What it means
Inventory is first recorded at cost, meaning the purchase price plus the cost of getting it ready for sale. The rule then asks a second question at each reporting date: could we still sell this for at least what we paid, after the costs of selling it?
If the answer is no, the carrying value is reduced. Net realisable value is the estimated selling price in the ordinary course of business, less any costs needed to finish the product and make the sale.
Think of it as the cash you can realistically expect to collect per item once the packaging, commission and delivery are paid for. It is a judgement, so it relies on recent prices, sales trends and the condition of the goods.
The practical effect is that losses are recognised early but gains are not. A write-down hits profit in the period when the price falls, while a later recovery in price is not booked as a gain beyond original cost.
Under international standards a write-down can be reversed, up to the original cost, if the value recovers; under US rules for most inventory the written-down amount becomes the new cost. The test is normally applied item by item, or to groups of similar items, rather than to the whole warehouse at once.
Applying it to the total would let gains on one product hide losses on another. Businesses that hold fashion, technology or perishable goods usually test more often because their prices move fast.
Nuance matters for materials held to make finished goods. Raw materials are not usually written down if the finished product they go into is still expected to sell above cost.
A write-down is only needed when a price fall on the finished goods suggests the cost of the materials cannot be recovered.
In practice
Real-world examples
Example 1
A fashion retailer holds 5,000 coats at the end of winter that cost $80 each. Clearance pricing means they will sell for about $70 after selling costs. The company writes the inventory down by $10 per coat, or $50,000 in total, in the same period.
Example 2
A food manufacturer has a batch of fresh sauce that cost $30,000 to produce and is two weeks from its use-by date. The best it can achieve is a discount sale worth $22,000 net of costs. Finance records an $8,000 write-down before the next reporting date.
Example 3
A hardware reseller holds smartphone cases for a model that has been discontinued. Cost is $12,000 and the supplier has offered a clearance buyback at $3,000. The reseller values the stock at $3,000 and records a $9,000 loss.
Think of it
Imagine buying a vintage car for 10,000 pounds to resell. If a sudden flood damages the engine and the car is now only worth 4,000 pounds, you would not insure or list it on a personal asset sheet at 10,000 pounds. You would immediately adjust its value to the realistic 4,000 pounds.
Formula
Calculation
Net realisable value = Estimated selling price - Costs to complete - Costs to sell
Carrying value = Lower of cost and net realisable value
Suppose a company holds 1,000 laptops that cost $500 each, so the inventory cost is 1,000 x 500 = $500,000. A new model launches and the old laptops can only be sold for $460 each, with $18 of selling costs per unit. Net realisable value per unit = 460 - 18 = $442, so the total is 1,000 x 442 = $442,000. Because $442,000 is lower than $500,000, the inventory is written down by 500,000 - 442,000 = $58,000, which is recorded as an expense.Case study
Seen in the real world
Brightfield Electronics is an illustrative, fictional distributor of home audio equipment. At its year end, the warehouse held 2,400 soundbars that had cost $150 each, a total of $360,000. A rival had just launched a newer model and was clearing its old stock, so Brightfield's expected selling price fell to $135 with $10 of selling costs per unit.
The finance manager worked out a net realisable value of $125 per soundbar, or $300,000 for the lot. That was $60,000 below cost, so the company booked a $60,000 write-down. Gross profit for the year fell by the same amount, which surprised the sales director.
The illustrative lesson is that the loss was economic from the moment the rival cut its price, not from the day the accounts were closed. Recognising it promptly gave the board a true picture of margins and prompted a rethink of order quantities.
Watch out
Common mistakes
- Comparing cost with the selling price instead of with the selling price net of the costs to complete and sell the goods.
- Netting gains on one product against losses on another, which hides write-downs that the rule requires.
- Assuming a write-down can always be reversed when prices recover, when the answer depends on the accounting framework being used.
Questions
People also ask
Is the write-down a cash cost?
No, the cash was spent when the stock was bought, and the write-down simply moves part of that cost into the income statement earlier.
Does the rule apply to all inventory methods?
In US reporting, a lower of cost and net realisable value test applies to inventory valued on first-in first-out or average cost, while last-in first-out inventory uses a different cost or market test.
Who estimates net realisable value?
Management does, using recent selling prices, post year-end sales and market data, and auditors then challenge those estimates.