Establishing the Lower of Cost and Net Realisable Value (LCNRV) is a fundamental principle in inventory valuation under accounting standards like the International Financial Reporting Standards (IFRS) and Generally Accepted Accounting Principles (GAAP). This concept ensures that inventory is not overstated on financial statements and reflects its true value in the market. By valuing inventory at the lower of its historical cost or its net realisable value, businesses adhere to the principle of prudence, preventing potential overstatements of assets and profits.
1. What is the Lower of Cost and Net Realisable Value (LCNRV)?
The Lower of Cost and Net Realisable Value is an accounting rule that requires inventory to be valued at the lower of:
- Cost: The original purchase price or production cost of the inventory, including all expenses incurred to bring the inventory to its current location and condition.
- Net Realisable Value (NRV): The estimated selling price of the inventory in the ordinary course of business, minus any costs needed to complete the sale, such as marketing, distribution, or further processing expenses.
Formula for Net Realisable Value:
NRV = Estimated Selling Price – Costs to Complete and Sell
2. Importance of Using LCNRV
Applying the LCNRV principle ensures that a company’s financial statements accurately reflect the value of inventory. Here’s why it’s important:
A. Prevents Overstatement of Assets
Valuing inventory at the lower of cost and NRV prevents the overstatement of assets on the balance sheet. This ensures the company’s financial position is presented fairly.
B. Ensures Accurate Profit Measurement
When inventory values decline, recognizing these losses promptly ensures that profits are not overstated. This adheres to the principle of prudence, which emphasizes caution in financial reporting.
C. Reflects Market Conditions
LCNRV helps align the value of inventory with current market conditions. If market prices fall below the cost of goods, the inventory is written down to reflect its actual recoverable value.
D. Compliance with Accounting Standards
Using LCNRV ensures compliance with IFRS and GAAP, both of which mandate this method for inventory valuation. Failure to comply can lead to audit issues and regulatory penalties.
3. When to Apply LCNRV
LCNRV should be applied when there is evidence that the net realisable value of inventory has fallen below its original cost. Common situations include:
- Obsolescence: When inventory becomes outdated due to technological advancements or market changes.
- Damage: When goods are damaged and can no longer be sold at their original price.
- Market Price Decline: When the market price of goods drops due to increased competition or reduced demand.
- Excess Inventory: When surplus stock exceeds demand, leading to potential markdowns.
4. Steps to Establish the Lower of Cost and NRV
Determining the LCNRV involves a systematic approach to evaluating and comparing the cost and net realisable value of inventory.
A. Determine the Cost of Inventory
Calculate the original cost of inventory, including all expenses related to acquisition and production:
- Purchase Price: The amount paid to acquire the inventory.
- Direct Costs: Expenses like shipping, handling, and storage.
- Production Costs: For manufactured goods, this includes raw materials, labor, and overhead.
B. Estimate the Net Realisable Value (NRV)
Estimate the selling price of the inventory and subtract any costs associated with completing and selling the product:
- Estimated Selling Price: The expected sale price in the ordinary course of business.
- Costs to Complete: Any additional expenses required to make the product saleable.
- Costs to Sell: Marketing, distribution, or shipping expenses.
C. Compare Cost and NRV
For each item or category of inventory, compare the cost and NRV. The inventory should be valued at the lower of these two amounts.
D. Record the Adjustment (if necessary)
If NRV is lower than the cost, write down the inventory to its NRV and recognize the loss in the income statement.
5. Examples of Applying LCNRV
Example 1: No Adjustment Needed
Scenario: A company has 100 units of a product with a cost of $15 per unit. The estimated selling price is $18 per unit, and the cost to sell is $2 per unit.
- Cost per Unit: $15
- NRV per Unit: $18 – $2 = $16
Conclusion: Since NRV ($16) is higher than the cost ($15), the inventory is valued at cost, and no adjustment is needed.
Example 2: Inventory Write-Down Required
Scenario: A company holds 200 units of a product at a cost of $20 per unit. Due to market conditions, the selling price has dropped to $18 per unit, with $2 per unit in selling costs.
- Cost per Unit: $20
- NRV per Unit: $18 – $2 = $16
Conclusion: Since NRV ($16) is lower than the cost ($20), the inventory must be written down to $16 per unit.
Journal Entry:
| Account | Debit (Dr.) | Credit (Cr.) |
|---|---|---|
| Inventory Loss (Expense) A/c | $800 | |
| Inventory (Stock) A/c | $800 |
(Note: 200 units x ($20 – $16) = $800)
6. Accounting Treatment of LCNRV Adjustments
When the NRV of inventory falls below its cost, the difference must be recognized as a loss in the income statement. This ensures that inventory is not overstated, and the financial statements reflect the true financial position of the company.
A. Recording the Loss
Inventory write-downs are recorded as an expense in the income statement under “Inventory Loss” or “Cost of Goods Sold (COGS)”, depending on the company’s accounting policies.
B. Reversing Write-Downs (if applicable)
Under IFRS, if the conditions causing the write-down improve in a subsequent period, the write-down can be reversed. However, under GAAP, reversals are generally not allowed.
7. Challenges in Applying LCNRV
While LCNRV is a standard accounting practice, businesses may encounter several challenges:
- Estimating NRV Accurately: Predicting future selling prices and costs can be difficult, especially in volatile markets.
- Frequent Market Fluctuations: Rapid changes in market conditions require regular reassessment of inventory values.
- Complex Inventory Structures: Companies with diverse or complex inventories may struggle to apply LCNRV consistently across all items.
- Subjectivity in Cost Allocation: Determining which costs to include in the NRV calculation can introduce subjectivity.
8. Best Practices for Establishing LCNRV
To ensure accurate and consistent application of LCNRV, businesses should follow these best practices:
- Regular Inventory Reviews: Conduct periodic reviews of inventory to assess for obsolescence, damage, or market price declines.
- Consistent Valuation Methods: Apply the same valuation methods consistently across reporting periods to ensure comparability.
- Use Reliable Data Sources: Base NRV estimates on reliable market data and historical sales trends.
- Document Assumptions and Estimates: Maintain detailed records of the assumptions and calculations used in determining NRV.
- Implement Internal Controls: Establish internal procedures for reviewing and approving inventory valuations to minimize errors.
The Role of LCNRV in Financial Reporting
Establishing the Lower of Cost and Net Realisable Value (LCNRV) is a vital accounting principle that ensures inventory is not overstated on financial statements. By valuing inventory at the lower of its historical cost or its net realisable value, businesses adhere to prudent accounting practices, accurately reflect market conditions, and comply with accounting standards. Regular inventory reviews, accurate NRV estimations, and consistent application of LCNRV help businesses maintain transparency and reliability in financial reporting.