Lower of cost or net realizable value
/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.
Accounting for the Lower of Cost or Net Realizable Value
To account for an asset write-down under the lower of cost or net realizable value rule, you should debit the amount of the write-down in the Loss on Decline in Net Realizable Value account, and credit the offsetting amount in the the related inventory account. An example of this journal entry is noted next.
The amount of this write-down 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 you 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.