Inventory values can fall over time, especially for items that are subject to stiff competition or the life cycle of the product declines with time. Thus, we need a way to accurately reflect the true financial value of such assets. Net realizable value is one of the approaches to asset valuation.
Definition and Purpose
The definition of the NRV is a price the company estimates to sell the asset for minus the cost of its sale or disposal. To get the asset’s net realizable value, you need to deduct from the selling price (real or perceived) the costs directly related to the cost of all sales efforts (commissions to sales agents, the cost of packaging for a specific buyer, etc.).
Why and who needs to calculate net realizable value? First of all, it is used when testing for impairment of inventories in order to avoid overestimation of their carrying amount. After all, what are inventories? It is an asset, that is, a resource that will bring economic benefits. So, when considering the net realizable value, we are talking about the net economic benefit that the company will receive from the sale of this asset or what it can literally get from the market.
What if the economic benefit the company will receive when trading this asset is below the current book value? This is when net realizable value comes in. Hopefully, when calculating the net realizable value, the business does not find out that the value has declined past what it cost to make it.
Unfortunately, since it does happen in some cases that the value falls below what it cost to make or buy the item, the US GAAP requires that a revaluation of the inventory’s value in the company’s book. In the revaluation, the inventory may be written down to its lower value.
For example, the current amount for inventory on the accounting books is the purchase price of $3,000. The calculation of the net realizable value shows that after all the efforts to sell this asset will only bring in $2,500 for the business.
If the company continues to keep this inventory in our books at the value of $3,000, then instead of seeing information relevant for decision-making, users will see a book value that we will never get upon the sale of this asset. To prevent this from happening, you need to reflect the more accurate inventory balance and recognize an inventory impairment loss in the amount of $500.
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Author: Charles Lutwidge