What it means
The principle behind Net Realizable Value is conservatism. A business is allowed to carry assets at what it paid for them, but not at more than it can sensibly expect to recover, because carrying overvalued stock makes a company look healthier than it is.
Inventory is the classic application. Accounting standards require stock to be measured at the lower of cost and Net Realizable Value, so a batch of goods bought for $100 a unit that can now only be sold for $80 after selling costs must be written down to $80.
The measure also applies to receivables. The gross amount customers owe is reduced by an estimate of what will never be collected, and the resulting figure is the amount the business realistically expects to turn into cash.
Deciding on the number requires judgement rather than arithmetic alone. Management has to estimate a selling price in current conditions, then subtract the remaining costs of completion and of selling, which can include finishing work, packaging, freight, commission and listing fees.
Auditors scrutinise these estimates closely, because optimism here flatters both the balance sheet and this year's profit. There is an important timing effect.
A write-down hits profit in the period the value falls, not the period the goods are eventually sold, so a business that ignores deteriorating stock values is quietly borrowing profit from a future year. Standards also allow a previous write-down to be reversed if conditions improve and the value recovers.
In practice
Real-world examples
Example 1
A fashion retailer holds 2,000 winter coats at a cost of $80 each, a total of $160,000. The season has ended and the coats will clear at $70 with $8 of handling and delivery cost per unit, giving a Net Realizable Value of $62 each, or $124,000. The retailer books a write-down of $36,000.
Example 2
A consulting firm is owed $400,000 across its invoice ledger but expects, based on its collection history and two disputed accounts, to recover only $370,000. It carries receivables at that $370,000 and holds a $30,000 allowance against the rest.
Example 3
An electronics distributor is holding 300 units of a model the manufacturer has just superseded. Cost was $250 a unit, the current market price is $210 and selling costs are $25, so Net Realizable Value is $185 and the write-down is $65 per unit, or $19,500 in total.
Think of it
Imagine selling your used car. You might think it is worth five thousand pounds because you bought it for that much, but after paying for minor repairs and advertising, you will only walk away with four thousand pounds. That four thousand pounds is your net realizable value.
Formula
Calculation
Net Realizable Value = Estimated selling price - costs to complete - costs to sell
Inventory is then carried at the lower of cost and Net Realizable Value.
A furniture maker holds 500 partly finished chairs that cost $120 each to produce so far, giving a carrying cost of 500 x $120 = $60,000. Current market conditions suggest a selling price of $144 each, or $72,000 in total. Finishing the chairs will cost $10 each ($5,000), and commission plus freight will cost $18 each ($9,000).
Net Realizable Value = $72,000 - $5,000 - $9,000 = $58,000, which is $116 per chair.
Because cost of $120 per chair exceeds the $116 recoverable, the stock is written down to $58,000 and a charge of $60,000 - $58,000 = $2,000 goes through the profit and loss account this period.Case study
Seen in the real world
Brightwater Outdoor Co, an illustrative and entirely fictional camping equipment brand, ends its summer season with 4,000 tents in the warehouse carried at cost of $95 each, a book value of $380,000. The sales director is confident they will move next spring at full price and argues against any adjustment.
The finance manager checks the actual clearance market. Comparable tents are moving at $88, and the company's own costs of getting them out of the door, covering marketplace commission, packaging and delivery, run to $14 a unit. Net Realizable Value is therefore $88 - $14 = $74 per tent, or $296,000 for the batch, and the required write-down is $380,000 - $296,000 = $84,000.
Recording the charge is uncomfortable, but it produces a more honest picture, and it prevents a much larger surprise the following spring. In this fictional case the board also tightens purchasing limits, because the write-down exposed a buying pattern that consistently over-ordered late-season stock.
Watch out
Common mistakes
- Using the gross selling price as Net Realizable Value and forgetting to deduct the commission, freight and completion costs still to be incurred.
- Deferring a write-down because the goods might sell at full price eventually, which pushes a loss that has already happened into a later period.
- Applying the test to the business as a whole rather than to individual items or groups of similar items, which lets profitable lines mask unsellable ones.
Questions
People also ask
Is Net Realizable Value the same as fair value?
No, fair value is a market exit price viewed from a general market participant's position, while Net Realizable Value is specific to the entity and its own remaining costs.
Can a write-down be reversed later?
Under IFRS yes, if the circumstances that caused it no longer apply, though the reversal cannot take the carrying amount above original cost.
Does the test apply to raw materials?
Yes, but raw materials are usually written down only if the finished product they go into is also expected to sell below cost.