Question

Steele Corporation purchased a significant amount of raw materials inventory for a new product that it is manufacturing. Steele uses the lower-of-average-cost-or-net realizable value (LCNRV) rule for these raw materials. The net realizable value of the raw materials is below the original cost. 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) (1) At which amount should Steele’s raw materials inventory be reported on the balance sheet? Why? (2) In general, why is the LCNRV rule used to report inventory? (b) What would have been the effect on ending inventory and cost of goods sold had Steele used the LIFO inventory method instead of the average-cost inventory method for the raw materials? Why?

Short answer

1. The raw materials will be reported at net realizable value.
2. To record inventories correctly and record loss arising due to inventory decline.
3. The cost of goods sold will be lower, and ending inventory will be higher.

Step-by-step solution

Reporting of raw materials

The net realizable value of the raw material is below the original cost. Hence per the lower-of-cost or market-value method, raw materials will be reported at net realizable value.

Reason to use LCNRV for the inventory

The LCNRV method allows the business to record the inventories at the lowest of costs or the net realizable value. Through which inventories are recorded per their utility value and loss resulting from the decline in inventory value recorded in the year of loss.

Reason to use LCNRV for the inventory

Under the LIFO method, recent inventories purchased are sold first. Per the given case, prices are decreasing with subsequent purchases. The cost of goods sold will include inventories purchased at a lower price, which will result in a lower cost of goods sold. However, ending inventory will constitute inventory purchased at higher prices; hence it will be higher.