Inventory II: valuation and estimation

Lesson 7 determined the cost of inventory. But cost is a ceiling, not a guarantee: an asset should not be carried above the amount it is expected to realize. When sensor models become obsolete, when a competitor cuts prices or when parts are damaged, inventory must be written down. This lesson covers the lower of cost and net realizable value rule and how it differs between frameworks, the special 'lower of cost and market' rule that survives in US GAAP for LIFO and retail-method inventories, write-down reversals, losses on purchase commitments, the gross profit and retail methods used to estimate inventory when a count is impossible, the effects of inventory errors and the ratios users compute from inventory.

Lower of cost and net realizable value

IAS 2 and ASPE Section 3031 require inventories to be measured at the lower of cost and net realizable value (NRV). NRV is the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale. It is entity-specific, unlike fair value: it reflects what this entity expects to realize, not a market participant exit price. Write-downs are usually made item by item, although similar or related items (for example, items of the same product line with similar purposes that are produced and marketed in the same area and cannot practicably be evaluated separately) may be grouped. Writing down a whole class, such as 'all finished goods', is not appropriate.

Materials and supplies held for production are not written down below cost if the finished products in which they will be used are expected to sell at or above cost. Only when a decline in the price of materials indicates that the finished products will cost more than their NRV are the materials written down, and then replacement cost may be the best available measure of their NRV. NRV is estimated at the reporting date using the most reliable evidence available, including events after the period that confirm conditions existing at the end of the period, such as selling prices achieved in January.

# Lower of cost and net realizable value, item by item (illustrative)
items = [  # name, units, cost per unit, expected price, costs to complete and sell per unit
    ("Model A station (current)", 120, 3_400, 5_200, 300),
    ("Model S station (superseded)", 40, 3_200, 3_300, 350),
    ("Handheld meter", 900, 240, 400, 25),
    ("Damaged meters", 60, 240, 150, 30),
]
total_cost = total_lcnrv = 0
for name, n, cost, price, sell in items:
    nrv = price - sell
    value = min(cost, nrv)
    total_cost += n * cost; total_lcnrv += n * value
    flag = "write down" if nrv < cost else ""
    print(f"{name:<29} cost {cost:>5,} NRV {nrv:>5,} carry {value:>5,} {flag}")
print(f"Total cost {total_cost:,}; carrying amount {total_lcnrv:,}; write-down {total_cost - total_lcnrv:,}")

Model A station (current)     cost 3,400 NRV 4,900 carry 3,400 
Model S station (superseded)  cost 3,200 NRV 2,950 carry 2,950 write down
Handheld meter                cost   240 NRV   375 carry   240 
Damaged meters                cost   240 NRV   120 carry   120 write down
Total cost 766,400; carrying amount 749,200; write-down 17,200

Two items need write-downs. The superseded Model S station can be sold for only $3,300 and costs $350 a unit to refurbish and sell, so its NRV of $2,950 is below its $3,200 cost; the damaged meters' NRV of $120 is half their cost. The write-down totals $17,200 ($10,000 on Model S and $7,200 on the damaged meters), recognized as an expense (usually in cost of sales) in the period. The current models are not written up above cost, and their large margins cannot be used to offset the losses on the other items under item-by-item application.

Reversals of write-downs

Under IAS 2 and ASPE, if the circumstances that caused a write-down no longer exist, or there is clear evidence of an increase in NRV because of changed economic circumstances, the write-down is reversed, but only up to the amount of the original write-down, so that the new carrying amount is the lower of cost and the revised NRV. The reversal is recognized as a reduction of the inventory expense in the period it occurs. If Northlake finds a buyer for the Model S stations at $3,800 next quarter, the $10,000 write-down on any units still on hand is reversed, bringing them back to their $3,200 cost and no higher.

Lower of cost and market: the US rule, for comparison

Canadian students analysing US companies may meet the older 'lower of cost or market' rule, which US GAAP still applies to inventories measured using LIFO or the retail inventory method. Under it, market means current replacement cost, but not more than NRV (the ceiling) and not less than NRV minus a normal profit margin (the floor). The designated market value is the middle of replacement cost, ceiling and floor, and inventory is carried at the lower of cost and that designated market value. IFRS and ASPE do not use this rule.

