PAS 2, paragraph 9, provides that inventories shall be measured at the lower of cost and net

realizable value.

Net realizable value completion and the estimated cost of disposal.

The cost of inventories may not be recoverable under the following circumstances:

The measurement of inventory at the lower of cost and realizable value is now known as
LCNRV Net realizable value or NRV is the estimated selling price in the ordinary course of
business less the estimated cost of net

a. The inventories are damaged.

b. The inventories have become wholly or partially obsolete.

c. The selling prices have declined. d. The estimated cost of completion or the estimated cost of
disposal has increased.

The practice of writing inventories down below cost to net realizable value is consistent with the
view that assets shall not be carried in excess of amounts expected to be realized from their
sale or use.

Determination of net realizable value

Inventories are usually written down to net realisable value in an item by item or individual basis.
faventories

It is not appropriate to write down inventories based on a dassification of inventory, for example,
finished goods or all inventories in a particular industry or geographical segment.

In some circumstances, however, it may be appropriate to group similar or related items.

This may be the case with items of inventory relating to the same product line that have similar
purposes, are produced and marketed in the same geographical area and cannot be practically
evaluated separately.

Materials held for use in production are not written down below cost if the finished products in
which they will be incorporated are expected to be sold at or above cost.

However, when a decline in the price of materials indicates that the cost of the finished products
exceeds net realizable value, the materials are written down to net realizable value.

In such circumstances, the replacement cost of materials may be the best evidence of net
realizable value.
Accounting for inventory writedown

If the cost is lower than net realizable value, there is no accounting problem because the
inventory is measured at cost and the increase in value is not recognized.

If the net realizable value is lower than cost, the inventory is measured at net realizable value
and the decrease in value is recognized.

Methods of accounting for the inventory writedown

Direct method

The inventory is recorded at the lower of cost or net realizate value.

This method is also known as "cost of goods sold method" becaus any loss on inventory
writedown or gain on reversal of inventory writedown is not accounted for separately but
"buried" in the cost of goods sold.

Allowance method

The inventory is recorded at cost and any loss on inventory writedown is accounted for
separately. This method is also known as "loss method" because a loes account"loss on
inventory writedown" is debited and a valuation account "allowance for inventory writedown" is
credited.

In subsequent years, this allowance account is adjusted upward or downward depending on the
difference between the cost and ret realizable value of the inventory at year-end. If the required
allowance increases, an additional loss is recognized

If the required allowance decreases, a gain on reversal of inventory writedown is recorded.

However, the gain is limited only to the extent of the allowance balance.

Preferably, the allowance method is used in order that the effects of writedown and reversal of
writedown can be clearly identified.

As a matter of fact, PAS 2, paragraph 36, requires disclosure of the amount of any inventory
writedown and the amount of any reversal of inventory writedown.

The gain on reversal of inventory writedown is presented as a deduction from cost of goods
sold.
PAS 2, pagragraph 34, provides that the amount of any reversal of any writedown of inventory
arising from an increase in net realizable value shall be recognized as a reduction in the amount
of inventory recognized as an expense in the period in which the reversal occurs.

The amount of inventory recognized as an expense of the period is actually the cost of goods
sold during the period.

Purchase commitments

Purchase commitments are obligations of the entity to acquire certain goods sometime in the
future at a fixed price and fixed Actually, a purchase contract has already been made for future
quantity, delivery of goods fixed in price and in quantity Where the purchase commitments a
disclosure is required in the accompanying notes to financial are significant or unusual,
statements.

Any losses which are expected to arise from firm and noncancelable commitments shall be
recognized.

If there is a decline in purchase price after a purchase commitment has been made, a loss is
recorded in the period of if there the price decline. Note that a purchase commitment must be
noncancelable in order that a loss purchase commitment can be recognized.

Thus, if at the end of the reporting period, the purchase price falls below the agreed price the
difference is accounted for as a debit to loss on purchase commitments and a credit to an
estimated liability.

The loss on purchase commitment is classified as other expense and the estimated liability for
purchase commitment
is classified as current liability.

When the actual purchase is made in the subsequent period and the current replacement cost
drops further to P420,000, the journal entry is:

LCNRV Adaptation

Actually, the recognition of a loss on purchase commitment Text an adaptation of the

Accordingly, if the market price rises by the time the entity makes the purchase, a gain on
purchase commitment would be recorded.
However, the amount of gain to be recognized is limited to the loss on purchase commitment
previously recorded.

