Principles of Financial Accounting: Inventory - Lower of Cost or Net, Realizable Value LCNRV LCM

What It Is

The Lower of Cost or Net Realizable Value (LCNRV / LCM) principle is a fundamental concept in accounting that ensures inventory is valued at the lower of its cost or its net realizable value. This principle matters because it helps prevent overvaluation of inventory, which can lead to inaccurate financial statements and misinformed business decisions. If a company buys $10,000 of inventory that can be sold for $8,000, the inventory should be valued at $8,000, not $10,000.

Key Concepts & Formulas

• LCNRV: The lower of cost or net realizable value, which is the amount at which inventory can be sold.
• Net Realizable Value (NRV): The expected selling price of inventory minus any costs associated with selling it. NRV = Expected Selling Price - Costs to Sell.
• Cost: The cost of acquiring or producing inventory. Cost = Purchase Price + Direct Costs.
• Gross Profit: The difference between sales revenue and the cost of goods sold. Gross Profit = Sales - COGS.
• Allowance for Obsolete Inventory: A contra-asset account that represents the estimated amount of inventory that will become obsolete or unsalable. Allowance for Obsolete Inventory = Estimated Value of Obsolete Inventory.
• Inventory Reserve: A contra-asset account that represents the estimated amount of inventory that will become obsolete or unsalable. Inventory Reserve = Estimated Value of Obsolete Inventory.
• Matching Principle: The principle that expenses should be matched with the revenues they help to generate. Matching Principle = Revenues - COGS.
• GAAP: Generally Accepted Accounting Principles, which provide the framework for financial accounting. GAAP = Principles and Standards for Financial Accounting.

Journal Entry Examples

1. Dr. Inventory $8,000 Cr. Cost of Goods Sold $8,000 Cr. Inventory Reserve $2,000

   Explanation: The company has $10,000 of inventory that can be sold for $8,000. The inventory is valued at $8,000, and an inventory reserve of $2,000 is established to account for the difference.

2. Dr. Inventory $5,000 Cr. Cost of Goods Sold $5,000

   Explanation: The company has $5,000 of inventory that can be sold for $5,000. The inventory is valued at $5,000, and no inventory reserve is necessary.

Common Mistakes

• Mistake: Confusing the allowance for obsolete inventory with the inventory reserve.
• Correction: The allowance for obsolete inventory is a contra-asset account that represents the estimated amount of inventory that will become obsolete or unsalable, while the inventory reserve is a contra-asset account that represents the estimated amount of inventory that will become obsolete or unsalable. Allowance for Obsolete Inventory-Inventory Reserve.
• Mistake: Failing to establish an inventory reserve when inventory is valued at the lower of cost or net realizable value.
• Correction: An inventory reserve should be established when inventory is valued at the lower of cost or net realizable value to account for the difference between the cost and net realizable value. Inventory Reserve = Estimated Value of Obsolete Inventory.
• Mistake: Confusing the matching principle with the LCNRV principle.
• Correction: The matching principle is the principle that expenses should be matched with the revenues they help to generate, while the LCNRV principle is the principle that inventory should be valued at the lower of its cost or its net realizable value. Matching Principle-LCNRV Principle.

Exam Tips

• Tip: When valuing inventory at the lower of cost or net realizable value, remember that the net realizable value is the expected selling price minus any costs associated with selling it. NRV = Expected Selling Price - Costs to Sell.
• Tip: When establishing an inventory reserve, remember that the reserve should be established to account for the difference between the cost and net realizable value of inventory. Inventory Reserve = Estimated Value of Obsolete Inventory.
• Tip: When applying the LCNRV principle, remember that the principle is based on the concept of matching, which is the principle that expenses should be matched with the revenues they help to generate. Matching Principle = Revenues - COGS.

Quick Practice

1. A company has $10,000 of inventory that can be sold for $8,000. What is the adjusting entry for the inventory?

   Answer: Dr. Inventory $8,000 Cr. Cost of Goods Sold $8,000 Cr. Inventory Reserve $2,000

   Explanation: The company has $10,000 of inventory that can be sold for $8,000. The inventory is valued at $8,000, and an inventory reserve of $2,000 is established to account for the difference.

2. A company has $5,000 of inventory that can be sold for $5,000. What is the adjusting entry for the inventory?

   Answer: Dr. Inventory $5,000 Cr. Cost of Goods Sold $5,000

   Explanation: The company has $5,000 of inventory that can be sold for $5,000. The inventory is valued at $5,000, and no inventory reserve is necessary.

Last-Minute Cram Sheet

• LCNRV: The lower of cost or net realizable value, which is the amount at which inventory can be sold.
• NRV: The expected selling price of inventory minus any costs associated with selling it. NRV = Expected Selling Price - Costs to Sell.
• Cost: The cost of acquiring or producing inventory. Cost = Purchase Price + Direct Costs.
• Gross Profit: The difference between sales revenue and the cost of goods sold. Gross Profit = Sales - COGS.
• Allowance for Obsolete Inventory: A contra-asset account that represents the estimated amount of inventory that will become obsolete or unsalable. Allowance for Obsolete Inventory = Estimated Value of Obsolete Inventory.
• Inventory Reserve: A contra-asset account that represents the estimated amount of inventory that will become obsolete or unsalable. Inventory Reserve = Estimated Value of Obsolete Inventory.
• Matching Principle: The principle that expenses should be matched with the revenues they help to generate. Matching Principle = Revenues - COGS.
• GAAP: Generally Accepted Accounting Principles, which provide the framework for financial accounting. GAAP = Principles and Standards for Financial Accounting.
• Dividends are NOT an expense – they go directly to retained earnings.
• The allowance for obsolete inventory is a contra-asset account that represents the estimated amount of inventory that will become obsolete or unsalable.
• The inventory reserve is a contra-asset account that represents the estimated amount of inventory that will become obsolete or unsalable.
• The matching principle is the principle that expenses should be matched with the revenues they help to generate.