Agricultural produce (which are harvested from biological assets) are
measured at fair value less costs to sell (NRV) at the point of harvest.
Once harvested, the NRV of the agricultural produce becomes its
cost and this asset is accounted for similar to other inventories held
for sale in the normal course of business.
 SOLUTIONS TO BRIEF EXERCISES

BRIEF EXERCISE 9-1

Item Cost NRV LCNRV

Skis $190.00 $161.00 $161.00

Boots 106.00 108.00 106.00

Parkas 53.00 50.00 50.00

BRIEF EXERCISE 9-2

(a) Item Cost NRV LCNRV

Item-by-item

Jokers € 2,000 € 2,100 € 2,000

Penguins 5,000 4,950 4,950

Riddlers 4,400 4,625 4,400

Scarecrows 3,200 3,830 3,200

Total €14,600 €15,505 €14,550

(b) 1. Penguins only: €50

2. None on a whole group: €15,505 > €14,600.

BRIEF EXERCISE 9-3

(a) Cost-of-goods-sold-method
 Cost of Goods Sold..................................................................
21,000,000

Allowance to Reduce Inventory to NRV........................ 21,000,000

(b) Loss method

Loss Due to Decline of Inventory to NRV................................

21,000,000

Allowance to Reduce Inventory to NRV........................ 21,000,000

BRIEF EXERCISE 9-4

Biological Assets – Shearing Sheep........................................4,125*

Unrealized Holding Gain or Loss – Income.................... 4,125

*€4,700 – €575 = €4,125.

BRIEF EXERCISE 9-5

Wool Inventory......................................................................... 9,000

Unrealized Holding Gain or Loss – Income.................... 9,000

Cash.........................................................................................10,500

Cost of Goods Sold.................................................................. 9,000

Wool Inventory................................................................ 9,000

Sales............................................................................... 10,500
 SOLUTIONS TO EXERCISES

EXERCISE 9-1 (15–20 minutes)

Final
Item Cost Net Inventory
No. per Realizable LCNRV Quantity Value
Unit Value
1320 $3.20 $2.90* $2.90 1,200 $ 3,480

1333 2.70 2.40 2.40 900 2,160

1426 4.50 3.60 3.60 800 2,880

1437 3.60 1.85 1.85 1,000 1,850

1510 2.25 1.85 1.85 700 1,295

1522 3.00 3.10 3.00 500 1,500

1573 1.80 1.30 1.30 3,000 3,900

1626 4.70 4.50 4.50 1,000 4,500

$21,565
*$4.50 – $1.60 = $2.90.

EXERCISE 9-2 (10–15 minutes)

(a) 12/31/10 Cost of Goods Sold..................................................................

24,000

Allowance to Reduce
Inventory to NRV........................................................24,000

12/31/11 Allowance to Reduce

Inventory to NRV.................................................................
4,000

Cost of Goods Sold........................................................ 4,000

(b) 12/31/10 Loss Due to Decline of

Inventory to NRV..................................................................
24,000
 Allowance to Reduce
Inventory to NRV........................................................24,000

12/31/11 Allowance to Reduce

Inventory to NRV.................................................................
4,000*

Recovery of Inventory Loss........................................... 4,000

*Cost of inventory at 12/31/10............................................ £346,000

LCNRV at 12/31/10............................................................ (322,000)

Allowance amount needed to reduce inventory

to NRV (a)...................................................................... £ 24,000

Cost of inventory at 12/31/11............................................ £410,000

LCNRV at 12/31/11............................................................ (390,000)

Allowance amount needed to reduce inventory

to NRV (b)...................................................................... £ 20,000

Recovery of previously recognized loss = (a) – (b)

= £24,000 – £20,000

= £4,000.

(c) Both methods of recording lower-of-cost-or-NRV adjustments have the same

effect on net income.
EXERCISE 9-3 (10–15 minutes)

(a) Unrealized Holding Gain or Loss – Income.............................

212,000

Biological Assets – Milking Cows..................................... 212,000

(b) Milk Inventory..........................................................................72,000

Unrealized Holding Gain or Loss – Income....................... 72,000

(c) Cash.........................................................................................74,000

Cost of Goods Sold..................................................................72,000

Milk Inventory................................................................... 72,000

Sales................................................................................. 74,000

EXERCISE 9-4 (10–15 minutes)

(a) Biological Assets – Shearing Alpaca........................................ 6,725

Unrealized Holding Gain or Loss – Income....................... 6,725

(b) Wool Inventory..........................................................................13,000

Unrealized Holding Gain or Loss – Income....................... 13,000

(c) Cash..........................................................................................14,500

Cost of Goods Sold...................................................................13,000

Wool Inventory.................................................................. 13,000

Sales.................................................................................. 14,500
(d) (1) The birth of a baby Alpaca may result in a gain on the initial
recognition of the biological asset.

