Applying the lower of cost or net realizable value rule, this item should be valued at:
|
The value for which an asset can be sold adjusted for the costs associated with the sale of the asset Show
What is Net Realizable Value (NRV)?Net realizable value (NRV) is the value for which an asset can be sold, minus the estimated costs of selling or discarding the asset. The NRV is commonly used in the estimation of the value of ending inventory or accounts receivable. The net realizable value is an essential measure in inventory accounting under the Generally Accepted Accounting Principles (GAAP) and the International Financing Reporting Standards (IFRS). The calculation of NRV is critical because it prevents the overstatement of the assets’ valuation. The NRV complies with a more conservatism approach to accounting. The conservatism approach directs accountants to use valuation methods that generate a smaller profit and do not overstate the value of the assets in situations when professional judgment is required for the evaluation of the transactions. CFI’s Reading Financial Statements course will go over how to read a company’s complete set of financial statements. NRV and Lower Cost or Market MethodNet realizable value is an important metric that is used in the lower cost or market method of accounting reporting. Under the market method reporting approach, the company’s inventory must be reported on the balance sheet at a lower value than either the historical cost or the market value. If the market value of the inventory is unknown, the net realizable value can be used as an approximation of the market value. How to Calculate the NRVThe calculation of the NRV can be broken down into the following steps:
Mathematically, the net realizable value can be found through the following equation: However, the net realizable value is also applicable to accounts receivables. For the accounts receivable, we use the allowance for doubtful accounts instead of the total production and selling costs. Example of Calculating the NRVCompany ABC Inc. is selling the part of its inventory to Company XYZ Inc. For reporting purposes, ABC Inc. is willing to determine the net realizable value of the inventory that will be sold. The expected selling price of the inventory is $5,000. However, ABC Inc. needs to spend $800 to complete the goods and an additional $200 for transportation expenses. Considering the available information, the net realizable value of the inventory should be calculated in the following way: NRV = $5,000 – ($800 + $200) = $4,000Related ReadingsThank you for reading CFI’s guide to Net Realizable Value. To keep learning and advancing your career, the following resources will be helpful:
learning objective LO3 – Explain and calculate lower of cost and net realizable value inventory adjustments. In addition to the adjusting entry to record the shrinkage of merchandise inventory (discussed in Chapter
5), there is an additional adjusting entry to be considered at the end of the accounting period when calculating cost of goods sold and ending
inventory values for the financial statements. Generally accepted accounting principles require that inventory be valued at the lesser amount of its laid-down cost and the amount for which it can likely be sold — its net realizable value (NRV). This concept is known as the lower of cost and net realizable value, or LCNRV. Note that the laid-down cost includes the invoice price of the goods (less any purchase discounts) plus transportation in, insurance while in transit, and any other
expenditure made by the purchaser to get the merchandise to the place of business and ready for sale. As an example, a change in consumer demand may mean that inventories become obsolete and need to be reduced in value below the purchase cost. This often occurs in the electronics industry as new and more popular products are introduced. The lower of cost and net realizable value can be applied to individual inventory items or groups of similar items, as shown in Figure 6.4.1 below. Figure \(\PageIndex{1}\): LCNRV Calculations Depending on the calculation used, the valuation of ending inventory will be either $2,600 or $2,650. Under the unit basis, the lower of cost and net realizable value is selected for each item: $1,200 for white paper and $1,400 for coloured paper, for a total LCNRV of $2,600. Because the LCNRV is lower than cost, an adjusting entry must be recorded as follows.
The purpose of the adjusting entry is to ensure that inventory is not overstated on the balance sheet and that income is not overstated on the income statement. If white paper and coloured paper are considered a similar group, the calculations in Figure 6.4.1 above show they have a combined cost of $2,650 and a combined net realizable value of $2,700. LCNRV would therefore be $2,650. In this case, the cost is equal to the LCNRV so no adjusting entry would be required if applying LCNRV on a group basis. When Should inventory be valued at its net realizable value?Under the market method reporting approach, the company's inventory must be reported on the balance sheet at a lower value than either the historical cost or the market value. If the market value of the inventory is unknown, the net realizable value can be used as an approximation of the market value.
When applying the lower of cost or market rule to inventory valuation market generally means?The lower of cost or market rule states that a business must record the cost of inventory at whichever cost is lower – the original cost or its current market price. This situation typically arises when inventory has deteriorated, or has become obsolete, or market prices have declined.
Why are inventories measured at lower cost and net realizable value?Obsolescence, over supply, defects, major price declines, and similar problems can contribute to uncertainty about the “realization” (conversion to cash) for inventory items. Therefore, accountants evaluate inventory and employ lower of cost or net realizable value considerations.
In what circumstances would the net Realisable value be lower than the cost of the inventory?Net realisable value may be less than cost because of deterioration, obsolescence, or changes in demand. At the reporting date, however, there may be a reasonable expectation that the proceeds of sale of some stock in future reporting periods will not produce enough income to cover its cost.
|
