 Hello, and welcome to this session in which we would learn about the concept of lower of cost or net Realizable value so we would report our inventory at lower of cost or net realizable value rather than the historical cost And basically this is a deviation from the historical cost historical cost is how much we paid for that item Well, the question is why there are two reasons why we do so the first one is being conservative and accounting if We have overstated inventory we cannot report it at an overstated amount We have to reduce the cost of that inventory Why because the inventory lost utility somehow the inventory is not that is not as valuable as it was one We originally purchased it it could be for many reasons. It could be technology changes It could be market demand for some reason the asset lost utility For example, if you have oil if you have oil and oil prices go down Well, if you purchase them already your inventory cost is now your inventory valued at lower than the cost because It's you purchase them at $60 now each barrel of oil is 50 Well, it lost utility ten dollars of utility The other reason is Record your losses earlier. So don't wait until you sell your inventory If you if you know that your inventory lost value, guess what? Don't wait until you sell it because you may not sell it until a year from now or two years from now You want to record the loss in the year that inventory took place Also, what's that gonna do? It's gonna spread your losses rather than having losses all at once and this way will give a picture of what's going on in your company as As time goes by rather than selling this item two years later and you have a large loss that Investors creditors are not aware of so those are the two reasons why we need to learn about lower-off cost or net Realizable value this topic is covered in intermediate accounting as well as the CPA exam whether you are an accounting students or a CPA Candidate I strongly suggest you take a look at my website for head lectures calm I don't replace your CPA review course I'm a useful addition to your CPA review course. I explained the material differently than your CPA review course. I provide you alternative resources alternative Explanation alternative multiple choice questions alternative exercises. That's gonna help you understand your CPA review course better Your risk is one month of subscription. Give it give it a try if you find it's helping you you keep it Otherwise you cancel your potential gain is passing the exam If not for anything take a look at my website to find out how well or not well your university doing on the CPA exam I do have resources for other accounting courses lectures multiple choice such as advanced accounting managerial accounting auditing. I Also have all the previously AI CPA released questions almost 1500 of those questions with detailed solution my CPA review courses CPA supplemental review courses are aligned with your becker Wiley Roger and Gleam this way you can go back and forth between my material and your CPA Review course if you have not connected with me on LinkedIn, please do so take a look at my LinkedIn recommendation like this recording Share it with other connect with me on Instagram Facebook Twitter and Reddit So the first thing we want to know is what is net realizable value because we have to choose between our cost Which is we know what what our cost is and something called net realizable value or an RV NRV is computed by taking the estimated selling price in the in the ordinary course of business It means it's an not a fire sale You're not selling it at a discount because you need to get rid of it. It's the normal selling price Which is the selling price minus? Reasonably predicted cost to sell so what are some reasonably predicted cost to sell? Well, you might incur sales commission You might incur Transportation out freight out you might incur some packaging or some other cost the best way to illustrate this is to look at An example Adam purchases an item for $950 it has a sales value today of a thousand Estimated cost to complete the sale is 50 and the estimated selling price is $200 well, let's take a look at how we would compute an RV The selling price is a thousand. This is the estimated selling price minus Predictable cost to sell well estimated cost to complete the sale is 50 Estimated cost to sell is 250. We have another another $250 to sell it therefore what we're gonna be getting for this item if we sell it is 750 The cost of this item is guess what 950 we are at a loss of $200 so what we have to do we have to report this 750 in the inventory And we have to report a loss in the income statement of $200 the best way to illustrate this concept a little bit further is to look at an example So we're gonna be assuming we sell fruits and we have apples and pears and we have different type of apples and different type of pears And we're gonna look at their cost They're not realizable value and we're gonna have to choose between the two and look at the journal entry So the first thing is we are doing we are selling apples the red are apples gala Macintosh granny Smith golden red delicious And we have Asian pear European pear and gold pear This is how many pounds we have right now. This is how much we paid for each pound Right and this is how much the net realizable value if we want to sell those pounds How much can we sell it per pound 85 cents 75 cent 20 cent? 60 cent, you know, the red delicious. We can get anything barely sent for it Okay, now we're gonna compute total cost and basically total cost is how many pounds we have times the cost of the pear Which is $600 the Macintosh the same thing now. We're gonna compute the total net realizable value We are giving the net realizable value per pound will just take 800 times 85 cent will give us 680 and we'll do we'll compute the net realizable value for all now we have total cost And by the way, this is the total cost So ignore the red the red because the total for the apple and the green is the total for the pear So we're gonna do I'm gonna add all the individuals I'm adding all the individual total cost here all the individual total cost here and They add up to five thousand six hundred and five dollars I'm gonna do the same thing for the total net realizable value and what I have to do is Already computed the net realizable value notice. This is the total and this is the total Okay, so now what I'm gonna do I'm gonna compare the total cost To the net realizable value and I find out I have a difference when I look at my inventory overall of $119 so that's one way to compute the difference. So what what does that mean? It means you have to write down your inventory by $119 so I looked at the total inventory Another way to do so is to select the rather than selecting the whole inventory I'm gonna be selecting each item and finding out The lower of cost or net realizable value. Well, what does that mean? It means I'm gonna look at the 600 versus the 680 and I'm gonna choose the 600 as my reported inventory. I'm gonna look at 360 for the Macintosh versus 450 Well, I'm gonna look I'm gonna choose the 360 because 360 is lower for the Granny Smith I'm gonna look at 225 