6.4 Apply Accounting Standards for Inventory

Investors like to compare a company’s financial statements from one period to the next. Therefore, a company must use the same accounting method for inventory from one period to the next.

However, under certain circumstances, companies might want to change their accounting method. Both IFRS and Accounting Standards for Private Enterprises (ASPE) allow a change in the accounting method, if it “results in the financial statements providing reliable and more relevant information.” If a change to the account method meets the requirement, then:

The change should be applied retrospectively, and
The effect of the change on the current financial statements should be disclosed in the notes to the financial statements.

(Harrison et al., 2018, p. 248)

Lower-of-Cost-and-Net-Realizable-Value (LCNRV) Rule

Inventory is reported initially at historical cost (acquisition cost) in conformity with the cost principle. However, per the accounting standards, inventory must be reported at whichever is lower of 1) historical cost or 2) net realizable value (NRV) (current replacement cost). This needs to be done on an ongoing basis.

If the net realizable value is lower than the historical cost, an inventory write-down is required.

Journal entry to record inventory write-down:

journal entry for recording inventory write-down
Cost of goods sold	Dr. $ZZZ
Inventory	Cr. $ZZZ

Let’s take a look at an example:

example of changing widget prices
Item	Quantity	Unit Acquisition Cost	NRV	LCNRV	Total LCNRV
Widget 1	1,000	$250	$200 ← Lower	$200	$200,000
Widget 2	500	$100 ← Lower	$120	$100	$50,000

In the scenario above, a write-down for Widget 1 is required for ($250 - $200) × 1,000 units = $50,000.

If, in a subsequent period, the net realizable value of a previously written down inventory increases, the company can reverse its previous write-down up to the new net realizable value. However, it cannot be written up to a value that exceeds the original cost, because then it is no longer carried at lower of cost and net realizable value.

From the previous example, assume that the net realizable value of Widget 1 has increased to $230, then the total LCNRV is $230,000, which is $30,000 greater than the previous LCNRV for Widget 1 of $200,000. The journal entry to adjust for this increase in NRV is as follows: