·
Conservatism dictates that accountants avoid
overstatement of assets and income
·
Inventory that is held may have an uncertain
future: Obsolescence, over supply, defects, major price declines, etc., can
contribute to uncertainty about the “realization” (conversion to cash) of
inventory items
·
Lower of cost or market considerations are employed:
If inventory is carried on the accounting records at greater that its market
value, a write-down is made (1)inventory is credited (2) loss for decline in
market value is debited (reduces income)
·
“market” is defined as the replacement cost:
i.e. The cost to acquire or reproduce the inventory
·
The “market” must not exceed a ceiling (1) known
as the Net Realizable Value (NRV) (2) NRV = selling price – competition and disposal
costs (3) Required because some items may be very expensive to replace, but
have no market, i.e. out-of-date cell phones
·
The “market” must not be below a floor(1) floor
= NRV – normal profit margin
Step1: Determine the market
Replacement cost, not to exceed the ceiling or be less than
the floor
Step 2: Report inventory at the lower of its cost or market
(as determined in step 1)
·
Adjustments can be made for each item in
inventory or for the aggregate of all the inventory: for the aggregate, the
good offsets the bad, and write-down is only needed if the overall market is
less than the overall cost
·
Once a write-down is deemed necessary, losses
should be recognized in income and inventory should be reduced: write-ups of
previous write-downs for any recovery in value would not be permitted under
United States GAAP
·
International standards do not use “ceilings”
and “floors”: (1) NRV is the only benchmark for assessing market (2) recoveries
of previous write downs are recognized, but only to the amounts previously
written off