cost net realizable value 90. I'm gonna choose the 90 the lower Golden 240 versus 180. I will choose the lower red delicious there Basically, we have to get rid of them 390 versus six dollars the six dollars and I will do the same thing for the peers I will choose each individual item. So here what I'm looking. I'm looking at each item separately and what I find out My lower of cost or net realizable value per item is 4996 my cost is 5605 I have a utility loss of 609. I have a difference of 609 Or what I can do rather than looking at the whole inventory or leather rather than looking at each item I can I can value my inventory by categories. I can take a look at the Total cost for all the apples the net realizable value for all the apples and choose the lower of the two Which is 1406 I can do the same thing for the peers add up all the peers add up the all the peers at the net realizable value and choose between the lower between the cost and the net realizable value the 3790 cost is lower than net realizable value. This is what I would report And I will you know, I will add them up and the difference between those is 409 dollars 409 dollars So now the question is the question is which one would I report you could report any loss You would like to but the most conservative one is when you compute them per item You compute them per item and this is what we're gonna do. We're gonna look at the the we're gonna assume we're gonna be reporting the Lower of cost or net realizable value per each item, which is gonna give us 609 dollars of losses now we need to book the loss Well, there are two methods to book the loss There is the loss method which we will debit a loss It's called the loss method due to decline in inventory to an RV of 609 dollars and we will credit Allowance to reduce inventory 609 Or we could use the cost of goods sold method Which is the everything cost of goods sold directly 609 and crediting inventory 609 So what's gonna happen is this the loss due to decline in inventory It's gonna be close to cost of goods sold anyway But there are the two methods just in case your textbook or your CPA review course use a different method and again We can credit inventory directly or we can credit allowance the allowance would reduce Inventory now it doesn't make a difference which method you use on the financial statements because if you use the allowance method Rather than reducing inventory for example here We have 40,000 of inventory then you would reduce the inventory by 609 when we add up our current assets They will add up to 94,000 392 if you reduce inventory directly rather than reporting inventory at 40,000 You would reduce it directly by 609 your total current assets will be the same because you are You are reducing inventory directly rather than indirectly also on the income statement It doesn't make a difference because whether you debited cost of goods sold directly under the cost of goods sold method Or if you debited loss then close the loss into cost of goods sold the 609 will eventually Reduce the increase the cost of Goods sold by 609 which is we end up in the same place So we end up whether we are using the loss or the cost of cost of goods sold method The effect on income should be the same In the effect on the balance sheet should be the same. That's the point. I'm trying to make here Whether you use the loss or the cost of goods sold method now if you use the loss method You're gonna have to worry about the allowance and this is the point that we're trying to make The allowance is is a contra asset account and you have to keep it contra asset account stays with you from the year to year For example, if we have this This this data and we have inventory at cost of 200,000 that realizable value as 188 It means we have a loss of 12,000 That's the required valuation because we have to reduce our inventory by 12,000 So we have to have a valuation account, which is allowance allowance account In allowance account allowance to reduce inventory to be more specific to reduce inventory And we have to have in there 12,000 and what we do is we debit Loss due to decline in inventory and credit allowance to reduce inventory now we reduce our inventory in year one by 12,000 in year two December 31st acts to our inventory is 190,000 our inventory at an RV is 183 now the difference is 7,000 this is an allowance account simply put we have to have an hour allowance account 7,000 rather than 12,000. What does that mean? It means we have to reduce our allowance by Five let me choose a different color here by 7,000 okay, we have the adjustment is a decrease in our allowance and the effect on income It's gonna be an increase Although we have a losses of 7,000 but but relative to the prior year We improve by 5,000 Therefore we debit allowance to reduce inventory to reduce this account to reduce this balance by five and we have some sort of a gain or Revenue so simply put On a timeline Okay, we were let's this is zero. Okay, and we're always We're always working on the negative end. Let me put this timeline down here So on a timeline, it looks something like this. This is the zero valuation and we started at 12,000 We had $12,000 of negative valuation now we are at 7 7,000 so we move to the right $5,000, $5,000 Okay, every time we move to the right. It's a positive in 20x3 In 20x3 The cost and the NRV were equal to each other. Well, what does that mean? Well, that's good because now our valuation Should be zero for valuation to be zero. We have to debit Allowance in additional in additional 7,000. It means now we're gonna move from Negative 7,000 to zero. So we're moving to the right another 7,000. Okay, so again, we debit allowance credit some sort of a gain in year four the cost is 282 the NRV is is 280 it means we now we need another and when now we need to go back You know, we can we can go above zero obviously now we need to go back to negative 2,000 negative 2,000 that therefore we have to increase the allowance by 2000 and the income obviously will decrease because when we increase the allowance We book a loss of 2000 of 2000. Okay, so the point I'm trying to make is the allowance Don't go away now in the real world. It might go away, but but for for CPA purposes For your class purposes the allowance account will stay with you from year to year and it's a contra asset Therefore you need to know how to adjust it from year to year. Remember the allowance account could go up to zero That's it because because even if even if your net realizable value is higher than your cost You cannot book again. You just have you reported at cost. So you're always working below zero Basically, the allowance is reducing your inventory. That's what that's what I mean below zero. It means you have losses to book At the end of this recording I'm gonna remind you whether you are an accounting student or a CPA candidate to take a look at my website farhat-lectures.com I don't replace your CPA review course. Keep it. I'm a useful addition to your CPA review course You study for your exam once in your lifetime. Give it all what you got. Don't shortchange yourself Invest in yourself put the CPA exam behind you. It's worth it. Good luck study hard and stay safe