What you’ll learn to do: Apply the conservatism principle to inventory costing

Generally, companies should use historical cost to value inventories and COGS. However, some circumstances justify departures from historical cost. One of these circumstances is when the utility or value of inventory items is less than their cost. In other words, if you have items in inventory that are worth less than you paid for them, you either need to write them off or at least write them down.

Therefore, in addition to periodic and perpetual methods of record-keeping, and in addition to the specific identification, FIFO, LIFO, and weighted-average inventory costing methods, accountants have to deal with a permanent decline in the value of inventory using either the lower of cost or net realizable value (LCNRV) rule or the similar lower of cost or market (LCM) rule. We’ll cover the lower of cost or net realizable value (LCNRV) here because lower of cost or market (LCM) is similar.

Lower of cost or net realizable value (LCNRV) is an application of the conservatism principle. Recall that the conservatism principle requires us to recognize and record expenses and liabilities-certain or uncertain, as soon they are measurable, but to recognize revenues and assets only when they are earned and likely to be realized.

Applying that concept to inventory, we find that GAAP requires that merchandise inventory be reported in the financial statements at whichever is lower of the following:

• The historical cost of the inventory determined by FIFO, LIFO, weighted average, or specific identification
• The net realizable value of the inventory, which is the estimated selling price in the ordinary course of business minus costs of completion, disposal, and transportation.