Another reason for not valuing items in inventory at their selling prices is that inventory items cannot be sold without a sales effort. Until that effort is made and an item is actually sold, the company cannot report the $10 increase from $40 to $50. This is referred to as the revenue recognition principle. In other words, only after an item is actually sold can the company report the revenue of $50 minus the cost of $40 for a gross profit of $10.

There are some exceptions to cost. One exception is industries where no sales effort is required and the extensive effort of production has been completed. In these industries the inventory can be reported at its net realizable value, which is the sales value minus the costs to dispose of the items. The gold mining industry and certain other commodities are examples of this exception to cost.

Another exception can occur in any industry when a product will have to be sold for less than its cost. In that situation the item might be reported in inventory close to its net realizable value, provided it is less than the item’s cost. (U.S. income tax rules require conformity between tax and financial reporting. As a result, there are complexities involved.)

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If the amount of the Loss on Write-Down of Inventory is relatively small, it can be reported as part of the cost of goods sold. If the amount of the Loss on Write-Down of Inventory is significant, it should be reported as a separate line on the income statement.

Since the amount of the write-down of inventory reduces net income, it will also reduce the amount reported as owner’s or stockholders’ equity. Hence for the balance sheet and in the accounting equation, the asset inventory is reduced and the owner’s or stockholders’ equity is reduced.

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In the case of accounts receivable, net realizable value means the debit balance in the asset account Accounts Receivable minus the credit balance in the contra asset account Allowance for Uncollectible Accounts. For example, if Accounts Receivable has a debit balance of $100,000 and the Allowance for Doubtful Accounts has a proper credit balance of $8,000, the resulting net realizable value of the accounts receivable is $92,000.

In the context of inventory, net realizable value is used in the calculation of the lower of cost or market. In this situation, net realizable value or NRV means the expected selling price in the ordinary course of business minus any costs to complete and dispose. Net realizable value amount becomes the ceiling for the replacement cost. NRV minus the normal profit becomes the floor. See Lower of Cost or Market for an in-depth explanation and many examples.

The conservatism principle requires that an amount less than cost be used when the replacement cost is less than the original cost. When this is the case, the selling price minus the cost to complete and dispose might be the amount to be reported. (The selling price minus the cost to complete and dispose is the net realizable value.) In a few industries, such as gold mining and meatpacking, it is accepted practice to report the inventory at its net realizable value.

Since the unit cost of items in inventory is likely to be changing (think inflation), the costs used for inventory reporting will be based on a cost flow assumption. For example, the FIFO cost flow assumption will result in the inventory being reported at the more recent costs, since the first costs are assumed to have been the first costs out of inventory. Under the LIFO cost flow assumption, the inventory will be valued at the older costs, since the more recent costs are assumed to be the first costs to flow out of inventory.

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The ceiling for the market value is the net realizable value. The net realizable value is calculated as the selling price in the ordinary course of business minus the cost of completion and disposal.

The floor for the market value is the net realizable value minus the normal profit. The floor is calculated as the selling price in the ordinary course of business minus the cost of completion and disposal and minus the normal profit.

The following is one illustration of the calculations. A company has an item with a cost of $10. Its replacement cost is $9, its net realizable value is $8, and its normal profit is $2. This means that the market amount for the lower of cost or market cannot be greater than the ceiling of $8 (the net realizable value). We also know that the market amount cannot be lower than the floor of $6 (the net realizable value of $8 minus the normal profit of $2). Since the replacement cost of $9 is greater than the ceiling, it cannot be used. As a result, the accountant will value the inventory item at the lower of (1) the cost of $10, or (2) the constrained replacement cost of $8. This makes the lower of cost or market amount $8.

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I see two reasons why the January loss might be reduced/recovered in February. The first possibility is that the market (constrained replacement cost) has increased for the items that were on hand on January 31 and remain on hand at February 28. The second possibility is that some of the items on hand on January 31 that had a market value less than their cost were sold during February–thereby eliminating the need for most of the balance that had been in the Allowance account.

For more information on the lower of cost or market, see the explanation, drills, and crossword puzzles for Lower of Cost or Market on www.AccountingCoach.com.

Net realizable value is also associated with accounts receivable. In this situation, NRV is the amount of accounts receivable that is expected to turn to cash. Net realizable value sometimes refers to the balance in the general ledger account Accounts Receivable minus the balance in the account Allowance for Doubtful Accounts (or Allowance for Uncollectible Accounts.)

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The conservatism principle does not say that accountants are to be conservative. Accountants should be fair and objective. The conservatism principle is used to “break a tie” between two reasonable options. It is not intended to motivate accountants to beat down a company’s earnings and assets.

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If there is uncertainty as to whether there was a gain, the rule says don’t record it. Because of the uncertainty and because you did not record the potential gain, there will be less profit and less asset amounts being reported.

(If there is certainty about a gain, then you do report the gain. For example, if a company sells its old delivery truck for cash and the amount received is greater than the truck’s book value, there is no uncertainty and a gain is reported.)

If there is uncertainty about whether or not there is a loss, the rule directs you to record the loss. By recording the potential loss, you will be reporting less profit and less asset amounts.

If there is a potential loss, but it is impossible to measure the amount for a journal entry, there needs to be a disclosure in the notes to the financial statements.

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