(2) Losses may result as the fair value of the older Alpaca will likely
decrease because the shearing is more limited than with the other
Alpacas.

SOLUTIONS TO CONCEPTS FOR ANALYSIS

CA 9-1

(a) The purpose of using the LCNRV method is to reflect the decline of
inventory value below its original cost. A departure from cost is justified
on the basis that a loss of utility should be reported as a charge against
the revenues in the period in which it occurs

(b) The term “net realizable value” in LCNRV generally means the estimated
selling price in the ordinary course of business less reasonably
predictable costs of completion and disposal.
(c) The LCNRV method may be applied either directly to each inventory item,
to a category, or to the total inventory. The application of the rule to the
inventory total, or to the total components of each category, ordinarily
results in an amount that more closely approaches cost than it would if
the rule were applied to each individual item. Under the first two
methods (applying LCNRV to the inventory total or to the total
components of each category), increases in net realizable value offset, to
some extent, the decreases in net realizable value. The most common
practice is, however, to value the inventory on an item-by-item basis.
Many companies favor the individual item approach because tax rules in
certain jurisdictions require that an individual item basis be used unless
it involves practical difficulties. In addition, the individual item approach
gives the most conservative valuation for statement of financial position
purposes.
(d) Conceptually, the LCNRV method has some deficiencies. First, decreases
in the value of the asset and the charge to expense are recognized in the
period in which loss in utility occurs—not in the period of sale. On the
other hand, increases in the value of the asset are recognized only at the
point of sale. This situation is inconsistent and can lead to distortions in
the presentation of income data.
Second, net realizable value reflects the future service potential of the
asset and, for that reason, it is conceptually sound. But net realizable
value cannot often be measured with certainty.

From the standpoint of accounting theory there is little to justify the

LCNRV rule. Although conservative from the statement of financial
position point of view, it permits the income statement to show a larger
net income in future periods than would be justified if the inventory were
carried forward at cost. The rule is applied only in those cases where
 strong evidence indicates that market declines in inventory prices have
occurred that will result in losses when such inventories are disposed of.

FINANCIAL REPORTING PROBLEM

(a) Inventories are valued at the lower-of-cost-or-net realisable value using the
retail method, which is computed on the basis of selling price less the
appropriate trading margin. All inventories are finished goods.

(b) Inventories are reported on the statement of financial position simply as

“Inventories.” The footnotes indicate that all inventories are finished
goods.

(c) The only information given is “The cost of sales above represents cost
of inventories recognised as an expense in the year.”

Cost of Sales £5,535.2

(d) Inventory turnover = =
Average Inventory £488.9 + £416.3
2
= 12.23 or approximately 30 days to turn its inventory. Turnover remains
high.

Its gross profit percentages for 2008 and 2007 are as follows:

2008 2007
Net sales................................. £9,022.0 £8,588.1
Cost of sales........................... 5,535.2 5,246.9
Gross profit............................. £3,486.8 £3,341.2

Gross profit percentage......... 38.6% 38.9%

M&S had a small improvement in its gross profit and slight decline in gross
profit percentage. Sales in 2008 showed a 5.1% increase, due to increased
UK locations and strong international performance. It appears that M&S has
been able to maintain gross profit percentage on these increased sales.
 PROFESSIONAL RESEARCH

(a) The standard that addresses inventory pricing is IAS 2.

(b) Inventories are assets:

(a) held for sale in the ordinary course of business;

(b) in the process of production for such sale; or

(c) in the form of materials or supplies to be consumed in the production

process or in the rendering of services.

(IAS 2, paragraph 6)

This Standard applies to all inventories, except:

(a) work in progress arising under construction contracts, including

directly related service contracts (see IAS 11 Construction Contracts);

(b) financial instruments (see IAS 32 Financial Instruments: Presentation

and IAS 39 Financial Instruments: Recognition and Measurement);
and

(c) biological assets related to agricultural activity and agricultural

produce at the point of harvest (see IAS 41 Agriculture).

(IAS 2, paragraph 2)

(c) Net realisable value refers to the net amount that an entity expects to
realise from the sale of inventory in the ordinary course of business. Fair
value reflects the amount for which the same inventory could be
exchanged between knowledgeable and willing buyers and sellers in the
marketplace. The former is an entity-specific value; the latter is not. Net
realisable value for inventories may not equal fair value less costs to
sell. (IAS 2, paragraph 7).

(d) This Standard does not apply to the measurement of inventories held by:

(a) producers of agricultural and forest products, agricultural produce

after harvest, and minerals and mineral products, to the extent that
they are measured at net realisable value in accordance with well-
established practices in those industries. When such inventories are
 measured at net realisable value, changes in that value are
recognised in profit or loss in the period of the change.

(b) commodity broker-traders who measure their inventories at fair

value less costs to sell. When such inventories are measured at fair
value less costs to sell, changes in fair value less costs to sell are
recognised in profit or loss in the period of the change.

(IAS 2, paragraph 3).