Professor Adams' Lecture Materials

LO9-01: Understand and apply rules for measurement of inventory at the end of the reporting period.

Apple's iPhone XR, announced in 2018, did not sell well. Suppose, at the end of 2018, Apple had a huge amount of iPhone XR inventory that was sitting in their warehouses. The cost of the XR inventory was based on the costs of production (e.g., materials, labor, production facility rent). Now, suppose Apple determined that in order to sell all of its remaining XR inventory, it would have to offer deep discounts to customers. The discounts would take the price of the phone below the cost to make the phone. [01] Assuming these things actually happened, would it have still been appropriate for Apple to value its iPhone XR inventory at its production cost?

Inventory write-downs

GAAP requires that companies evaluate their unsold inventory at the end of each reporting period. When the expected benefit of unsold inventory is estimated to have fallen below its cost, companies must reduce the value of their inventory in their financial statements. An adjusting journal entry is made to reduce the reported amount of inventory. This adjusting adjusting journal entry is called an inventory write-down and also results in the company recording a loss in its income statement.

How do we measure the write-down amount?

Lower of cost or net realizable value (LCNRV)

This method is for companies that use FIFO or the average cost inventory methods.Under this method, a company must compare inventory cost to inventory net realizable value (NRV), which is the estimated selling price less costs of completion, disposal, and transportation. Effectively, this represents the estimate proceeds from selling the inventory at a reduced price. Two possibilities from this comparison:

1. NRV > Cost: no write-down is needed.
2. NRV < Cost: inventory has to be adjusted to its NRV. Therefore, an inventory write-down is required.

For financial reporting purposes, LCNRV can be applied to: (a) individual inventory items, (b) major categories of inventory, or (c) to the entire inventory. Any of the three is allowed. However, companies must be consistent (i.e., they can't switch from year to year).

Lower of cost or market (LCM)

This method is for companies that use LIFO or the retail inventory methods. The method is similar, in concept, to LCNRV. However, instead of using net realizable value, "market" price is used. A company must compare inventory cost to its estimated market price.

To determine the market price, a company looks at three different values:

1. Replacement cost: The estimated cost to re-manufacture the same inventory item or, if company is not a manufacturer, the cost to re-purchase the same item from a supplier.
2. Net realizable value (NRV): The estimated selling price less costs of completion, disposal, and transportation (same as above in the previous section).
3. Net realizable value (NRV) less a normal profit margin (NPM): The inventory item's selling price, used in the estimation of NRV, includes a price markup for profit. For example, Apple sells iPhones for about $1,000 and makes a gross profit of about $640 per phone. [01] We're trying to approximate inventory cost so LCM says another data point to use in determining market price is NRV less profit or, in Apple's case, $1,000 - $640 = $360.

Once these three data points are determined, the value that falls in the middle of the three data points becomes the estimated market price.

Recording an inventory write-down under LCM

In terms of the journal entry, recording an inventory write-down under LCM is identical to recording an inventory write-down under LCNRV.

- If Cost > Market then no write-down is necessary.
- If Cost < Market then a write-down is necessary and the amount of the write-down is the difference between cost and market.

Different levels of aggregation

Like LCNRV, the LCM approach can be applied to (1) individual inventory items, (2) inventory categories, or (3) total inventory. Example given here.

Footnotes

[01] This did not actually happen. Apple sells its iPhones at around a 64% gross profit margin, so even with price cuts Apple still likely made money. But, lets just make this assumption for illustration purposes.

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