What is Net Realizable Value?
Net realizable value (NRV) is the value of an asset that can be realized upon the sale of the asset, less a reasonable estimate of the costs associated with either the eventual sale or the disposal of the asset in question. NRV is a common method used to evaluate an asset's value for inventory accounting, and NRV is used to apply Generally Accepted Accounting Principles (GAAP) to accounting transactions.
Net Realizable Value
Understanding Net Realizable Value (NRV)
The GAAP rules require certified public accountants (CPAs) to apply the principle of conservatism to accounting work. Many transactions require CPAs to make a judgment, and the principle of conservatism requires accountants to choose the more conservative approach to all transactions. A conservative approach means that the accountant should post the transaction that potentially generates less profit and does not overstate the value of assets. Net realizable value (NRV) is a conservative method for valuing assets, because it estimates the true amount the seller receives if the asset is sold. Two of the largest assets that a company may list on a balance sheet are accounts receivable and inventory, and NRV is used to value both of these asset balances.
Factoring in Accounts Receivable
An accounts receivable balance is converted into cash when customers pay outstanding invoices, but the balance must be adjusted for clients who don’t make payment. For accounts receivable, NRV is calculated as the receivable balance less an allowance for doubtful accounts, which is the dollar amount of invoices that the company labels as bad debt.
How Lower of Cost or Market Valuation Works
When a company buys inventory, the firm may incur extra costs to prepare the goods for sale. Assume, for example, that a retailer purchases large pieces of expensive furniture as inventory, and the firm has to build a display case and hire a firm to carefully move the furniture to the buyer's home. The extra costs are subtracted from the selling price to compute NRV.
GAAP also requires CPAs to use the lower of cost or market (LCM) rule to value inventory on the balance sheet. If the current market price of inventory is less than the cost, the principle of conservatism requires accountants to use the market price to value inventory, and a lower market price can occur if the inventory becomes obsolete.
Examples of Cost Accounting
NRV is also used to account for costs when two products are produced together in a joint costing system until the products reach a split-off point. Each product is produced separately after the split-off point, and NRV is used to allocate joint costs to each of the products, so that managers can calculate a total cost and assign a sale price to the product.