Accounting is a conservative discipline. In fact, conservatism is one of the 10 underlyingprinciples of accounting and guides accountants to be purposefully moderate — forexample,to avoid overstating the value of assets and income, or understating the value ofliabilities. Net realizable value is an approach to valuing assets fairly — andconservatively. It applies to all reporting under both Generally Accepted AccountingPrinciples (GAAP) and International Financial Reporting Standards (IFRS). So, it’simportantto understand the concept, how it is calculated and what it may mean for your financialresults.
What Is Net Realizable Value (NRV)?
Net realizable value analysis is a way to check the balances of assets on a company’saccounting books to ensure they are properly valued under the theory of conservatism. Thismeans that the books should always err on the side of caution, recording assets and revenueswhen certain they will occur and recording or disclosing liabilities when they can bemeasured and have a greater than 50% chance of occurring. For accounting purposes, assetvalues are initially recorded using their original (or “historical”) cost, butover timetheir value might change, for example, due to market activity outside the company, thusrequiring an adjustment to the asset value on the company’s books. NRV is most oftenappliedto inventory but can be brought to bear on any asset, such as accounts receivable, fixedassets or investments.
Specifically, NRV considers two factors for measuring value: an asset’s fair marketvalue andthe costs a company would incur to sell the asset and obtain that value. Accountingguidelines define fair market value (FMV) as the amount a willing, informed buyer would payfor the asset on the open market. NRV analysis then reduces an asset’s FMV by thecosts theseller might incur during the sale transaction, such as transportation costs, taxes,commissions or disposal fees. If the NRV of an asset is less than its book value, anadjusting journal entry is made to write down the asset to its NRV. Such adjustments alsoreduce a company’s profits.
Key Takeaways
- Net realizable value checks balance sheet asset values against their fair market valuesand then adjusts the balance sheet to reflect asset values at the lower of cost ormarket value.
- NRV is required for compliance with both U.S. GAAP and IFRS.
- NRV analysis is commonly used for inventory, AR, fixed assets and in cost accounting.
- Adjustments uncovered during NRV affect a company’s balance sheet and theprofitabilityon its income statement.
- NRV requires well-researched estimates and, therefore, can be tedious. The rightaccounting data is essential for accurate valuations.
Net Realizable Value Explained
NRV can be applied to any asset, although it’s most commonly used for valuing inventoryandaccounts receivables (AR). Changes in the FMV or selling price of inventory could cause anNRV adjustment. For AR and other receivables such as notes receivable, increased collection risk cancause a potential NRV concern. For other assets, such as real estate or fixed assets, marketvalues are affected by time, obsolescence, and economic conditions, any of which can triggerNRV issues.
In the case of inventory, GAAP-compliant companies must record and track inventory valuesusing an approved inventorycost-accounting method, such as first-in-first-out (FIFO) or specificidentification. To maintain up-to-date inventory values, accountants do periodic NRVanalyses to verify that the value being carried is appropriate. It’s common for NRV tobedone at year’s end or quarter’s end, or any time a condition arises thatsuggests asignificant change in the fair market value of the inventory. For example, a computermanufacturer might initially record its PC inventory using the FIFO method. But when anext-generation processor is released, the expected selling price of those PCs is likely todecline. So, the company performs an NRV analysis to compare the inventory’s value onthecompany’s balance sheet with its estimated NRV. If NRV is lower than the book value,thevalue of the PC inventory is written down and a loss from NRV is recorded on the incomestatement directly or as an increase in cost of goods sold.Because of accepted conservative accounting practices, a potential gain — i.e., in theeventthat estimated NRV is greater than book value — would never be recorded under U.S.GAAP.
Most times, NRV is higher than book value, so no adjustment is required. This is, of course,because companies set selling prices higher than their costs to manufacture or purchasesomething so that they can make a profit. Further, the open market selling price is usuallyso much higher than the book value that, even after deducting the costs to get ready forsale, NRV is higher than book value. This is especially true during inflationary periods andfor high-margin items. However, factors like obsolescence or increasing competition cansometimes push down the open market selling price, making an NRV adjustment necessary.
How to Calculate Net Realizable Value
Companies calculate NRV for individual assets as well as for overall asset classes. Forexample, a technology retailer might analyze the NRV of all its cell phone accessories oronly its stock of power cords. Similarly, an NRV analysis can be done for all AR or just ARfrom a particular customer. In either case, there are three steps in calculating NRV:
- Determine the asset’s FMV. The first step is to figure out theasset’sopen market value. In some cases, the FMV might simply be a product’s current saleprice, but other cases may require a fair amount of research or an appraisal.
