For accounts receivable, for example, net realizable value refers to the amount of cash the company expects to receive from its accounts receivable, which is the balance net of estimates for bad debts.
Net Realizable Value and Asset Valuation
Inventory items are recorded at historical cost at the time of purchase. Like other asset examples in GAAP’s mixed rules, however, historical cost is only the starting point of recording the asset’s book value.
Fixed assets are subject to depreciation, goodwill and land are subject to write-downs from impairment, and accounts receivable values are subject to write downs due to estimates for bad debt. Assets are therefore recorded at historical cost, and adjusted to the net realizable value on the balance sheet. (Note that these assets are never written up under current U.S. GAAP. However, the transition to replace historical cost recognition with fair value recognition is currently under review as part of the convergence to international accounting standards).
Using Net Realizable Value for Inventory Valuation at Lower of Cost or Market
Similarly, recognizing inventory at the net realizable value is a departure from historical cost. Inventory items are especially subject to lost value due to damage, spoilage, obsolescence, or lower demand resulting in discounted items. GAAP requires an annual test to adjust the balance to the lower of cost or market, or LCM. The test is required so that losses on inventory are matched with earnings for the same period. This prevents the reporting of inflated earnings for the same period discounted inventory items are sold.
At year end, remaining inventory items are measured at the lower of cost or market, or LCM. This means that any items remaining are compared to the current replacement value. If the current replacement value is less than the historical cost, the items are adjusted down to the replacement cost, or market, to account for the lost value. If the current replacement cost is greater than the historical cost, the items remain at historical cost, acquiring the name Lower of Cost or Market.
In the context of inventory valuation and lower of cost or market, net realizable value takes on a meaning very specific to inventory. It is defined as the estimated selling price minus all estimated selling costs and costs to complete the product. For example, if Sunny sells sunglasses for $50 and estimates that each sale costs $1.18 in advertising costs, the net realizable value for a pair of sunglasses is equal to $48.82.
Net realizable value is then used to calculate the ceiling and floor on the replacement cost (market).
Steps in Determining Inventory Valuation Using Lower of Cost or Market (LCM) and Net Realizable Value (NRV)
|1). Determine the historical cost of inventory (typically based on LIFO, FIFO, average cost, etc.).
2). Obtain the market value, or the replacement cost of the inventory item.
3). Calculate the net realizable value of the inventory item, used as the ceiling for the market price.
4). Calculate the net realizable value less the normal profit margin for inventory, used as the floor for the market price.
5). Determine the market value of the inventory.
6). Compare the historical cost from Step 1 with the market value in Step 5, and use the lowest amount for the inventory item (LCM).
For example, if Sunny sells sunglasses for $50 and incurs no additional selling expenses, the NRV equals the selling price of $50 as in Item A below. If Sunny estimates that each sale costs $1.18 in advertising costs, and also offers custom fitting that costs $5 per sale, the NRV equals $43.82 (50 – 1.18 – 5) (see item B below).
For Item A, the market price of $16 is within the range of the $50 ceiling and the $15 floor. Consequently, the replacement cost of $16 is compared to the historical cost of $15 to determine LCM. Because the historical cost of $15 is less than the replacement cost of $16, LCM is $15.
For Item B, the market price of $14 is within the range of the NRV ceiling of $43.82 and the NRV floor of $8.82, so the market price of $14 is compared to the cost. Since the original cost is $15, the LCM equals $14.
|Inventory Item||Historical Cost (LIFO, FIFO, etc.)||Replacement Cost (market)||Estimated Selling Price||Cost to Complete (to calculate NRV)||Normal Profit Margin %||Normal Profit Amount (to calculate floor)|
|Inventory Item||Historical Cost
||Replacement Cost (market)||NRV (Ceiling)||NRV less profit (floor)||Market||LCM|
|A||$15||$16||$50 (50-0)||$15 (50-35)||$16||$15|
|B||15||14||43.82 (50-6.18)||8.82 (50-6.18-35)||14||14|
|C||25||10||85 (100-15)||15 (100-15-70)||15||15|
|D||40||35||30 (60-30)||6 (60-30-24)||30||30|
Notice that item C uses the floor for the market replacement value, since the replacement cost of $10 falls below the NRV floor of $15. Similarly, Item D uses the NRV ceiling of $30 since the replacement cost of $35 exceeded the NRV ceiling limitation of $30.
Determing Market Value in LCM
|Market value in LCM is the current replacement cost not exceeding the ceiling of net realizable value (selling price less costs) and not below the floor of NRV adjusted for a normal gross profit margin (NRV – normal profit margin).|
Generally falling replacement costs indicate loss of inventory utility which transfer to falling selling prices. Rising replacement costs indicate increasing selling prices, which is the underlying logic of LCM valuation.
In cases where the selling price falls disproportionately to the replacement cost, the gross profit relationship, typically 70% for Sunny Sunglasses Shop, is no longer valid. The ceiling prevents additional losses from occurring in the future when the selling price is falling faster than the replacement cost. For example, Sunny would not pay $35 to sell an item for $30 as in item D, so the value of inventory would not be greater than its NRV of $30 in future periods when the items is sold.
Similarly, a floor is put in place to prevent unrealistic profits in the future when the replacement cost is falling faster than the selling price. Normally, Sunny would receive 70% gross profit on average for Item C. The replacement cost fell below the normal profit margins of 70%, so the NRV “floor” is put in place as a more accurate measure of inventory utility. When the items are sold in the future, unrealistic profits over the normal profit margin are prevented. The ceiling and floor maintain normal profit margins and prevent the reporting of exaggerated losses and gains in the future respectively when the newly valued inventory items are later sold.
Inventory write downs may be recorded in COGS, or, if material, recorded as a debit to a loss account, and a credit either directly to the inventory account, or a valuation inventory account, a contra account, for inventory.
Firms try to avoid carrying excess inventory while meeting current demand to avoid inventory obsolescence that would lead to write downs and lost value.
This is especially important for retailers of fashion goods, seasonal goods, and goods that rely on rapidly changing technologies like PC’s, microprocessors, and other hardware. Companies use the inventory turnover ratio to monitor appropriate inventory levels.