What is net realizable value? Is it the same as fair value?
Net realizable value is the net amount that an enterprise expects to realize from the sale of inventory in the ordinary course of business and is defined in IAS 2 paragraph 6 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.
As such, net realizable value is specific to an individual enterprise and is not necessarily equal to fair value less costs to sell. Fair value is defined as ‘the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction’ (IAS 2, paragraph 6).
Why is the LCM net realizable value rule used in the accounting standard? Why is Net Realizable Value Important
Net realizable value is the net amount that an enterprise expects to realize from the sale of inventory in the ordinary course of business. Where net realizable value is lower than cost the inventory item must be written down.
The rationale for this measurement rule is stated in IAS 2 paragraph 28, ‘assets should not be carried in excess of amounts expected to be realized from their sale or use’.
Inventory cannot be revalued upwards unless there has been a previous write down. 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.
Under no circumstances can inventory be valued beyond its original cost.