- Estimate selling costs. The second step is to estimate the costs to getan item ready for sale or other disposal. For inventory orphysical assets, this might involve estimating transportation costs,advertising, commissions or packaging. For AR, “disposal costs” couldinclude legal feesor collection agency commissions.
- Calculate the asset NRV. The third step is to subtract theselling/disposal costs from the FMV to get the NRV.
Once you determine the NRV, you can compare it with the asset’s carrying value on thecompany’s books to determine whether an adjustment is necessary.
NRV formula
The formula used in step 3 to calculate the NRV of an asset is:
NRV = Fair market value - costs to sell or dispose
NRV and the lower of cost or market method
The final step in NRV analysis is to compare the NRV against the asset’s carrying valueonthe company’s books. Remember, the carrying value is initially recorded as theasset’soriginal cost and may have been subsequently adjusted, such as with depreciation orallowances for obsolescence or doubtful accounts. If the NRV is greater than the carryingvalue, then no further action is required, since the asset is already being reported at thelower of cost or FMV. However, if the NRV is lower than the carrying value, an adjustmentwould be created to write down the asset to the NRV. This adjustment would credit (orreduce) the asset’s value and debit (or increase) an expense or loss account on theincomestatement. NRV write-downs reduce net income in theperiod the NRV analysis is performed. Assets written down cannot be written back up infuture periods under U.S. GAAP, although this is allowed under IFRS.
Net Realizable Value Examples
Consider three examples of NRV analysis for a fictional retailer of technology accessories,KMR Inc.
- NRV for inventory. KMR Industries has 100 power cords in stock for thecurrent cell phone model, with a historical cost of $15 each. KMR sells the cords for$42 each. When the next cell phone model launched, demand for KMR’s power cordsdropped,so the company reduced the selling price to $22. This market event triggered an NRVanalysis by KMR’s accountants. The new FMV is $22. KMR’s costs to update thepower cordpackaging and restock the shelves is estimated to be $4 per cord. The NRV of the powercords is calculated as: $18 ($22 - $4). Since the $18 NRV is greater than the historicalcost of $15, no adjustment is needed.
- NRV for AR. One of KMR’s commercial customers owes $50,000 forpastcredit sales, so KMR has an open AR on its books for $50,000. When the customer filesfor bankruptcy, KMR estimates it would likely collect only half of the AR and will needto pay legal fees of $3,000 for representation in the liquidation case. KMR’saccountantcalculates the NRV of this individual AR account to be $22,000 (50% of $50,000 -$3,000). Since the NRV is lower than the book value, KMR writes down the AR to its NRV,causing its bad debt expense to increase by $28,000 and lowering its profits for theperiod by that amount.
- NRV for a fixed asset. KMR has a delivery truck in its fleet that waspurchased for $100,000, has an expected life of 10 years and has been depreciated on astraight-line basis for the past four years. KMR carries the truck in its books at$60,000. KMR decides to sell the truck as part of its conversion to a hybrid electricfleet and performs $3,000 worth of service and cleaning to get it ready for sale. Basedon industry valuation tables, KMR accountants estimate the FMV of the vehicle is about$40,000 due to higher-than-average mileage. The NRV of the truck is $37,000 ($40,000 -$3,000), which is $23,000 less than the carrying value on the books. KMR would writedown the value of the truck to its NRV, reflecting a loss of $23,000 in the currentperiod.
Net Realizable Value Use Cases
NRV is a commonly used approach to help companies conservatively report the value of theirassets. It can be applied to any asset, but popular use cases tend to be for inventory andAR. Additionally, NRV has application for cost accounting – a branch of accountingthatdeals with allocating and accumulating the costs of products and processes. Considerationsfor each of these common use cases are described below.
Inventory
Valuation approaches for inventory deal with accumulating historical costs, such as rawmaterials, labor and other direct costs to produce a product. Initial sales prices aretypically set above the historical costs in order to generate profits when the inventory issold. However, changes in market conditions can make the target sale price unachievable andsometimes depress prices to levels close to or below historical costs. NRV is a realitycheck on inventory valuation by comparing FMV less selling costs to the historical costs onthe books. It’s an unfortunate reality of business that inventory more often losesvalueover time instead of appreciating, thus making NRV analysis particularly relevant toinventory.
