Lower of Cost and Net Realisable Value (NRV)

Introduction

The Lower of Cost and Net Realisable Value (NRV) rule is a fundamental principle in accounting for inventory. It dictates how inventory should be valued on the Balance Sheet. The core idea is that inventory should be recorded at the lower of its original cost or its net realisable value. This ensures that assets are not overstated and that a faithful representation of the business’s financial position is provided.

KEY TAKEAWAY: Inventory is valued at the lower of its cost or NRV to uphold the principle of faithful representation.

Cost

Cost refers to the original purchase price of the inventory, plus any costs incurred to bring the inventory to its present location and condition ready for sale. This includes:

• Purchase price
• Freight in
• Import duties
• Other directly attributable costs

VCAA FOCUS: VCAA expects students to know what costs are included when determining the “Cost” of inventory.

Net Realisable Value (NRV)

Net Realisable Value (NRV) is the estimated selling price of the inventory in the ordinary course of business, less any costs of completion, disposal, and transportation. It represents the net amount a business expects to receive from selling the inventory.

$$
NRV = \text{Estimated Selling Price} - \text{Costs of Completion} - \text{Costs of Disposal} - \text{Costs of Transportation}
$$

• Estimated Selling Price: The expected price the inventory can be sold for.
• Costs of Completion: Costs needed to finish the inventory and make it ready for sale (if applicable).
• Costs of Disposal: Costs directly related to selling the inventory (e.g., advertising, sales commissions).
• Costs of Transportation: Costs to transport the inventory to the point of sale.

APPLICATION: Consider a furniture store. The NRV of a damaged table would be the price they expect to sell it for “as is,” minus any costs to advertise the damaged item.

The Lower of Cost and NRV Rule

The Lower of Cost and NRV rule states that inventory should be valued at the lower of its cost and its NRV.

• If Cost < NRV: Inventory is valued at Cost.
• If NRV < Cost: Inventory is valued at NRV. An inventory write-down is required.

This rule is applied to ensure that assets are not overstated on the balance sheet. If the NRV is lower than the cost, it indicates that the business is unlikely to sell the inventory at a profit and the inventory should be written down to its NRV.

EXAM TIP: Always calculate both Cost and NRV before determining the appropriate valuation.

Reasons for NRV being Lower than Cost

Several factors can cause the NRV to fall below the cost:

• Damage or physical deterioration: Inventory may be damaged, shop-soiled, or otherwise unsaleable at its original price.
• Obsolescence: Inventory may become outdated or superseded by newer models.
• Decrease in demand: Changes in consumer preferences or market conditions can reduce demand.
• A purposeful decrease in selling price: Used as a marketing strategy (e.g., loss leader) or to clear out old stock.
• Out of date (expiry): Particularly for food items, the expiry date limits the selling price.

REMEMBER: DODAO - Damage, Obsolescence, Demand decrease, Advertising (purposeful decrease), Out of date.

Inventory Write-Down

An inventory write-down occurs when the NRV is lower than the cost, and the inventory’s value needs to be reduced on the balance sheet.

The write-down is treated as an expense in the Income Statement, decreasing profit. The Inventory asset account on the Balance Sheet is also decreased.

The journal entry for an inventory write-down is:

COMMON MISTAKE: Forgetting to record the inventory write-down in the General Journal.

Impact on Financial Statements

• Income Statement: The inventory write-down is recognized as an expense, reducing the profit.
• Balance Sheet: The value of inventory is reduced to its NRV, resulting in a lower asset value. This provides a more faithful representation of the business’s financial position.

STUDY HINT: Practice different scenarios where NRV is lower than the cost and calculate the inventory write-down.

Qualitative Characteristics

The Lower of Cost and NRV rule is primarily related to the qualitative characteristic of Faithful Representation.

• Faithful Representation: The rule ensures that the financial information is complete, free from material error, and neutral (without bias). Valuing inventory at NRV when it is lower than cost provides a more accurate and reliable picture of the company’s financial position. It prevents overstating assets and profits.

While Verifiability is important (as cost can be verified through source documents), it is sometimes overridden by the need for Faithful Representation.

KEY TAKEAWAY: Applying the Lower of Cost and NRV rule enhances the faithful representation of financial information.