Purchase commitments

Northlake signs fixed-price contracts to buy rare-earth sensor components months ahead. If the market price falls below the contract price so that the inventory to be received will not be recoverable, the contract may be onerous: under IAS 37 a provision is recognized for the unavoidable costs of meeting the obligation that exceed the economic benefits expected, and the loss is expensed. ASPE requires disclosure of significant commitments and recognition of losses where they are likely and measurable.

Estimating inventory: the gross profit method

Sometimes inventory cannot be counted: interim statements are prepared monthly or quarterly without a count, or inventory is destroyed by fire or flood and an insurance claim must be filed. The gross profit method estimates ending inventory from the historical gross margin. Cost of goods available for sale is computed from the records (opening inventory plus purchases); estimated cost of goods sold is sales multiplied by (1 − gross margin); estimated ending inventory is the difference. The method is only as good as the margin assumption, so it is not acceptable for annual statements, but it is valuable for interim estimates, insurance claims and audit reasonableness checks.

# Gross profit method: estimating inventory destroyed in a flood (illustrative)
opening, purchases, sales = 4_450_000, 3_900_000, 9_600_000
gross_margin = 0.40                  # on sales, from recent years
goods_available = opening + purchases
est_cogs = sales * (1 - gross_margin)
est_ending = goods_available - est_cogs
salvaged = 380_000                   # damaged goods, at net realizable value
print(f"Goods available {goods_available:,}; estimated COGS {est_cogs:,.0f}")
print(f"Estimated inventory at the flood date {est_ending:,.0f}")
print(f"Estimated loss for the insurance claim {est_ending - salvaged:,.0f}")

markup_on_cost = 0.60                # a 60% markup on cost
print(f"A {markup_on_cost:.0%} markup on cost is a {markup_on_cost / (1 + markup_on_cost):.1%} margin on sales")

Goods available 8,350,000; estimated COGS 5,760,000
Estimated inventory at the flood date 2,590,000
Estimated loss for the insurance claim 2,210,000
A 60% markup on cost is a 37.5% margin on sales

Northlake's estimated inventory at the flood date is $2,590,000; after deducting $380,000 of salvaged goods at NRV, the insurance claim is for $2,210,000. A common trap is confusing a markup on cost with a margin on sales: a 60 per cent markup on cost is only a 37.5 per cent gross margin, and using the wrong figure would misstate the estimate by hundreds of thousands of dollars.

The retail inventory method

Retailers with thousands of low-value items use the retail inventory method, which tracks goods available at both cost and retail selling prices and applies a cost-to-retail ratio to ending inventory at retail (counted or computed). Under the conventional version, the ratio includes net markups but excludes net markdowns, which approximates the lower of average cost and market by producing a lower ratio. Under the average-cost version, both markups and markdowns are included. IAS 2 permits the retail method for measuring cost if the results approximate cost, typically using a percentage that reflects inventory marked down below its original selling price; ASPE similarly allows it as a measurement technique.

Inventory errors

Because ending inventory of one year is opening inventory of the next, an inventory error affects two years' income and then reverses. Overstating ending inventory understates cost of goods sold and overstates profit and equity in the year of the error; next year, the overstated opening inventory overstates cost of goods sold and understates profit by the same amount, so retained earnings are correct after two years (ignoring tax). The balance sheet at the end of the first year is wrong; at the end of the second, it is right. A material error discovered later is corrected retrospectively (lesson 1), restating the comparative figures, even if it has already reversed in total.

Disclosure and analysis

The notes disclose the accounting policies for inventory, including the cost formula, the carrying amount by classification (raw materials, work in progress, finished goods, merchandise), the amount recognized as expense, write-downs and reversals with the circumstances, and inventory pledged as security. IAS 2 requires disclosure of the amount of any reversal and the circumstances that led to it. Inventory turnover (cost of goods sold ÷ average inventory) and days in inventory (365 ÷ turnover) show how efficiently inventory is managed. For Northlake, cost of sales of $36.6 million and average inventory of $4.3 million give a turnover of about 8.5 and about 43 days in inventory. Falling turnover can signal obsolete stock that should be written down, so analysts read turnover and write-down disclosures together.