Explain how inventory is carried at cost or net realisable value, whichever is lower
The idea
Inventory is written down when its value has fallen below cost, measured as net realisable value — the estimated selling price less the costs to complete and sell — under IFRS and most of US GAAP, and as market value within a collar derived from it under US GAAP for LIFO and the retail method. The write-down is recognised as an expense in the period, usually within cost of goods sold. Reversals of a previous write-down are permitted under IFRS, up to the original cost, and prohibited under US GAAP, which means a recovery in value shows in one company's earnings and not in another's.
A practice question
What is net realisable value?
- The original purchase cost of the inventoryWhy not: That is the other side of the lower-of-cost-and-NRV test. Comparing cost with itself would test nothing.
- The estimated selling price less the costs to complete and sell — correct
- The replacement cost of the inventoryWhy not: That is what it would cost to buy the stock again, which is an entry price. Net realisable value is an exit price — what selling it will actually net.
It is what the company expects to actually net from selling the goods, which is the ceiling on what the asset can be worth.
A harder one
Cost is 120, expected selling price 140 and selling costs 35. What is the carrying amount?
- 140Why not: The expected selling price with no deduction. Net realisable value is 140 − 35 = 105, and inventory is never carried above what it will net.
- 120Why not: Cost, which is carried only when it is the lower figure. Here NRV of 105 is below it, so the inventory is written down.
- 105 — correct
Net realisable value is one hundred and five, which is below cost, so the inventory is written down to it.
The hardest tier
Why can a recovery in inventory value affect two companies' earnings differently?
- Because some standards permit reversal — correct
- Because recoveries are taxed differentlyWhy not: Tax treatment varies by jurisdiction, but the question is about what reaches the income statement at all — one regime recognises the recovery and the other does not.
- Because net realisable value is not defined consistentlyWhy not: The definition is substantially the same: selling price less costs to complete and sell. What differs is whether a previous write-down may be reversed.
Some allow a prior write-down to be reversed up to original cost and others prohibit it entirely. The same economic recovery produces a gain for one reporter and nothing for the other, so an analyst comparing them must know which regime each follows.
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