Accounting standards (IRFS and US GAAP) require that we apply a conservatism principle when we assess the value of assets and transactions.

The Net Realizable Value (NRV) is the amount we can realize from an asset, less the disposal costs. The most often use of the method is when we evaluate inventory and accounts receivable balances.

Companies usually record assets at cost (how much it cost to acquire the asset). Sometimes the business cannot recover this amount and must report such assets at the lower of cost and Net Realizable Value.

NRV is a conservative method as it estimates the real value of an asset, after deducting selling costs or costs of disposal.

Understanding the Net Realizable Value

Employing the NRV method is a way to evaluate inventory and accounts receivable while applying conservatism and following the accounting standards’ stipulations.

In the context of inventory, NRV represents the expected selling price in a regular business transaction, less the estimated costs of delivery, completion, and disposal. This value can be highly subjective and requires a certain level of professional judgment in its estimation. It is also important for both internal and external auditors. Management often tries to show better results by playing around with the assumptions for the NRV calculation.

For accounts receivable, the NRV is the full balance of the receivables, less the allowance for doubtful and uncollectible debt for customers we expect to default on their payments. In most financial statements, you can see that the line on the balance sheet reads’ Accounts receivable, net.’

You can read more on how to derive the Doubtful Debt Allowance (DDA) in our article on Accounts Receivable Ageing Analysis.

IFRS and US GAAP

Accounting standards require that we present inventory and accounts receivable at the lower of cost and NRV. Both sets of standards refer to NRV. However, there are some differences worth noting.

IFRS requires applying the same assumptions and formula for the NRV calculation of similar items, while US GAAP has no such stipulation.

IFRS allows us to reverse the write-down of an item if its value increases over time. On the other hand, US GAAP does not allow for such a reversal of write-downs once recognized.

In IFRS, we are required to present at the lower of cost and NRV. US GAAP refers to a different term, stipulating we have to show assets at the lower of cost and market value. Market value refers to the asset’s current replacement cost, and it has a defined ceiling and floor, although the floor can be subjective.

Calculating Net Realizable Value

The calculation for NRV is not as complicated as deriving the inputs for it. To arrive at it, we can follow these three steps:

1. Determine the expected selling price or market value of the asset
2. Identify all costs associated with the sale (e.g., marketing, delivery, insurance)
3. Calculate NRV as the market value [1] less the costs of disposal [2]

Although the formula here is for inventory, it is relatively easy to convert it for accounts receivable. We need to change the market value with the gross receivable balance and the associated costs – with the doubtful debt allowance (DDA).

We usually calculate the NRV adjustment on a ‘per item’ basis. However, in some instances where we have extensive inventory databases, this can become tedious and impractical. Also, our system does not always provide an easy way to book the adjustment with such detail.

When we face such circumstances, it is acceptable to book as a total adjustment. Then we must track the calculation in a spreadsheet and track sold finished goods and materials that went to production. This is crucial, as when we sell an item, we have to write-off its cost and its NRV allowance.

An alternative is to separate our inventory into groups of similar items and calculate the Net Realizable Value on an aggregated basis. It is important to note that we might have some ‘good’ items offset the effect of such with NRV issues by doing so. This might go as far as to not needing a write-down for this group. There are no additional guides to separate inventory into groups, other than the items having to be similar. What this means is a matter of professional judgment and solid knowledge of the business.

Calculating the NRV of inventory and accounts receivable regularly prevents overstatement of assets in the Balance Sheet and helps us conform with the conservatism principle.

Accounting Records

If we carry inventory in our accounting records at a value greater than its NRV, we must write it down to the lower NRV.

Whenever we assess a need to book a write-down, the next step is to recognize it as an expense item in our profit and loss (Income Statement) and decrease the inventory value in our Balance sheet.

In essence, we do not book a decrease directly in the inventory balance. A separate credit account is where we recognize an NRV allowance. We then use this account to offset the value of inventory in our financial statements.

