Inventory at Lower of Cost and Net Realisable Value
- Working out net realisable value
- The journal entry
- Why item by item matters
- Signs that NRV may be below cost
- Raw materials
- When value recovers
- What not to do
- Where this fits
Inventory is carried in the accounts at the lower of what it cost and what it can be sold for, after deducting the costs of finishing and selling it. That second figure is its net realisable value, or NRV. When stock has become damaged, obsolete, slow-moving or simply cheaper in the market, and its NRV falls below cost, the difference is written off as an expense in that period. The test is applied item by item or to groups of similar items, not to the stock as a whole.
The principle is simple: an asset should not be shown at more than the business expects to recover from it.
Working out net realisable value
NRV = estimated selling price in the ordinary course of business − estimated costs to complete − estimated costs to sell.
A business holds 500 units of a product that cost ₹800 each, a total of ₹4,00,000. A newer model has launched, and the old units will now have to be cleared at ₹700 each. Selling them involves commission and delivery costs of about ₹50 a unit.
| Per unit | 500 units | |
|---|---|---|
| Cost | ₹800 | ₹4,00,000 |
| Expected selling price | ₹700 | ₹3,50,000 |
| Less costs to sell | ₹50 | ₹25,000 |
| Net realisable value | ₹650 | ₹3,25,000 |
| Write-down required | ₹150 | ₹75,000 |
Illustrative figures.
The stock is carried at ₹3,25,000, and ₹75,000 is recognised as an expense now, in the period the loss in value became evident, rather than when the units are eventually sold.
The journal entry
| Account | Debit | Credit |
|---|---|---|
| Inventory write-down (part of cost of goods sold) | ₹75,000 | |
| Inventory, or a stock valuation allowance | ₹75,000 |
Many businesses use a separate allowance account so the stock records still show the original cost and the write-down is visible and reviewable. Either way, the balance sheet shows the reduced figure.
Why item by item matters
Suppose a business holds two products:
| Product | Cost | NRV | Lower of the two |
|---|---|---|---|
| Product A | ₹2,00,000 | ₹2,60,000 | ₹2,00,000 |
| Product B | ₹4,00,000 | ₹3,25,000 | ₹3,25,000 |
| Total | ₹6,00,000 | ₹5,85,000 | ₹5,25,000 |
Comparing totals would suggest a write-down of only ₹15,000. Applied properly, product by product, the stock is carried at ₹5,25,000, a write-down of ₹75,000. The expected profit on Product A is not recognised until A is sold, so it cannot be used to hide the loss on Product B.
Grouping is reasonable for items that are genuinely similar, such as sizes of the same product line sold in the same market. It is not reasonable across unrelated products or whole categories.
Signs that NRV may be below cost
- Items that have not moved in six or twelve months.
- Damaged, expired or near-expiry goods.
- Products superseded by a newer model or design.
- Selling prices that have fallen in the market, or planned clearance discounts.
- Rising costs to complete work in progress that will not be recovered in the selling price.
- Sales after the period end at prices below cost, which give good evidence of NRV at the period end.
A stock ageing report and a list of recent selling prices below cost are the two most useful tools for finding them.
Estimates of NRV should rest on the most reliable evidence available when the accounts are prepared: actual selling prices achieved, firm orders, price lists after planned discounts, and the realistic cost of getting the goods to a buyer. Record the basis for each significant write-down, such as the price list or clearance plan used, so that the figure can be reviewed and updated at the next reporting date.
Raw materials
Raw materials and components are generally not written down simply because their own replacement price has fallen, as long as the finished goods they will go into are expected to sell at or above cost. If the finished product itself will sell below cost, the materials for it are written down too, and the replacement cost of the materials is often a practical measure of their NRV.
When value recovers
NRV is reassessed at each reporting date. If the circumstances that caused a write-down no longer apply, for example a clearance discount turns out not to be needed, the write-down is reduced accordingly. The carrying amount never goes above original cost.
What not to do
- Do not create general, round-number provisions such as 10% of all stock “to be safe”. A write-down should be based on evidence for specific items or groups.
- Do not defer the loss until the goods are sold. If the evidence exists at period end, the write-down belongs in that period.
- Do not forget selling costs. An item that sells at exactly its cost still needs a write-down if it costs something to sell.
The requirements come from AS 2, Valuation of Inventories, or Ind AS 2, Inventories, for companies on Ind AS. Confirm with your accountant which applies to your business and the disclosures needed.
Where this fits
- How cost itself is measured: FIFO vs weighted average
- Finding the products that lose money: product line profitability
- Where the review belongs in the month: month-end close checklist
- Reading inventory in the accounts: how to read a balance sheet