Question

Ogala Corporation purchased a significant amount of raw materials inventory for a new product that it is manufacturing. Ogala uses the LCNRV rule for these raw materials. The net realizable value of the raw materials is below the original cost. Ogala uses the FIFO inventory method for these raw materials. In the last 2 years, each purchase has been at a lower price than the previous purchase, and the ending inventory quantity for each period has been higher than the beginning inventory quantity for that period. Instructions (a) At which amount should Ogala’s raw materials inventory be reported on the balance sheet? Why? (b) In general, why is the LCNRV rule used to report inventory? (c) What would have been the effect on ending inventory and cost of goods sold had Ogala used the average-cost inventory method instead of the FIFO inventory method for the raw materials? Why?

Short answer

1. Raw materials will be reported at net realizable value
2. The LCNRV method is used to report the inventory per its utility value.
3. Ending inventory will be higher, and the cost of goods sold will be lower than FIFO.

Step-by-step solution

Reporting of raw materials

a. The net realizable value of the inventory is lower than its cost. Hence, per the Lower-of-cost-or-net-realizable-value, it will be reported at net realizable value as it is the lowest.

Reason for LCNRV

b. The future utility of the goods decreases, thereby decreasing the value of the goods. The various reasons for the decrease in the value are obsoleteness, physical deterioration, etc. hence, it is important to record the inventory per its benefit that will be received in the future. In the LCNRV method, the lowest value of original cost or NRV is used to report the value of inventory.

Effect on ending inventory and cost of goods sold

c. In the case of the FIFO method, in the event of decreasing price, the cost of goods sold will be higher as it will include the inventory purchased early at a higher price. The ending inventory will be lower as it includes the inventory purchased at lower prices. Inventories are valued at the same constant rate when an average method is used. Hence it will result in a higher value of ending inventories as ending inventories are higher, and also cost of goods sold be lower, as fewer units are sold.