Net realizable value is a valuation technique mandated under Generally Accepted Accounting Principles. The technique requires that you calculate the estimated selling price of inventory items, less any reasonably predictable costs of completing the inventory, transporting it, and/or disposing of it.
You need to know net realizable value, because a company is supposed to record its inventory at the lower of cost or market, and net realizable value is one of the factors considered in this determination. There is an ongoing need to examine the value of inventory to see if its recorded cost should be reduced, due to the negative impacts of such factors as damage, spoilage, obsolescence, and reduced demand from customers. Further, writing down inventory prevents a business from carrying forward any losses for recognition in a future period. Thus, the use of net realizable value is a way to enforce the conservative recordation of inventory asset values.
Follow these steps to determine the net realizable value of an inventory item:
- Determine the market value of the inventory item.
- Summarize all costs associated with completing and selling the asset, such as final production, testing, and prep costs.
- Subtract the selling costs from the market value to arrive at the net realizable value.
Thus, the formula for net realizable value is:
Inventory market value - Costs to complete and sell goods = Net realizable value
Example of Net Realizable Value
ABC International has a green widget in inventory with a cost of $50. The market value of the widget is $130. The cost to prepare the widget for sale is $20, so the net realizable value is $60 ($130 market value - $50 cost - $20 completion cost). Since the cost of $50 is lower than the net realizable value of $60, you continue to record the inventory item at its $50 cost.
In the following year, the market value of the green widget declines to $115. The cost is still $50, and the cost to prepare it for sale is $20, so the net realizable value is $45 ($115 market value - $50 cost - $20 completion cost). Since the net realizable value of $45 is lower than the cost of $50, you should record a loss of $5 on the inventory item, thereby reducing its recorded cost to $45.
If this calculation does result in a loss, you should charge the loss to the cost of goods sold expense with a debit, and credit the inventory account to reduce the value of the inventory account. If the loss is material, you may want to segregate it in a separate loss account, which more easily draws the attention of a reader of a company's financial statements.
Net realizable value is actually only one of the factors you consider in determining the lower of cost or market, so see the Lower of Cost or Market article for a complete explanation.
Net realizable value can also refer to the aggregate total of the ending balances in the trade accounts receivable account and the offsetting allowance for doubtful accounts. This net amount represents the amount of cash that management expects to realize once it collects all outstanding accounts receivable.