Net Realizable Value
Represents the estimated selling price of an asset, less any anticipated costs associated with its sale, considering current market conditions
What Is Net Realizable Value (NRV)?
The net realizable value (NRV) represents the estimated selling price of an asset, less any anticipated costs associated with its sale, considering current market conditions.
When we say costs of an asset sale, we mean subtracting any cost of fees, penalties, advertising, or taxes associated with the sale. The NRV is a robust valuation method, especially in accounting. More specifically, it is used when accountants measure their respective businesses' final inventory in value.
The "Generally Accepted Accounting Principles" (GAAP) and "International Financial Reporting Standards" (IFRS) both acknowledge this valuation method as a credible one.
The NRV method is widely categorized as conservative. However, not following a traditional approach in some transactions would mean overstating the value of an asset.
Instead, the goal here is to use a method that generates the least profits, so a professional like a certified public accountant must carefully apply a conservative approach when selling an asset.
One might wonder about the rationale behind this. The answer to this concerns the business not taking a risky approach. Instead, the accountant should have a "worst-case" scenario mentality during the valuation process to mitigate future company risks.
You want to be assured you have the correct valuation of an asset and that you are not overvaluing it, which is why the accountant will need to be cautious and check their work several times before calculating the ending inventory.
The business accountant discloses the net realizable value on the company's balance sheet.
Key Takeaways
- Net Realizable Value (NRV) represents the estimated selling price of an asset minus any anticipated costs associated with its sale, used primarily for inventory valuation, accounts receivable balance, and joint cost accounting.
- The NRV is determined by subtracting the costs associated with producing and selling the asset from the estimated selling price, i.e.,
- Estimated selling price - Costs of production and sale = Net realizable value
- Factors influencing NRV include the stability of the economy, overall demand for the product, and the collection of unreceived payments, which impact accounts receivable balances.
- NRV uncovers transaction costs, reflects the creditworthiness of clients, determines net proceeds, unveils operating risks, and determines the value of specific products, offering valuable insights for decision-making.
Uses For Net Realizable Value
The net realizable value is used for several situations. Let's discuss each situation below:
1. Inventory valuation
One of the primary uses of net realizable value is inventory valuation in accounting. If a business buys goods, it needs to make a product that it can sell; it might suffer some extra costs through this process. In this case, businesses should use the net realizable value method.
As mentioned above, this task is typically carried out by a certified public accountant (CPA) due to the need for caution and accuracy, ensuring proper valuation without overstatement, and following a method that reflects realistic profits.
For example, let's say a company sells TVs. They have to buy several TVs and put them in their storage. This company can incur several costs, such as paying someone to build a stand for the TV or changing the screen of the TV for better protection.
These costs must be factored into the net realizable value (NRV) calculation. The company subtracts these costs from the revenue generated from selling a TV. If this is not done, the company has failed to use the NRV method in the accounting process properly.
2. Accounts receivable balance
A business's accounts receivable balance should increase when a transaction is made. For example, this is the money they generate after selling a product to a customer.
The important thing here is that sometimes, due to unfortunate circumstances, there could be an uncollected amount that should have been counted in the accounts receivable.
If a customer fails to pay on time, the accountant must consider this when reporting the final accounts receivable balance and subtract the uncollected amount as a potential loss.
When calculating the net realizable value, the accountant will sum up all receivables expected to be collected. Any doubtful or uncollectible payments should be deducted from the total receivables.
This approach aligns with the conservative principle of net realizable value, where uncollectible payments are recognized as potential losses rather than part of the total earnings.
3. Joint cost accounting
The NRV is an excellent method to use when facing a situation of joint costs. Cost accounting generally considers all expenses realized within the company during the production of a product.
To make sense of this, let's imagine a scenario where a business produces a type of nest basket for sale. Basket 1 and Basket 2 are identical. This is because both nest baskets are produced using the same materials and goods, incurring identical costs.
Toward the end of the process, the baskets will no longer be identical due to the different design ideas that customers have requested to add to their baskets. As we can see, the business will incur different costs depending on the customer's demands.
Note
The difference in costs results from a difference in production.
As mentioned above, NRV is also used for accounts receivable balance. In that case, we subtract the amount not received from the production and sale costs.
The point of using the net realizable value is to recognize the difference in costs for each nearly identical product, which will better equip the business to decide what to price each of their products.
How To Calculate The NRV
Below, you can find the steps to calculate the net realizable value:
- First, carefully estimate how much the asset can sell for. Knowledge of the market is needed in this step!
- Secondly, determine all the costs incurred in producing and selling the asset. This includes advertising expenses and taxes
- Finally, subtract the estimated selling price of the asset (step 1) from the costs in the production and sale of the asset (step 2). This will give you the net realizable value
The above steps can be summarized with a simple formula:
(Estimated selling price) - (Costs of production and sale) = Net realizable value
If you look at the formula, it is worth mentioning that to get the estimated selling price, you should find out how many products you have multiplied by the selling price of each good to get the total.
Note
The estimated selling price refers to the anticipated price at which the product will sell based on market expectations.
Example of Calculating the NRV
Let’s apply what we know about NRV through some examples.
Example 1
Suppose a furniture business wants to sell some of its furniture to a local mall. The business expects to sell its couches for $25,000. The business will update its balance sheet and determine the net realizable value as part of its accounting process.
The business will incur some losses due to several processes. There is a transportation fee of $320 for transporting all of the heavy couches from the business to the local mall.
