Lower of Cost or Net Realizable Value
The “Lower of Cost or Net Realizable Value” (LCNRV) method is an inventory valuation approach similar to the “Lower of Cost or Market” method. This method compares the cost of inventory with its net realizable value (NRV) and uses the lower of the two to value the inventory. This method is used to ensure that inventory is not overvalued on the financial statements.
Net Realizable Value (NRV) is the estimated selling price of the inventory in the ordinary course of business, minus any costs for completion, disposal, and transportation.
If the NRV of the inventory is lower than its cost, it suggests that the company may not recover the cost of the inventory through its sale. Hence, in accordance with the principle of conservatism, the inventory is written down to its NRV and a loss is recognized.
For example, if a company has inventory that cost $20,000, but due to market conditions, it’s expected to sell for only $18,000 after all costs of completion and disposal, the company would then write down the inventory to the lower NRV of $18,000, recognizing a loss of $2,000.
The LCNRV method is generally accepted under International Financial Reporting Standards (IFRS), and U.S. Generally Accepted Accounting Principles (GAAP) for certain types of inventory. It’s always a good idea to consult with a financial professional or an updated resource to get the most accurate and current information.
Example of Lower of Cost or Net Realizable Value
Imagine a furniture manufacturing company has an inventory of chairs. The cost of producing each chair (including materials, labor, etc.) is $100. The chairs are expected to sell for $150 each. However, the company has an additional $60 per chair to finish, market, and deliver to the customers.
The Net Realizable Value (NRV) for each chair is calculated as the estimated selling price minus the cost of completion and sale, which is $150 – $60 = $90.
According to the “Lower of Cost or Net Realizable Value” rule, the company should compare the cost ($100) with the NRV ($90). Since NRV is lower than the cost, the company should write down the value of the inventory to the lower amount, which is $90. This would also involve recognizing a loss of $10 per chair.
This write-down reflects that the company doesn’t expect to recover the full cost of the inventory due to the additional costs required to finish and sell the chairs. This is a simplified example, and real-world inventory write-downs can be more complex, involving large quantities of diverse products. It’s always a good idea to consult with a financial professional for accurate accounting.