The lower of cost or net realizable value concept means that inventory should be reported at the lower of its cost or the amount at which it can be sold. Net realizable value is the expected selling price of something in the ordinary course of business, less the costs of completion, selling, and transportation. Thus, if inventory is stated in the accounting records at an amount higher than its net realizable value, it should be written down to its net realizable value. This is done by crediting the amount of the write down to the inventory account, and debiting the Loss on Decline in Net Realizable Value account. The loss appears within the cost of goods sold line item in the income statement.

The Reason for the Lower of Cost or Net Realizable Value Concept

The lower of cost or realizable value rule is associated with the conservatism principle. This principle holds that one should recognize expenses and liabilities as soon as possible when there is uncertainty about the outcome, but only recognize revenues and assets when they are assured of being received. This means that the inventory asset will always be reported at a value representing at least the amount that can be collected from its eventual sale.