Although every attempt is made to prepare and present financial data that are free from bias, accountants do employ a degree of conservatism.
Conservatism dictates that accountants avoid overstatement of assets and income. Conversely, liabilities would tend to be presented at higher amounts in the face of uncertainty. This is not a hardened rule, just a general principle of measurement. ApplicationNRV, in the context of inventory, is the estimated selling price in the normal course of business, less reasonably predictable costs of completion, disposal, and transportation. Obviously, these measurements can be somewhat subjective, and may require the exercise of judgment in their determination. It is also important to note that a company using LIFO or the retail method (as described in the next section of this chapter) would not use the lower-of-cost-or-NRV method, but would instead value inventory at lower of cost or “market.” Substitution of the word “market” entails subtle technical distinctions, the details of which are usually covered in more advanced accounting classes. It is noteworthy that the lower-of-cost-or-NRV adjustments can be made for each item in inventory, or for the aggregate of all the inventory. In the latter case, the good offsets the bad, and a write-down is only needed if the overall value is less than the overall cost. In any event, once a write-down is deemed necessary, the loss should be recognized in income and inventory should be reduced. Once reduced, the Inventory account becomes the new basis for valuation and reporting purposes going forward. Unlike international reporting standards, U.S. GAAP does not permit a write-up of write-downs reported in a prior year, even if the value of the inventory has recovered. Need help preparing for an exam?Check out ExamCram the exam preparation tool!
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Net realizable value (NRV) sounds complicated, and a lot of accountants may still use the old term: Lower of Cost of Market (LCM). However, in July 2015, the Financial Accounting Standards Board (FASB) adopted ASU 2015-11, FASB’s Accounting Standards Codification (ASC) Topic 330, Inventory, that replaced LCM with LCNRV. Lower of cost or market (old rule) The old rule (that still applies to entities that use LIFO or a retail method of inventory measurement) required entities to measure inventory at the LCM. The term market referred to either replacement cost, net realizable value (commonly called “the ceiling”), or net realizable value (NRV) less an approximately normal profit margin (commonly called “the floor”). In other words, market was the price at which you could currently buy it from your suppliers. Except, when you were doing the LCM calculation, if that market price was higher than net realizable value (NRV), you had to use NRV. If the market price was lower than NRV minus a normal profit margin, you had to use NRV minus a normal profit margin. Lower of cost or NRV (new rule)The new rule, LCNRV, was designed to simplify this calculation. NRV is the estimated selling price in the ordinary course of business, minus costs of completion, disposal, and transportation. Say Geyer Co. bought 200 Rel 5 HQ Speakers five years ago for $110 each and sold 90 right off the bat, but has only sold 10 more in the past two years for $70. There are still a hundred on hand, costs using FIFO, but the speakers are obsolete and management feels they can sell them with some slight modifications to each one that cost $20 each. So, the NRV is:
ExampleLet’s say the Geyer Co. looked at the HQ Speakers product # Rel 5 and determined that the current wholesale price was $60. There are a bunch on the shelf at the end of the year, 100 in fact, that using FIFO, are assigned a cost of $110.00. These speakers are antiquated and just aren’t selling, so even though they are on the books at FIFO (which means the cost is based on the most recent purchases, regardless of how old the actual speakers are), they are a couple of years old and could be purchased today for a lot less, if Geyer even wanted them.
So under the old rule of LCM, replacement cost (what our wholesale distributor sells to them to us for) would be the ceiling. Let’s also say we would normally mark them up and expect to make about $20 on the sale, so the floor, the lowest we could adjust them to, would be $30. If we lowered the cost to $30 on our books and sold them for $70 minus the $20 it takes to make them saleable, we’d make a normal profit.
Under the old rule that still applies to LIFO and retail inventory methods, the item could be written down to market because it is lower than the historical cost of $110. Market is somewhere between the ceiling and the floor: between $50 and $30. Since the replacement cost is over the ceiling, we’d use the $50 NRV for market. If the replacement cost had been $20, the most we could write the inventory down to would be the floor of $30. If the replacement cost had been $45, we would write the inventory down to $45. Under the new rule, which Geyer would be using because it is using FIFO cost flow assumption, the calculation is actually simpler: NRV. So, $50. As a result of our analysis, we would write down the cost of Rel 5 HQ Speakers, highlighted below in yellow, by $6,000 so the new cost on our books is $50 each. Inventory List
In the next section, we’ll look at how to adjust total inventory, but first to review: From ASU 2015-11:
By adjusting the inventory down, the balance sheet value of the asset, Merchandise Inventory, is restated at a more conservative number. Notice that we never adjust inventory up to fair market value, only downward. One final note: ASU 2015-11, FASB’s Accounting Standards Codification (ASC) Topic 330 carved out an exception to the new rule for LIFO and retail inventory methods. One of the simplest versions of the retail inventory method calculates ending inventory by totaling the value of goods that are available for sale, which includes beginning inventory and any new purchases of inventory. Total sales are multiplied by the cost-to-retail ratio (or the percentage by which goods are marked up from their wholesale purchase price to their retail sales price) in order to get an estimate of COGS. Using the formula: [latex]\text{Beginning inventory}+\text{purchases}-\text{ending inventory}=\text{COGS}[/latex] Modified slightly: [latex]\text{Beginning inventory}+\text{purchases}-\text{COGS}=\text{ending inventory}[/latex] A large company like Home Depot that has a consistent mark-up can reasonably estimate ending inventory. Home Depot undoubtedly uses a more sophisticated version of this calculation, but the basic idea would be the same. Because the estimated cost of ending inventory is based on current prices, this method approximates FIFO at LCM. Let’s see how companies apply this conservative rule to inventories. Practice QuestionWhat is net realizable value also known as?Net Realizable Value is also known as net sales value or net resale value. It's calculated by subtracting the selling cost from the sale price. To arrange it as a formula it would look like this: The selling price also includes any fees or predictable costs associated with selling.
How is net realizable value calculated?Net realizable value is the estimated selling price of goods, minus the cost of their sale or disposal.
Is net Realisable value same as selling price?Net realizable value is generally equal to the selling price of the inventory goods less the selling costs (completion and disposal). Therefore, it is expected sales price less selling costs (e.g. repair and disposal costs). NRV prevents overstating or understating of an assets value.
What is net realizable value quizlet?Net realizable value is defined as estimated selling price less purchase price.
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Net realizable value is defined as estimated selling price less purchase price
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