Net Realizable Value
The net realizable value gives us a valuation regarding how much an asset can be sold according to market demand while discounting the costs of the asset sale.
The net realizable value gives us a valuation regarding how much an asset can be sold according to market demand while discounting the costs of the asset sale.
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 amount of profits which is why a professional like a certified public accountant must carefully apply a conservative approach when selling an asset.
You might be wondering what the reason behind this is. 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.
Finally, a business accountant will reveal the NRV on the company balance sheet.
What is Net Realizable Value Used For?
The net realizable value, called the net sales value, is used for several situations.
Let's discuss each situation below:
One of the primary uses of net realizable value is inventory valuation in accounting. If a business buys goods they need 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 sales value method.
As mentioned above, this is usually done by a professional with a CPA license as it requires caution and ensuring not to overvalue an asset by following the method that generates minor 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 in the NRV method. To do so, the company must deduct these costs from the money they generate after selling a TV.
If this is not done, the company has failed to properly use the net sales value method in the accounting process.
2. Accounts receivable balance
A business's account 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.
This could be caused by a customer not making the payment on time. In that case, an accountant must consider this when reporting for the final accounts receivable balance and, in that case, must subtract that amount as if it is a cost.
When calculating the net realizable value, the accountant will add up all the money placed or will be placed in the accounts receivable balance. Any payment not likely to be received should be subtracted from the sum.
This way, the business follows the conservative net sales value approach and counts missing payments as deducted costs from the total earnings.
The NRV is an excellent method to use when facing a situation of joint costs.
Cost accounting generally considers all expenses realized during the production of a product within the company.
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 the same materials and goods are used to create both nest baskets at the exact cost.
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 start incurring different costs depending on what the customer demands.
Note
The difference in costs results from a difference in production.
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 in deciding what to price each of their products.
Calculating the Net Realizable Value (NRV)
As a reminder, the net realizable gives us a valuation of how much an asset can be sold according to market demand while subtracting the costs of the asset sale.
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 the asset's production and sale. This also includes advertising and tax fees.
- 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.
We can summarize the above steps with a very easy formula:
(Estimated selling price) - (Costs of production and sale) = Net realizable value
Note
As mentioned above, NRV is also used for accounts receivable balance. In that case, we subtract the amount not received instead of the production and sale costs.
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.
The estimated selling price does not mean the literal price of a product you are selling. Instead, it is the price you believe it will sell for according to market expectations.
Examples of NRV
Let's apply what we know about NRV through some examples.
1. Example A
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 sales value of the couches will be put as $24,500 on the balance sheet.
2. Example B
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 net sales value, 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 sales 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.
3. Example C
As mentioned above, there are instances where we use the net sales 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 sales value of the accounts receivable is $9,850.
Factors That Can Influence NRV
Some circumstances can affect NRV; below are a few:
The economy's health greatly affects NRV. This means factors such as interest, inflation, and unemployment rates can affect our daily lives.
If the economy is doing good, there is more money to spend overall, and consumers are not worried about overspending. The same applies to companies and businesses.
If the economy is facing a downhill battle, consumers are not spending much, and businesses are not striving like they used to.
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 sales 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
As this affects people's consumption choices, it will also affect companies and their balance sheets.
3. Collection of unreceived payments
As we discussed, accountants use the NRV method when calculating the accounts receivable balance of their company.
We also mentioned that when computing the net sales value, 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.
Usually, big companies do not do business with anyone. Instead, they ensure their partners are trustworthy and likely to pay their debt on time.
Key Takeaways
- The NRV provides us with a valuation of how much an asset can be sold according to market demand while discounting the costs of the asset sale.
- The NRV method is globally seen as a conservative method.
- Not following this conservative approach in some transactions could lead to overstating the value of an asset.
- NRV is used for inventory valuation, joint cost accounting, and the accounts receivable balance.
- According to the formula, after we realize the sum of the income we generated, we must subtract all production and selling costs or the costs of any uncollected payment amounts.
- To follow this conservative approach, we must not look at the official sales price of an item; instead, we look at the expected market selling price.
- The economy's health and overall market demand have the biggest influence on the NRV.
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