Accounting is a conservative discipline. In fact, conservatism is one of the 10 underlying principles of accounting and guides accountants to be purposefully moderate — for example, to avoid overstating the value of assets and income, or understating the value of liabilities. Net realizable value is an approach to valuing assets fairly — and conservatively. It applies to all reporting under both Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS). So, it’s important to understand the concept, how it is calculated and what it may mean for your financial results.
What Is Net Realizable Value (NRV)?
Net realizable value analysis is a way to check the balances of assets on a company’s accounting books to ensure they are properly valued under the theory of conservatism. This means that the books should always err on the side of caution, recording assets and revenues when certain they will occur and recording or disclosing liabilities when they can be measured and have a greater than 50% chance of occurring. For accounting purposes, asset values are initially recorded using their original (or “historical”) cost, but over time their value might change, for example, due to market activity outside the company, thus requiring an adjustment to the asset value on the company’s books. NRV is most often applied to inventory but can be brought to bear on any asset, such as accounts receivable, fixed assets or investments.
Specifically, NRV considers two factors for measuring value: an asset’s fair market value and the costs a company would incur to sell the asset and obtain that value. Accounting guidelines define fair market value (FMV) as the amount a willing, informed buyer would pay for the asset on the open market. NRV analysis then reduces an asset’s FMV by the costs the seller 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, an adjusting journal entry is made to write down the asset to its NRV. Such adjustments also reduce a company’s profits.
- Net realizable value checks balance sheet asset values against their fair market values and then adjusts the balance sheet to reflect asset values at the lower of cost or market 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 the profitability on its income statement.
- NRV requires well-researched estimates and, therefore, can be tedious. The right accounting 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 inventory and accounts receivables (AR). Changes in the FMV or selling price of inventory could cause an NRV adjustment. For AR and other receivables such as notes receivable, increased collection risk can cause a potential NRV concern. For other assets, such as real estate or fixed assets, market values are affected by time, obsolescence, and economic conditions, any of which can trigger NRV issues.
In the case of inventory, GAAP-compliant companies must record and track inventory values using an approved inventory cost-accounting method, such as first-in-first-out (FIFO) or specific identification. To maintain up-to-date inventory values, accountants do periodic NRV analyses to verify that the value being carried is appropriate. It’s common for NRV to be done at year’s end or quarter’s end, or any time a condition arises that suggests a significant change in the fair market value of the inventory. For example, a computer manufacturer might initially record its PC inventory using the FIFO method. But when a next-generation processor is released, the expected selling price of those PCs is likely to decline. So, the company performs an NRV analysis to compare the inventory’s value on the company’s balance sheet with its estimated NRV. If NRV is lower than the book value, the value of the PC inventory is written down and a loss from NRV is recorded on the income statement directly or as an increase in cost of goods sold. Because of accepted conservative accounting practices, a potential gain — i.e., in the event that 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 purchase something so that they can make a profit. Further, the open market selling price is usually so much higher than the book value that, even after deducting the costs to get ready for sale, NRV is higher than book value. This is especially true during inflationary periods and for high-margin items. However, factors like obsolescence or increasing competition can sometimes 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. For example, a technology retailer might analyze the NRV of all its cell phone accessories or only its stock of power cords. Similarly, an NRV analysis can be done for all AR or just AR from 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 the asset’s open market value. In some cases, the FMV might simply be a product’s current sale price, 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 get an item ready for sale or other disposal. For inventory or physical assets, this might involve estimating transportation costs, advertising, commissions or packaging. For AR, “disposal costs” could include legal fees or collection agency commissions.
- Calculate the asset NRV. The third step is to subtract the selling/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 the company’s books to determine whether an adjustment is necessary.
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 value on the company’s books. Remember, the carrying value is initially recorded as the asset’s original cost and may have been subsequently adjusted, such as with depreciation or allowances for obsolescence or doubtful accounts. If the NRV is greater than the carrying value, then no further action is required, since the asset is already being reported at the lower of cost or FMV. However, if the NRV is lower than the carrying value, an adjustment would be created to write down the asset to the NRV. This adjustment would credit (or reduce) the asset’s value and debit (or increase) an expense or loss account on the income statement. NRV write-downs reduce net income in the period the NRV analysis is performed. Assets written down cannot be written back up in future 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 the current 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 cords dropped, so the company reduced the selling price to $22. This market event triggered an NRV analysis by KMR’s accountants. The new FMV is $22. KMR’s costs to update the power cord packaging and restock the shelves is estimated to be $4 per cord. The NRV of the power cords is calculated as: $18 ($22 - $4). Since the $18 NRV is greater than the historical cost of $15, no adjustment is needed.
- NRV for AR. One of KMR’s commercial customers owes $50,000 for past credit sales, so KMR has an open AR on its books for $50,000. When the customer files for bankruptcy, KMR estimates it would likely collect only half of the AR and will need to pay legal fees of $3,000 for representation in the liquidation case. KMR’s accountant calculates 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 the period by that amount.
