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8.4 Reporting Inventory at Lower of Cost or Market

Learning Objectives

At the end of this section, students should be able to meet the following objectives:

  1. Explain the need for reporting inventory at lower of cost or market.
  2. Differentiate between a reporting problem caused by a drop in the purchase value of inventory and one resulting from the sales value of the merchandise.
  3. Understand the difference in applying the lower-of-cost-or-market rule under U.S. GAAP and IFRS.

Inventory—The Reporting of Cost or Market Value

Question: In the example of Rider Inc., Model XY-7 bicycles have been bought and sold, and one unit remains in stock at year’s end. The cost of this model has held steady at $260. However, its market value is likely to differ from that figure.

Assume that, because of the sales made during the period, company officials believe that a buyer will soon be found to pay $440 for this last bicycle. Is inventory always reported on a balance sheet at historical cost or is market (or fair) value ever taken into consideration? Should this bicycle be shown as an asset at $260, $440, or some other pertinent figure?


Answer: Under normal conditions, market value is rarely relevant in the reporting of inventory. For Rider Inc. this bicycle will likely appear as an asset at its cost of $260 until sold. Value is such a subjective figure that it is usually ignored in reporting inventory. The company has no reliable proof that the bicycle will bring in $440 until a sale actually occurs. The conservative nature of accounting resists the temptation to inflate reported inventory figures based purely on the anticipation of a profitable transaction at some future point in time.

An exception to this rule becomes relevant if the value of inventory falls below cost. Once again, the conservatism inherent in financial accounting is easily seen. If market value remains greater than cost, no change is made in the reported balance until a sale occurs. In contrast, if the value drops so that inventory is worth less than cost, a loss is recognized immediately. Accountants often say that losses are anticipated but gains are not.

As a note to the May 31, 2011, financial statements for Nike Inc. states, “inventories are stated at lower of cost or market.” Whenever inventory appears to have lost value for any reason, the accountant compares the cost of the item to its market value and the lower figure then appears on the balance sheet.

Arriving at a Figure for Market Value

Question: As mentioned, market value is a subjective figure. When applying the lower-of-cost-or-market approach to inventory, how does the owner of the merchandise ascertain market value?


Answer: The practical problem in applying the lower-of-cost-or-market approach arises from the difficulty in ascertaining an appropriate market value. There are several plausible ways to view the worth of any asset. For inventory, there is both a “purchase value” (replacement cost—the amount needed to acquire the same item again at the present time) and a “sales value” (net realizable value—the amount of cash expected from an eventual sale). When preparing financial statements, if either of these amounts is impaired, recognition of a loss is likely. Thus, the accountant must watch both values and be alert for potential problems.

Purchase Value. In some cases, often because of bad timing, a company finds that it has paid an excessive amount for inventory. Usually as the result of an increase in supply or a decrease in demand, replacement cost might drop after an item is acquired.

To illustrate, assume that Builder Company—the manufacturer of bicycle Model XY-7—has trouble selling the expected quantity of this particular style to retail stores because the design is not viewed as attractive. Near the end of the current year, Builder reduces the wholesale price offered for this model by $50 in hopes of stimulating sales. Rider Inc. bought a number of these bicycles earlier at a total cost of $260 each but now, before the last unit is sold, could obtain the same model for only $210. The bicycle held in Rider’s inventory is literally worth less than what the company paid for it. The purchase value, as demonstrated by replacement cost, has fallen to a figure lower than its historical cost.

When replacement cost for inventory drops below the amount paid, the lower (more conservative) figure is reported on the balance sheet, and the related loss is recognized on the income statement. In applying lower of cost or marketConservative approach to the reporting of inventory used when either the purchase value or the sales value has decreased; a reduction in the asset is recorded along with a loss to reflect the decline in market value if it falls below cost., the remaining bicycle is now reported by Rider Inc. at its purchase value. A loss of $50 is created by the reduction in the inventory account from $260 to $210.

Sales value. Inventory also has a sales value that is, frequently, independent of replacement cost. The sales value of an item can fall for any number of reasons. For example, technological innovation will almost automatically reduce the amount that can be charged for earlier models. This phenomenon is typically seen whenever a new computer, camera, or phone is introduced to the market. Older items still in stock must be discounted significantly to attract buyers.

Similarly, changes in fashions and fads will hurt the sales value of certain types of inventory. Swim suits usually are offered at reduced prices in August and September as the summer season draws to a close. Damage can also impact an owner’s ability to recoup the cost of inventory. Advertised sales tempt buyers by offering scratched and dented products, such as microwaves and refrigerators, at especially low prices.

For accounting purposes, the sales value of inventory is normally defined as estimated net realizable value. As discussed in the previous chapter, this figure is the amount of cash expected to be derived from an asset. For inventory, net realizable value is the anticipated sales price less any cost required to generate the sale. For example, the net realizable value of an older model digital camera might be the expected amount a customer will pay after money is spent to advertise the product. The net realizable value for a scratched refrigerator is likely to be the anticipated price of the item less the cost of any repairs that must be made prior to sale.