Accounts receivable
Accounts receivable isrecorded based on the terms of an invoice when goods or services are sold on credit. The FMVand initial book value of an AR are reflected in the amount of the invoice. However, changesin collectability can cause the FMV of the AR to change. Customer liquidity problems andbankruptcies, poor overall economic conditions and subpar collection processes are allfactors that could cause an AR balance to become partially or fully uncollectible. Moreover,businesses often incur added costs when trying to collect from customers with erodingcreditworthiness, such as legal or collection fees. Under these circ*mstances, a companymust reduce the carrying value of an AR to reflect its NRV. The journal entry to make thisadjustment increases bad debt expense on the income statement and increases the allowancefor doubtful accounts, a contra-receivable account, on the balance sheet. NRV with A/R couldbe a one-time write down, as illustrated in the example, but often, because of the matchingprinciple, companies calculate and book a write down of bad debt expense on a regular basis(monthly/quarterly/yearly).
Cost accounting
Cost accounting is a type of managerialaccounting that focuses on developing precise, distinct costs for products and services. Itis unlike financial accounting and reporting, and applies NRV for a different purpose. Incost accounting, NRV is used to allocate costs shared by multiple products, rather than as amethod to value assets at the lower of cost or market, as in financial accounting. NRV usesthe relative sale price of multiple finished products less any separable costs as a way todivvy up joint production costs among the products. For example, imagine two different modelcars being manufactured on the same assembly line up to a certain point, before splittingoff to be finished in different ways specific to their model. The costs up to the split arejoint costs and the costs after the split are separable costs. NRV first calculates theselling price of each model less its separable costs. It then uses a ratio of the figuresfrom the two models to divide up the joint costs before the split. Those distributed costsare added to the separable costs to determine the total cost basis of each model, and thenNRV is calculated to be able to fully compare/ weigh options and determine which products toproduce or stop producing if not profitable enough.
Use NetSuite to Manage Your Company’s Finances
NRV is an important method for ensuring that assets reported accurately to reflect the truevalue of the asset. It’s a simple concept, but execution can be tedious andtime-consuming.This is especially true since NRV can be applied to individual assets or to entire assetclasses. NetSuite Cloud AccountingSoftware tracks the carrying value of assets using specialized and integratedmodules for inventory, accounts receivable, fixed assets and more. When NRV considerationsare needed, you can be confident that the initial historical costs and all the subsequentaccounting activity have been properly included in the book value. Whether applying variousinventory cost valuation methods, systematically calculating depreciation on fixed assets orbetter analyzing AR collectability, NetSuite simplifies the whole process. And when NRVadjustments are required, the multi-dimensional chart of accounts can capture and report anylosses correctly.
Net realizable value is an approach to valuing assets fairly and conservatively, and isrequired for compliance with GAAP and IFRS. This is because assets are initially recorded incompany balance sheets based on their historical costs, but over time and for various otherreasons, their fair market value might change. NRV analysis is a way to check the balancesof assets on the accounting books to ensure that they are properly valued. When NRV is lowerthan the carrying value of assets, asset adjustments are made that also affect the incomestatement, reducing profits. NRV is most often discussed for inventory, but it can beapplied to any asset, such as AR and fixed assets, and has applications in the world of costaccounting as well.
#1 Cloud
Accounting
Software
Free ProductTour(opens in a new tab)
Net Realizable Value FAQs
What is accounting conservatism?
Conservatism is one of the 10 underlying principles of accounting, guiding accountants toavoid overstating the value of assets and income or understating the value of liabilities.Net realizable value (NRV) is an approach to valuing assets fairly and conservatively.
What is meant by net realizable value of accounts receivable?
NRV of AR takes collectability and collection costs into account to figure out the fairmarket value of the AR. If NRV is less than the book value of the AR, a company must reducethe carrying value of its AR to reflect its NRV.
What are NRV and fair value?
NRV considers two factors for measuring value — an asset’s fair market value(FMV) and thecosts to sell or obtain that value. The FMV is defined in accounting guidelines as theamount a willing, informed buyer would pay for the asset on the open market. NRV iscalculated by deducting from an asset’s FMV the costs the seller might incur duringthe saletransaction, such as transportation costs, taxes, commissions or disposal fees.
What is net realizable value with example?
A company performs an NRV analysis periodically, such as at year’s end orquarter’s end, orany other time when a condition arises that implicates a significant change in the fairmarket value of an asset. For example, a computer manufacturer’s PC inventory mightdeclinesignificantly in value when a next-generation processor is released. So, the company woulddo an NRV analysis that compares the inventory value with the inventory’s estimatedNRV. IfNRV is lower than the book value, the inventory value of the PCs is written down on thebalance sheet and a loss from NRV is recorded on the income statement.