- NRV for a fixed asset. KMR has a delivery truck in its fleet that was purchased for $100,000, has an expected life of 10 years and has been depreciated on a straight-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 electric fleet and performs $3,000 worth of service and cleaning to get it ready for sale. Based on 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 write down the value of the truck to its NRV, reflecting a loss of $23,000 in the current period.
Net Realizable Value Use Cases
NRV is a commonly used approach to help companies conservatively report the value of their assets. It can be applied to any asset, but popular use cases tend to be for inventory and AR. Additionally, NRV has application for cost accounting – a branch of accounting that deals with allocating and accumulating the costs of products and processes. Considerations for each of these common use cases are described below.
Valuation approaches for inventory deal with accumulating historical costs, such as raw materials, labor and other direct costs to produce a product. Initial sales prices are typically set above the historical costs in order to generate profits when the inventory is sold. However, changes in market conditions can make the target sale price unachievable and sometimes depress prices to levels close to or below historical costs. NRV is a reality check on inventory valuation by comparing FMV less selling costs to the historical costs on the books. It’s an unfortunate reality of business that inventory more often loses value over time instead of appreciating, thus making NRV analysis particularly relevant to inventory.
Accounts receivable is recorded based on the terms of an invoice when goods or services are sold on credit. The FMV and initial book value of an AR are reflected in the amount of the invoice. However, changes in collectability can cause the FMV of the AR to change. Customer liquidity problems and bankruptcies, poor overall economic conditions and subpar collection processes are all factors 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 eroding creditworthiness, such as legal or collection fees. Under these circumstances, a company must reduce the carrying value of an AR to reflect its NRV. The journal entry to make this adjustment increases bad debt expense on the income statement and increases the allowance for doubtful accounts, a contra-receivable account, on the balance sheet. NRV with A/R could be a one-time write down, as illustrated in the example, but often, because of the matching principle, companies calculate and book a write down of bad debt expense on a regular basis (monthly/quarterly/yearly).
Cost accounting is a type of managerial accounting that focuses on developing precise, distinct costs for products and services. It is unlike financial accounting and reporting, and applies NRV for a different purpose. In cost accounting, NRV is used to allocate costs shared by multiple products, rather than as a method to value assets at the lower of cost or market, as in financial accounting. NRV uses the relative sale price of multiple finished products less any separable costs as a way to divvy up joint production costs among the products. For example, imagine two different model cars being manufactured on the same assembly line up to a certain point, before splitting off to be finished in different ways specific to their model. The costs up to the split are joint costs and the costs after the split are separable costs. NRV first calculates the selling price of each model less its separable costs. It then uses a ratio of the figures from the two models to divide up the joint costs before the split. Those distributed costs are added to the separable costs to determine the total cost basis of each model, and then NRV is calculated to be able to fully compare/ weigh options and determine which products to produce 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 true value of the asset. It’s a simple concept, but execution can be tedious and time-consuming. This is especially true since NRV can be applied to individual assets or to entire asset classes. NetSuite Cloud Accounting Software tracks the carrying value of assets using specialized and integrated modules for inventory, accounts receivable, fixed assets and more. When NRV considerations are needed, you can be confident that the initial historical costs and all the subsequent accounting activity have been properly included in the book value. Whether applying various inventory cost valuation methods, systematically calculating depreciation on fixed assets or better analyzing AR collectability, NetSuite simplifies the whole process. And when NRV adjustments are required, the multi-dimensional chart of accounts can capture and report any losses correctly.
Net realizable value is an approach to valuing assets fairly and conservatively, and is required for compliance with GAAP and IFRS. This is because assets are initially recorded in company balance sheets based on their historical costs, but over time and for various other reasons, their fair market value might change. NRV analysis is a way to check the balances of assets on the accounting books to ensure that they are properly valued. When NRV is lower than the carrying value of assets, asset adjustments are made that also affect the income statement, reducing profits. NRV is most often discussed for inventory, but it can be applied to any asset, such as AR and fixed assets, and has applications in the world of cost accounting as well.
Net Realizable Value FAQs
What is accounting conservatism?
Conservatism is one of the 10 underlying principles of accounting, guiding accountants to avoid 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 fair market value of the AR. If NRV is less than the book value of the AR, a company must reduce the 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 the costs to sell or obtain that value. The FMV is defined in accounting guidelines as the amount a willing, informed buyer would pay for the asset on the open market. NRV is calculated by deducting from an asset’s FMV the costs the seller might incur during the sale transaction, 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 or quarter’s end, or any other time when a condition arises that implicates a significant change in the fair market value of an asset. For example, a computer manufacturer’s PC inventory might decline significantly in value when a next-generation processor is released. So, the company would do an NRV analysis that compares the inventory value with the inventory’s estimated NRV. If NRV is lower than the book value, the inventory value of the PCs is written down on the balance sheet and a loss from NRV is recorded on the income statement.