Thus, in the preceding illustration, if the replacement cost of the purchase commitment is
P600,000 when the actual purchas is made, the journal entry to record the actual purchase is:

As a simple guide, the actual purchase is recorded at the lower between the amount of
purchase commitment and the current replacement cost or current market price.

The gain on purchase commitment is the increase in market price from P450,000 at year-end to
P480,000 on the date of actual purchase. The gain on purchase commitment is classified as
other income.

Disclosures

With respect to inventories, the financial statements shall disclose the following, including the
cont formula used.

The accounting policies adopted in measuring inventories,

The total carrying amount of inventories and the carrying amount in classifications appropriate
to the entity.

Common classifications of inventories are merchandise, production supplies, goods in process

The carrying amount of inventories carried at fair value less cost of disposal. d.

The amount of inventories recognized as an expense during the period.

The amount of any writedown of inventories recognized as an expense during the period. The
amount of reversal of writedown that is recognized as income.

The circumstances or events that led to reversal of a writedown of inventories.

h. The carrying amount of inventories pledged as security for liabilities.

Agricultural, foreTextad mineral products

Accordingly, agricultural crops that have been harvested or mineral products that have been
extracted are measured at net realizable value: a. When a sale is assured under a forward
contract o government guarantee. b. When a homogeneous market exists and there is a
negligible risk of failure to sell.

Commodities of broker-traders PAS 2, paragraph 3, provides that commodities of broker-traders

PFRS 13, paragraph 9, defines fair value of an asset as the price that would be received to sell
the asset in an orderly transaction between market participants.

Broker-traders are those who buy and sell commodities for others or on their own account.

The inventories of broker-traders are principally acquired with the purpose of selling them in the
near future and generating a profit from fluctuations in price or broker-traders' margin.

ESTIMATE IN INVENTORY VALUATION In many cases, it is necessary to know the

of inventory when it is not possible to take a physical count. Even if the physical count is
possible, the same may prove costly. difficult or inconvenient at the moment. There are two
widely accepted procedures for approximating

the value of inventory, namely:

b. Gross profit method Retail inventory method

The approximation or estimation of inventory is made for varied reasons. The most common
reasons for making an estimate of the cost

of the goods on hand are: The inventory is destroyed by fire and other catastrophe, or theft of
the merchandise has occurred and the amount of inventory is required for insurance purposes.

b. A physical count of the goods on hand is made and it is necessary to prove the correctness
or reasonableness of such count by making an estimate.

This is known as the "gross profit test" in the acounting parlance.

Interim financial statements are prepared and a physical

count of the goods on hand is not necessary because it may

take time to do the same.

Moreover, only an estimate is required to fairly present the financial position and financial
performance of the entity for interim reporting purposes.
GROSS PROFIT METHOD The groen profit method is based on the assumption that the

rate of gross profit remains approximately the same tr

to net salee is relatively constant from period to period

Cost of goods sold

Thus

Obs

The gross profit method is so called because the cost of goods sold is computed through the
use of the gross profit rate.

The cost of goods sold is computed as follows: a. Net sales multiplied by cost ratio

Net

Co

Gr

This formula is used when the gross profit rate is based on sales.

b. Net sales divided by sales ratio

This formula is used when the gross profit rate is based on cost.

As exemplified earlier, the gross profit rate is expressed as percent of sales or as a percent of
cost of goods sold. gross profit rate on sales is computed by dividing the amount

250,000

of gross profit of P250,000 by the net sales of P1,000,000 or 25% The gross profit rate on cost
is computed by dividing the gross profit of P250,000 by the cost of goods sold of P750,000 or 33
1/3%.

The

The gross profit rate on sales is the common way of quoting

rather than on a cost basis.

Besides, the gross profit rate on sales is naturally lower than that based on cost and this lower
rate creates a favorable impression on the part of the customers. Gross profit rate on cost to
gross profit on sales

Sometimes, it becomes necessary to convert the gross profit

rate from one basis to another.

If the gross profit rate on cost is 25%, the gross profit rate on

sales is computed as follows:

Sales allowance and sales discount

Sales allowance and sales discount are ignored, that is, t

deducted from sales.

The reason is that while these items decrease the amount of sales, they do not affect the
physical volume of goods sold

Sales allowance and sales discount do not increase the physica

inventory of goods, unlike in sales return where there is a

actual addition to goods on hand.

To deduct sales allowance and sales discount from sales would result to overstatement of
inventory with a consequent understatement of cost of goods sold and overstatement of gross
income

Why overstate inventory when there is no addition to physical inventory created by sales
allowance and sales discount?