There is an extra $150 fee for advertising purposes and signature work. Knowing this information, we can finally apply the NRV formula:
- Expected selling price = $25,000
- Cost of production and sale = $320 + $150 = $470
NRV = $25,000 - $470
NRV = $24,530
The net realizable value of the couches will be $24,530 on the balance sheet.
Example 2
Let’s look at a similar example while adding a small trick:
Suppose we have a business (X) selling sports equipment. A random company (Y) is interested in buying basketballs from business X. The selling price of each basketball is $25. Company Y wants to buy 30 basketballs from them.
Business X believes it can sell its basketballs to Company Y for $20 each because the current market situation for basketballs is not strong since football is becoming increasingly popular.
In addition, business X will suffer some costs, including a transportation fee of $250 for getting the balls to company Y and a signature work fee of about $25. When calculating the NRV, your first instinct might be to use the $25 price tag, which is the official price of each basketball.
This would be incorrect. As mentioned above, the net realizable value is a conservative method; its goal is to use the least profitable method when doing accounting work. This means we cannot use the sale price of the basketballs; instead, we use the expected selling price of the relevant market.
In this case, it would be $20 per basketball.
- Expected selling price = $20 x 30 balls = $600
- Cost of production and sale = $250 + $25 = $275
Let’s apply the formula:
NRV = 600 - 275 = 325
The net realizable value of the basketballs will be $325.
Example 3
As mentioned above, there are instances where we use the net realizable value to calculate the accounts receivable balance.
Suppose an accountant from company X is counting the final accounts receivable balance. The accountant realizes that 5 out of the 100 accounts will be missing payments; therefore, those 5 accounts will be labeled as uncollected amounts.
The sum of the 100 accounts is $10,000. The predicted 5 uncollected payment accounts are worth $150. As we did with costs in previous examples, here we subtract any predicted uncollected amounts by the full earnings amount.
$10,000 - $150 = $9,850
The net realizable value of the accounts receivable is $9,850.
What Affects Net Realizable Value
Several factors can influence NRV; some of them are:
1. Stability of economy
The state of the economy significantly impacts NRV, with factors like interest rates, inflation, and unemployment rates influencing consumer behavior.
If the economy is doing well, there is more money to spend overall, and consumers are not worried about overspending. The same applies to companies and businesses.
During economic downturns, consumer spending decreases, and businesses struggle to maintain previous activity levels. People become hesitant to buy goods, and businesses become very conservative and are unable to grow.
This affects the NRV as accountants can report missing payments and lower earnings.
2. Overall demand
The market situation also affects the net realizable value. When using NRV as a valuation method, it is clear that the overall value of goods has a heavy influence. People’s demands determine the value of a good or industry. What people want and are willing to pay for brings up a product or an industry’s value.
Note
Changes in consumer demand also impact companies and their financial statements.
3. Collection of unreceived payments
As we discussed, accountants use the NRV method when calculating their company's accounts receivable balance. We also mentioned that when computing the NRV, we must deduct the costs of uncollected payments on the balance sheet.
As we can see here, the less uncollected debt, the higher the NRV. This proves that a company's strategy and commitment to collecting these debts can influence its NRV. Large companies often prioritize business relationships with reliable partners who commit to timely debt repayment.
What Net Realizable Value Can Tell You
Net realizable values (NRV) serve as a crucial indicator for analysts and accountants across various scenarios, offering valuable insights, such as:
- NRV uncovers transaction costs. While a company may be content with the asset's sale price, residual expenses like commissions or fees must be considered and factored in to assess net proceeds accurately.
- It reflects the creditworthiness of clients. Material reductions in gross accounts receivable due to allowances for doubtful accounts signal a need for companies to review and strengthen their credit-checking processes, ensuring transactions are conducted only with financially sound clients.
- It reveals net proceeds, particularly significant for cash-flow-conscious companies with pressing capital requirements. Understanding the expected cash amount, especially if the gross proceeds may not be fully collected, is essential for informed decision-making.
- It unveils operating risks. Reducing net proceeds prompts a company to assess the underlying reasons, identify potential risks leading to diminished proceeds, and formulate strategies to mitigate such exposure.
- It determines the value of specific products. In cost accounting, NRV aids in segregating costs among joint products, clarifying the individual value of each item.
Advantages And Disadvantages Of Net Realizable Value
Now, let's understand the pros and cons of NRV.
Some of the advantages are:
- Conservatism Principle: By adopting the lower of cost or net realizable value (NRV) for inventory measurement, companies adhere to the principle of conservatism in accounting. This approach helps prevent overstatement of income by reducing the carrying value of goods, ensuring financial statements reflect a more cautious valuation.
- Applicability: NRV offers versatility as a valuation method, often applicable across various inventory items. Companies typically assess different NRVs for each product line and then consolidate these figures to determine an overall valuation for the entire company.
On the other hand, the disadvantages include:
- Assumption Dependency: Utilizing NRV necessitates significant assumptions from management regarding the future of the product. Predicting factors such as obsolescence, product defects, customer returns, pricing fluctuations, or regulatory changes can be challenging or even impossible for goods clouded with uncertainty. Consequently, NRV assumptions may lead to inaccuracies in valuations.
- Complexity in Application: The application and analysis of NRV can be intricate. Companies face unique risks and business considerations, which may influence NRV calculations differently. For instance, industries dealing with customers having riskier credit profiles may need to allocate larger write-off allowances, adding complexity to NRV assessments.
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