Let’s illustrate the accounting treatment with an example. We have some parts in our warehouse, which we have recorded at the cost of acquisition of €20,000. Recently, manufacturers of such components have adopted a new production technology. As a result, this has brought down the realizable value of the items to €15,000. To reflect this change in value in our financial records, we take the following journal entry:

In some time, we still have the parts on hand when the manufacturers start producing a new, better part, and we can no longer realize the ones we have in stock. Management decides to write-off the components. We record this with the following entry:

If we managed to sell them for €12,000 before they become obsolete, then we would record the transaction as so:

And, in case the new production method fails, and the value of our parts returns to €20,000, we will adjust that as follows:

Remember that while this is permitted under IFRS, US GAAP does not allow for write-down reversals if inventory value goes up subsequently.

Net Realizable Value Analysis

Businesses perform regular NRV evaluation to assess whether they need to adjust the value at which they record inventory and accounts receivable. Usually, we perform the analysis once a year to present correct balances in our financial statements. It is also common to combine it with the Slow-moving and Obsolete Inventory analysis. Where possible, managers try to schedule the annual stock-take close to the year-end as it is the process where the company identifies damaged, spoiled and obsolete items.

Timely adjusting the values allows us to avoid carrying losses forward into future periods. However, this is also where management sometimes feels pressure to hide issues with NRV to present better results and meet their targets. If not addressed over more extended periods, such behavior can become a severe problem for the company.

This analysis is part of almost any audit, as inventory and accounts receivable overstatement is a more significant risk. If the auditors identify significant NRV issues, the company will either have to adjust their records or accept a qualified audit report.

Example NRV Analysis

I want to show you how you might approach an NRV analysis of inventory in a real-life situation. First, we need a breakdown of the items. As we assess as part of our annual close process, let’s look at the balance as of 31 December 2020.

Now that we have our available inventory as of year-end, we need to compare its cost to the estimated selling price. As we usually perform such analysis later in the next year, let’s assume we are now at the end of Q1 of 2021. This means that instead of estimating sales prices and looking into pricing lists (which many companies don’t have), we can take as reference the actual sales in the period between 31 December 2020 and 31 March 2021.

As our sales team offers discounts for various reasons, we also calculate the Net Sales for each item.

As our next step, let’s prepare our work file. Take the inventory breakdown as of 31 December 2020 and calculate the Average Cost per item (End V / End Q).

Then we use VLOOKUP to bring in the Quantity and Net Sales Value from Q1 2021, to calculate an average Net Sales Price. It is essential to take the Net Sales instead of Gross Sales, as the discount is a part of our cost to sell the items. We will not consider delivery costs, as our clients organize the delivery for themselves.

We calculate the Average Cost as so:

And then follow with the Average Price, based on Net Sales:

As we now have both the average cost and average sales price, we can compare those to identify potential NRV issues. As we might have no sales for some of our inventory items, we include another check and return “no sales” where the sold quantity is zero. For items we sold, where the Average Price is less than the Average Cost, we identify an NRV issue.

As our NRV Issues column shows the difference between prices only when the cost exceeds the selling price, we can calculate our NRV Adjustment Value by multiplying it with the quantity as of 31 December 2020.

It is essential to remember that we are performing our analysis as of 31 December 2020. Therefore, we apply the issue to the balance as of this date.

However, if you scroll through the file, you will notice that about 20% of our items had no sales in Q1 2021. There are different ways to approach the NRV calculation for these. Best would be to use a Price List or some confirmed offers to clients. In case these are not viable options, what I’d usually do is calculate the average percentage of NRV adjustment per inventory group. We need to make sure our inventory groups are homogenous and items within them have similar performance to employ this approach.

To do it in practice, we create a pivot table out of our analysis so far, and exclude items with “no sales.”

We then calculate the average percentage of NRV Adjustment Value off of End Value (the value as of 31 December 2020).

Now we can bring the average NRV Adjustment percentages back to our analysis by VLOOKUP-ing them from the Group Codes. We do this only if the item has “no sales” to avoid double NRV adjustments.

Applying these percentages to the End Value from the inventory breakdown gives us the additional expected NRV adjustment.

Whether the total NRV adjustment the company will recognize in its accounting records will include this additional amount is a matter of management’s professional judgment and knowledge of the business.

Conclusion

We use the Net Realizable Value to account that assets are sometimes worth less than on paper.

NRV is a conservative approach to accounting, which is in line with the principle of conservatism. The method helps avoid overstatements of inventory and accounts receivable.

Analysts use NRV to see if companies are following accounting standards and properly valuing their assets.

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