The net realizable value (VNR) is the value of an asset that can be achieved by selling it, less a sensible estimate of the costs associated with the final disposal or sale of said asset.
It is a common method used to calculate the value of an inventory asset in accounting. The VNR is used by applying generally accepted accounting principles (GAAP) to accounting transactions..
GAAP rules require certified public accountants to apply the principle of conservatism to their accounting work..
For many transactions, the accountant is required to issue an opinion, and the principle of conservatism demands that accountants select the most conservative perspective for all transactions..
A conservative perspective means that the transaction that does not exaggerate the value of the assets and that generates less potential profit should be recorded in the accounting.
Net realizable value is a conservative technique for valuing assets, because it estimates the amount that the seller will actually receive if the asset is sold..
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Accounts receivable and inventory are two of the largest assets a company can include on a balance sheet. The VNR is used to be able to value the balances of both assets.
Although these two assets are initially recorded at cost, there are times when the company will charge less than that cost. When that occurs, the company must report the lower of cost or net realizable value..
When customers pay outstanding invoices, an account receivable balance is converted into cash. However, this balance must be adjusted by customers who have not made the payment.
In the case of accounts receivable, the net realizable value can also be expressed as the debit balance in the accounts receivable account, minus the credit balance in the counter assets account for bad debts..
In the context of inventory, the net realizable value is the expected sale price in the ordinary course of business less the costs of completion, advertising, transportation, etc..
GAAP requires accountants to use the least cost or market value rule to value inventory on the balance sheet.
If the current market price of the inventory is below cost, the principle of conservatism requires that the market price be used to value the inventory. It can happen that the market price is lower when the inventory becomes obsolete.
There is an ongoing need to review the value of inventory to see if its recorded cost should be reduced, due to the negative impacts of factors such as damage, spoilage, obsolescence, and lower customer demand..
By noting the inventory, a company is prevented from having to bear the recognition of any loss in a future period.
Therefore, the use of net realizable value is a way to enforce a conservative record of the values of inventory assets..
To determine the net realizable value of an inventory item, follow these steps:
- Determine the expected market value or selling price of the inventory item.
- Find all costs associated with preparing and selling the asset, such as production, transportation, and advertising costs.
- The difference between the market value and the associated costs of sale is calculated to arrive at the net realizable value. Therefore, the formula is:
Net realizable value = Market value of inventory - Costs to prepare and sell the products.
For example, when a business purchases inventory, the business may incur additional costs to prepare those products for sale..
Suppose a retailer purchases large pieces of furniture as inventory. The company has to build a showcase and also hire a company to move the furniture to the buyer's home. Those additional costs must be subtracted from the sale price to calculate the VNR.
For accounts receivable, the VNR is calculated as the balance receivable minus the provision for doubtful accounts, which is the amount of invoices that the company qualifies as bad debt..
If the accounts receivable have a debit balance of $ 100,000 and the allowance for doubtful accounts has an adequate credit balance of $ 8,000, the resulting net realizable value of the accounts receivable is $ 92,000.
Adjustments to the provision account are reported in the income statement as bad debt expense.
Now suppose that a company's inventory has a cost of $ 15,000. However, at the end of the accounting year, inventory can sell for just $ 14,000, in addition to spending $ 2,000 on packaging, sales commissions, and shipping..
Therefore, the net realizable value of the inventory is $ 12,000, which is the selling price of $ 14,000 less $ 2,000 costs to dispose of the goods..
In that situation, the inventory should be reported at the lower of the cost of $ 15,000, and the VNR of $ 12,000..
Therefore, inventory should be reported on the balance sheet at $ 12,000, and the income statement should report a loss of $ 3,000 from inventory reduction..
ABC International has an item in inventory with a cost of $ 50. The market value of the item is $ 130. The cost to prepare the item for sale is $ 20, so the net realizable value is: Market value of $ 130 - Cost of $ 50 - Cost of preparation of $ 20 = $ 60.
Since the cost of $ 50 is less than the VNR of $ 60, the inventory item continues to be posted at its cost of $ 50.
The following year, the market value of the item drops to $ 115. The cost is still $ 50, and the cost to prepare for sale is $ 20, so the net realizable value is: Market value of $ 115 - Cost of $ 50 - Cost of preparation of $ 20 = $ 45.
Since the VNR of $ 45 is less than the cost of $ 50, a loss of $ 5 must be recorded on the inventory item, thus reducing its recorded cost to $ 45.
If this calculation results in a loss, the loss is charged to the cost of merchandise sold with a debit and the inventory account is credited to reduce the value of the inventory account..
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