Lower of Cost and Net Realisable Value Decisions
At 31 December, Umeh Stores holds four inventory lines. Line A cost $12,000; it is selling slowly and the owner has reduced the price to $15,000, which is expected to be achieved after selling costs of $1,800. Line B cost $9,000; its replacement cost is $7,500, but the business expects to sell it for $9,600 after paying $600 selling costs. Line C cost $5,000 and was damaged by water; it needs $700 of repair work before it can be sold for $3,200. Line D cost $14,000 and is subject to a firm sales contract signed on 20 December for $15,500, delivery in January. In addition, goods costing $2,400 were shipped by a supplier on 28 December on terms FOB shipping point and arrived on 4 January; they were not included in the count. Draft gross profit before any inventory adjustment is $58,000; the owner wants to value everything at cost because 'the sale will happen eventually'.
1. Value each inventory line at the lower of cost and net realisable value, and compute the total inventory value at 31 December.
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| Line | Cost $ | Net realisable value $ | Valuation $ |
|---|---|---|---|
| A | 12,000 | 15,000 - 1,800 = 13,200 | 12,000 |
| B | 9,000 | 9,600 - 600 = 9,000 | 9,000 |
| C | 5,000 | 3,200 - 700 = 2,500 | 2,500 |
| D | 14,000 | 15,500 | 14,000 |
| Goods in transit | 2,400 | 2,400 | 2,400 |
| Total | 42,400 | 39,900 |
Line C is written down by $2,500 ($5,000 - $2,500). The total inventory value is $39,900. The $2,400 goods in transit are included because FOB shipping point means title passed to Umeh Stores on 28 December, even though the goods arrived after the year end. The owner's 'sale will happen eventually' argument does not justify carrying C at cost: net realisable value is below cost at the reporting date, so the write-down is required.
2. Explain the reasoning for lines B, C and D, including why replacement cost and the firm contract matter.
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Line B: net realisable value is expected selling price less costs to complete and sell, so $9,600 - $600 = $9,000. Replacement cost of $7,500 is not the valuation basis. It is evidence that the item may be worth less, but the actual NRV is $9,000, equal to cost, so no write-down is needed. Valuing at replacement cost would understate inventory and profit.
Line C: the damaged item needs $700 of repair before sale. Repair cost is a cost to complete, so NRV is $3,200 - $700 = $2,500. Because this is below cost, inventory is written down to $2,500. The write-down is not optional; it reflects the loss of economic benefit already suffered.
Line D: the firm contract signed before the year end is strong evidence of the amount the business will receive. NRV is $15,500, above cost, so the item stays at $14,000. If the contract were only a non-binding intention, the general market price would be used instead. A firm contract also affects whether the item is dedicated to that customer, but here it supports cost.
3. Calculate the adjusted gross profit and explain the effect of the $2,400 goods in transit on the accounts.
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Adjusted gross profit depends on whether the purchase invoice for the goods in transit was recorded. If it was recorded, purchases already include $2,400 and only closing inventory needs correcting: gross profit = $58,000 - $2,500 write-down + $2,400 = $57,900.
If the invoice was not recorded, the business must record the purchase and the inventory: Dr purchases $2,400, Cr payables $2,400; Dr inventory $2,400, Cr cost of sales $2,400. The two entries offset, so gross profit remains $58,000 - $2,500 = $55,500, but the balance sheet grows by $2,400 on both sides.
In either case, the $2,400 must be included in closing inventory because FOB shipping point transfers title at dispatch. Omitting it understates inventory and overstates cost of sales. The key judgement is to check the purchase ledger for the invoice and to confirm the shipping terms, not simply to rely on the physical count date.