Under IFRS, whenever the value of inventory declines below the carrying amount on the balance sheet, the inventory carrying amount must be written down to its net realizable value. Most importantly, the loss must be recognized as an expense on the income statement.
Analysts need to consider the possibility of an inventory write-down because its impact on a company’s financial statements and ratios could be significant.
Write-downs reduce the value of inventory, and the loss in value (expense) is generally reflected in the income statement in the cost of goods sold. An inventory write-down will also reduce both profit and the carrying amount of inventory on the balance sheet. consequently, it will hurt profitability, liquidity, and solvency ratios.
For example, net profit margin and gross profit margin will both be lower because of a higher cost of sales (assuming that the inventory write-downs are reported as part of the cost of sales).
Activity ratios such as inventory turnover and total asset turnover will be positively affected because the asset base is reduced (due to a decrease in the average inventory balance, and the higher cost of sales).
Question 1
If a company values its inventory at the net realizable value, this will most likely:
- Improve the company’s profitability.
- Decrease the company’s inventory turnover.
- Lead to any loss being recognized as an expense on the company’s income statement.
Solution
The correct answer is C.
When a company’s inventory carrying amount is written down to its net realizable value, the loss is recognized as an expense on the income statement.
A and B are incorrect. If a company values its inventory at the net realizable value, its profitability will decrease as its inventory turnover increases.
Question 2
An inventory write-down reversal would increase a company’s assets (inventory), which is the denominator of all the activity ratios. The increase of the denominator of a ratio decreases the value of that ratio.
Net Realisable Value (NRV) is the amount by which the estimated selling price of an asset exceeds the sum of any additional costs expected to incur during the sale of the asset. NRV has significant importance in the valuation of inventory.
Both GAAP (Generally Accepted Accounting Principles) and IFRS (International Financial Reporting Standards), require us to consider the NRV of inventory for valuation purposes. Under GAAP, inventories are measured at Lower of Cost or market, provided that the market value must not exceed the NRV of inventory. Under IFRS, inventories must be valued at Lower of Cost and NRV.
The NRV
Net Realisable Value is a derivation of the estimated selling price of goods, minus some deductions. The derivation is used in the determination of the Lower of Cost or market for on-hand inventory items. The deductions from the estimated selling price are any reasonably predictable costs of:
- Finishing the stock
- Transporting the stock
- Discarding the stock
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 factors such as damage, spoilage, obsolescence, and reduced demand from customers. Furthermore, writing down inventory prevents a business from carrying forward any losses for recognition in a future period. Thus, the use of NRV is a way to enforce the conservative recordation of inventory asset values.
Thus, the formula for Net Realisable Value is:
- Net Realisable Value = Sale Value – Cost to Make Saleor
- Net Realisable Value = Inventory Market Value – Costs to complete and sell goods
This is where the sale value is the estimated selling price of inventory in the ordinary course of business; and the cost to make the sale is the sum of any additional costs expected to be incurred to make the sale including, but not limited to, the costs of finishing, repair, advertising expenses directly related to inventory and transportation costs borne by the owner etc. if any.
Example 1
Calculate the Net Realisable Value of inventory based on the following information:
Total Units19,000Estimated selling price each35Units damaged (all together)700Cost to repair each damaged unit£6Other selling costs per unit£2Solution
GoodDamagedEstimated price per unit£35£35– Repair cost£6– Other selling costs£2£2NRV per unit£33£27x units£18,300£700Net Realisable Value£603,900£18,900Total Net Realisable Value£622,800Example 2
ABC Ltd has a green gadget in stock with a cost of £50. The market estimation of the gadget is £130. The cost to set up the gadget is £20, so the Net Realisable Value is £60 (£130 market value – £50 cost – £20 finish cost). Since the cost of £50 is lower than the Net Realisable Value of £60, you keep on recording the inventory item at its £50 cost.
In the next year, the market estimation of the green gadget decreases to £115. The cost is still £50, and the cost to set up the gadget is £20, so the Net Realisable Value is £45 (£115 market value – £50 cost – £20 finish cost). Since the net realisable value of £45 is lower than the cost of £50, you should record a loss of £5 on the stock item, subsequently decreasing its recorded cost to £45.
If this calculation does result in a loss, charge the loss to the cost of goods sold expenses 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 separate it in a separate loss account, which more easily draws the attention of a reader of a company’s financial statements.
Is inventory reported at net realizable value?
Net realizable value is an important metric that is used in the lower cost or market method of accounting reporting. Under the market method reporting approach, the company's inventory must be reported on the balance sheet at a lower value than either the historical cost or the market value.
When Should inventory be valued at its net realizable value?
So, net realizable value can only be used if it is lower than the inventory cost in the company's balance sheet. If the market value is available, the company should give preference to that value for reporting purposes.
On which basis should inventory be valued?
There are three methods for inventory valuation: FIFO (First In, First Out), LIFO (Last In, First Out), and WAC (Weighted Average Cost). In FIFO, you assume that the first items purchased are the first to leave the warehouse.
