Estimating Net Realizable Value of Inventory

Paragraph 9 of IAS 2 requires that ‘Inventories shall be measured at the lower of cost and net realizable value’. As the purpose of acquiring or manufacturing inventory items is to sell them at a profit inventory will initially be recognized at cost. This cost is periodically compared to the inventory’s net realizable value to determine if the sale of the inventory will recover at least its cost. If cost is not expected to be recovered the inventory is written down to net realizable value. The purpose of this measurement rule is to ensure that inventory items are not reported at values above their expected future benefits.

Two specific industry groups have been exempted from applying the lower of cost and net realizable value of inventory rule, namely:

(a)                producers of agricultural and forest mineral products, to the extent that they are measured at net realizable value, and

(b)               commodity broker-traders who measure their inventories at fair value less costs to sell.

Inventory must be reported in net realizable value in the financial reporting of a corporation. Estimates of net realizable value (NRV) must be based on the most reliable evidence available at the time the estimate is made (normally the end of the reporting period) of the amount that the inventories are expected to realize.

Thus, Estimates of net realizable value (NRV) must be made of:

• expected selling price

• estimated costs of completion (if any)

• estimated selling costs.

These estimates take into consideration fluctuations of price or cost occurring after the end of the reporting period to the extent that such events confirm conditions existing at the end of the reporting period.

The purpose for which inventory is held should be taken into account when reviewing net realizable values. For example, the net realizable value of inventory held to satisfy firm sales or service contracts is based on the contract price. If the sales contracts are for less than the inventory quantities held, the net realizable value of the excess is based on general selling prices.

Estimated selling costs include all costs likely to be incurred in securing and filling customer orders such as advertising costs, sales personnel salaries and operating costs, and the costs of storing and shipping finished goods.

It is possible to use formulas based on predetermined criteria to initially estimate net realizable value. These formulas normally take into account, as appropriate, the age, past movements, expected future movements and estimated scrap values of the inventories. However, the results must be reviewed in the light of any special circumstances not anticipated in the formulas, such as changes in the current demand for inventories or unexpected obsolescence.

IAS 2 states that materials and other supplies held for use in the production of inventories are not written down below cost if the finished goods in which they will be incorporated are expected to be sold at or above cost. When the sale of finished goods is not expected to recover the costs, then materials are to be written down to net realizable value (NRV). IAS 2 suggests that the replacement cost of the materials or other supplies is probably the best measure of their net realizable value.

Write-down to net realizable value (NRV):

Inventories are usually written down to net realizable value on an item-by-item basis. Where it is not practical to separately evaluate the net realizable value of each item within a product line, the write-down may be applied on a group basis provided that the products have similar purposes or end uses, and are produced and marketed in the same geographical area. IAS 2 generally requires that service providers apply the measurement rule only on an item-by-item basis, as each service ordinarily has a separate selling price.

If the circumstances that previously caused inventories to be written down below cost change, or if a new assessment confirms that net realizable value has increased, the amount of a previous write-down can be reversed (subject to an upper limit of the original write-down). This could occur if an item of inventory written down to net realizable value because of falling sales prices is still on hand at the end of a subsequent period and its selling price has recovered.

As the measurement rule mandated by IAS 2 for inventories is the lower of cost (LCM) and net realizable value (NRV), an estimate of net realizable value (NRV) must be made to determine if inventory must be written down. Normally, this estimate is done before preparing the financial statements but, where management become aware during the reporting period that goods or services can no longer be sold at a price above cost, inventory values should be written down to net realizable value. The rationale for this measurement rule is that ‘assets should not be carried in excess of amounts expected to be realized from their sale or use’.

Net realizable value (NRV) is the net amount that an entity expects to realize from the sale of inventory in the ordinary course of business. It is defined in paragraph 6 of IAS 2 as ‘the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale’.

Net realizable value is specific to an individual entity and is not necessarily equal to fair value less selling costs. Fair value is defined as ‘the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (IFRS 13 Fair Value Measurement).

Net realizable value (NRV) may fall below cost for a number of reasons including:

• a fall in selling price (e.g. fashion garments)

• physical deterioration of inventories (e.g. fruit and vegetables)

• product obsolescence (e.g. computers and electrical equipment)

• a decision, as part of an entity’s marketing strategy, to manufacture and sell products for the time being at a loss (e.g. new products)

• miscalculations or other errors in purchasing or production (e.g. over-stocking)

• an increase in the estimated costs of completion or the estimated costs of making the sale (e.g. air-conditioning plants).