Why are inventories valued at the lower-of-cost-or-net realizable value (LCNRV)? What are the arguments against the use of the LCNRV method of valuing inventories?
The usual basis for carrying forward the inventory to the next period is cost. Departure from cost is required; however, when the utility of the goods included in the inventory is less than their cost, this loss in utility should be recognized as a loss of the current period, the period in which it occurred. Furthermore, the subsequent period should be charged for goods at an amount that measures their expected contribution to that period. In other words, the subsequent period should be charged for inventory at prices no higher than those which would have been paid if the inventory had been obtained at the beginning of that period. (Historically, the lower-of-cost-and-net realizable value rule arose from the accounting convention of providing for all losses and anticipating no profits.)
In accordance with the foregoing reasoning, the rule of "cost and net realizable value, whichever is lower" may be applied to each item in the inventory, to the total of the components of each major category, or to the total of the inventory, whichever most clearly reflects operations. The rule is usually applied to each item, but if individual inventory items enter into the same category or categories of finished product, alternative procedures are suitable.
The arguments against the use of the lower-of-cost-and-net realizable value method of valuing inventories include the following:
(a) The method requires the reporting of estimated losses (all or a portion of the excess of actual cost over net realizable value) as definite income charges even though the losses have not been sustained to date and may never be sustained. Under a consistent criterion of realization, a drop in net realizable value below original cost is no more a sustained loss than a rise above cost is a realized gain.
(b) A price shrinkage is brought into the income statement before the loss has been sustained through sale. Furthermore, if the charge for the inventory write-downs is not made to a special loss account, the cost figure for goods actually sold is inflated by the amount of the estimated shrinkage in price of the unsold goods. The title "Cost of Goods Sold" therefore becomes a misnomer.
(c) The method is inconsistent in application in a given year because it recognizes the propriety of implied price reductions but gives no recognition in the accounts or financial statements to the effect of the price increases.
(d) The method is also inconsistent in application in one year as opposed to another because the inventory of a company may be valued at cost in one year and at net realizable value in the next year.
(e) The lower-of-cost-and-net realizable value method values the inventory in the balance sheet conservatively. Its effect on the income statement, however, may be the opposite. Although the income statement for the year in which the unsustained loss is taken is stated conservatively, the net income on the income statement of the subsequent period may be distorted if the expected reductions in sales prices do not materialize.
If the answers is incorrect or not given, you can answer the above question in the comment box. If the answers is incorrect or not given, you can answer the above question in the comment box.