Question

Explain the lower of cost and net realizable value approach to valuing inventory.

Answer 1

Answer:

Inventory transactions are recorded at cost. However, the cost prices may go down, in which case valuing inventory at cost at period end may overstate inventory and income of the period and understate income of next period.

The lower of cost and net realizable value approach to valuing inventory, is an example of conservative approach to value and report inventory. When inventory is purchased in one period at a higher cost and sold/used in another period, valuing it a higher cost will distort income of the periods.

Net realizable value is the value arrived at by deducting cost to complete and sale inventory from its sales value. Valuing inventory at lower of cost and net realizable value ensures inventory valuations are kept current, are valued conservatively and assets and income are not overstated. This also ensures loss due to purchase on inventory at a higher price is borne in the period in which it is purchased and not carried over to next period.