As with purchase value, if the sales value of an inventory item falls below its historical cost, the lower figure is reported along with a loss to mirror the impact of the asset reduction.

Applying Lower of Cost or Market

Question: Inventory records are maintained at the historical cost of each item. For reporting purposes, this figure is utilized unless market value is lower. A reduction in value can result because of a drop in replacement cost (a purchase value) or in net realizable value (a sales value). How is the comparison of cost and market value actually made when inventory is reported?

Assume that Rider Inc. is currently preparing financial statements and holds two bicycles in ending inventory. Model XY-7 cost the company $260 while Model AB-9 cost $380. As mentioned, Model XY-7 now has a replacement cost of only $210. Because of market conditions, the exact sales value is uncertain. The other unit, Model AB-9, has been damaged and can only be sold for $400 after $50 is spent for necessary repairs. This inventory has a cost of $640 ($260 + $380). What should Rider report for its asset inventory?


Answer: As a preliminary step in preparing financial statements, a comparison of the cost and market value of the inventory is made. Although other alternatives exist, assume that Rider compares the cost to the market value for each separate item.In applying the lower-of-cost-or-market approach to inventory, the comparison can be made on an item-by-item basis. For example, XY-7 can be valued based on the lower of cost and market for that one item and then, separately, a similar determination can be made for AB-9. A company can also group its inventory (all bicycles, for example, might comprise a group that is separate from all motorcycles) and report the lower amount determined for each group. A third possibility is to sum the cost of all inventory items and make a single comparison of that figure to the total of all market values. U.S. GAAP does not specify a mechanical approach to use in applying lower of cost or market. Market value used for the first item (XY-7) is its purchase value (replacement cost of $210) whereas the market value for the second item (AB-9) is the sales value of $350 (net realizable value of $400 minus $50). A problem with either value can lead to a reduction in the reported asset balance, which causes the recognition of a loss.

Figure 8.8 Recognition of a Loss on Impaired Inventory Value

Rider Inc. reports its inventory at the conservative $560 amount on its balance sheet with an $80 loss ($640 – $560) appearing in the income statement for this period. Such losses can be quite significant. Mitsui & Co. (U.S.A.) recognized a $25.3 million loss for the year ending March 31, 2011, that was attributed to applying the lower-of-cost-or-market approach to its inventory.

Test Yourself


A company has three items of inventory: one is red, one is green, and one is blue. They cost $300 each and are usually sold for a profit of $50. The red and green units have a replacement cost of $310 each. The blue item has a replacement cost of $280. The red item can be sold for $340, the green item can be sold for $330, and the blue item can be sold for $320. It will cost $30 to sell the red one, $40 to sell the green one, and $10 to sell the blue one. If lower of cost or market value is applied on an item-by-item basis, what balance should be company report for its inventory?

  1. $850
  2. $860
  3. $870
  4. $880


The correct answer is choice c: $870.


The red item has a replacement cost ($310) and a net realizable value (NRV) ($340 less $30 or $310) that are both above cost so the $300 figure continues to be reported. The green item has a replacement cost ($310) above cost ($300) but a NRV of only $290 ($330 less $40). That item is reported at this lower value. The blue item has a replacement cost ($280) that is below cost ($300) as well as NRV ($320 less $10 or $310) so the $280 is reported. The total is $870 ($300 + $290 + $280).

Talking with an Independent Auditor about International Financial Reporting Standards (Continued)

Following is a continuation of our interview with Robert A. Vallejo, partner with the accounting firm PricewaterhouseCoopers.

Question: When applying lower of cost or market to inventory, the determination of market value according to U.S. GAAP can be either net realizable value or replacement cost depending on whether a sales value or a purchase value is impaired. This process has been used in the United States for decades. How does International Financial Reporting Standards (IFRS) handle this issue? If a company begins to report its financial statements based on IFRS, how will the comparison of cost to market be made for inventory balances?

Rob Vallejo: International Accounting Standards 2, Inventories (IAS 2) states that inventories should be measured at the lower of cost and net realizable value. Net realizable value is defined as the anticipated sales price of the item (in the ordinary course of business) reduced by the estimated costs to complete the item and any estimated costs needed to make the sale. Replacement cost is not taken into consideration. In practice, because most U.S. companies determine net realizable value when considering whether or not to decrease the cost of their inventory, I do not expect any significant differences in this area of financial reporting (with the exception of some very industry specific circumstances) when a switch to IFRS is made. However, IFRS does allow reversals of previous write-downs if appropriate, whereas this is not allowed under U.S. GAAP.

Key Takeaway

Inventory is traditionally reported on a company’s balance sheet at historical cost. However, reductions can be made based on applying the conservative lower-of-cost-or-market approach. In some cases, purchase value is in question if an item’s replacement cost has dropped since the date of acquisition. For other inventory items, the problem is with the sales value if the net realizable value (expected sales price less any costs necessary to sale) falls below cost. Drops in sales value can occur because of changes in fads or technology or possibly as a result of damage. If either of these market values is below cost, the reported inventory figure should be reduced and a loss recognized.