Final answer:
The lower of cost and net realizable value approach is applied when the net realizable value of inventory is less than the cost, leading to a reported loss and adjustment of inventory value on the balance sheet.
Step-by-step explanation:
When the net realizable value (NRV) is lower than the cost of inventory, the loss method applying the lower of cost and net realizable value (LCNRV) approach is utilized. This accounting principle requires that inventory be reported at the lower value between its original cost and the net amount that can be realized from its sale. This conservative approach ensures that the inventory is not overstated on the financial statements. In essence, if inventory has a cost of $100 and an NRV of $80, it means that the inventory can only be sold for $80 after deducting the cost of making the sale. Thus, a $20 loss is recognized, and the inventory is reported at $80 on the balance sheet.