Inventory valuation

Net realisable value is the expected selling price of inventory (1) minus any costs still needed to complete and sell it (1) — for example, a jacket expected to sell for $30 after $5 of alterations has an NRV of $25.

A business should value its inventory at the lower of cost and net realisable value (NRV). Usually cost is lower, so inventory is valued at cost; but if the goods are damaged or obsolete and their NRV has fallen below cost, the business uses the lower NRV instead. This follows the prudence concept — it makes sure inventory, and therefore profit and assets, is never overstated, because an expected loss is recognised straight away.

One difficulty is that prices change over time. Items bought at different times cost different amounts, so it is unclear which cost applies to the units still held; different methods (such as FIFO or AVCO) then give different values, changing the reported profit.

A second difficulty is that inventory can lose value. Goods may become obsolete, go out of fashion, or be damaged or perishable, so their original cost no longer reflects what they are really worth. Estimating how far the value has fallen — and what the goods will eventually sell for — involves uncertain judgement.

These difficulties mean an exact value is impossible, which is why a business applies the prudent lower-of-cost-and-NRV rule.

When inventory's net realisable value falls below cost, the prudence rule requires it to be written down to the lower NRV — and this affects both financial statements.

On the statement of profit or loss, closing inventory is deducted in the cost-of-sales calculation. Writing it down reduces closing inventory, which increases cost of sales and so reduces gross profit (and every profit figure below it) in the current period. The expected loss is therefore recognised now rather than later.

On the statement of financial position, inventory is a current asset, so a lower valuation reduces current assets, net current assets and net assets. The statement shows the business at a realistic, prudent value rather than an inflated one.

This is the correct treatment because it prevents stakeholders being misled. Had the inventory been left at cost, profit and assets would both be overstated — shareholders might expect returns that are not real, and lenders might lend to a firm that looks stronger than it is. The downside is that reported profit looks lower this period; but this is the prudent, accurate outcome, and it avoids a worse surprise when the goods are eventually sold below cost.

Therefore correctly valuing the inventory lowers this period's profit and asset values, but produces reliable accounts — exactly what the prudence concept intends.

Inventory valuation is more important for a manufacturer than for many other businesses, because manufacturers hold large amounts of raw materials, work in progress and finished goods. But how important it is also depends on the scale of the inventory and the use being made of the accounts.

The case that correct valuation is very important. The inventory figure flows into both financial statements: closing inventory affects cost of sales and therefore profit, and it appears as a current asset affecting net current assets and net assets. An incorrect value distorts both. Over-valuing inventory overstates profit, which could lead the firm to pay dividends out of profit that does not really exist, and overstates assets, misleading lenders who judge liquidity from net current assets. For a manufacturer with high-value inventory, even a small percentage error can be a large absolute distortion. Correct valuation — using the prudent lower-of-cost-and-NRV rule — keeps the accounts reliable, supports good decisions and maintains stakeholder trust.

The case that its importance can be qualified. First, for a manufacturer with low or fast-moving inventory, valuation errors may be small relative to overall profit and assets, so the issue is less critical. Second, inventory valuation is only one of many factors affecting the accuracy and usefulness of accounts — cash flow, demand, costs and the validity of other estimates (e.g. depreciation) also matter, and may matter more. Third, the lower-of rule reduces this period's profit, which some managers dislike, and judgement about NRV introduces some subjectivity, so 'correct' is itself partly an estimate. Finally, what matters most to many decisions (e.g. whether to launch a product) is the future, which inventory valuation does not address.

Judgement. Valuing inventory correctly is important, but its importance is greatest where inventory is large and the accounts are relied on for decisions. For a typical manufacturer holding substantial stock, accurate valuation is essential to avoid overstated profit and assets, protect dividends and keep stakeholders correctly informed — so it should always be done prudently. However, it is one element of reliable accounting rather than the whole of it, and where inventory is small or decisions are forward-looking, its importance is more limited. The most defensible position is that correct inventory valuation is a necessary part of producing reliable, prudent accounts — vital for a stock-heavy manufacturer, but to be kept in proportion with the other factors that determine sound financial decisions.

The lower-of-cost-and-NRV rule is the standard, prudent way to value inventory, and it is required by accounting principles. The question is whether a business should always follow it, and how far the rule serves a business well.

The case for always using the lower-of rule. The rule embodies the prudence concept — anticipate likely losses, but not unrealised profits — so it prevents inventory, profit and assets from being overstated. This protects stakeholders: shareholders are not misled into expecting profits that do not exist, dividends are not paid out of overstated profit, and lenders are not misled about liquidity. Because the figure affects both financial statements, consistent use of the rule keeps the whole set of accounts reliable and comparable over time and between firms. It also aligns with accounting standards and the law, so a business that wants its accounts to be accepted (e.g. for audit, tax or lending) effectively must apply it. For these reasons, in the financial statements the rule should indeed be followed consistently.

The case against treating it as an absolute. First, the rule relies on estimates — NRV depends on a forecast selling price and selling costs, both uncertain — so 'correct' valuation involves judgement and could be manipulated. Second, the rule is cautious to a fault: it recognises expected losses but never expected gains, so it can understate the true economic value of inventory that will in fact sell well, arguably giving a pessimistic picture. Third, applying it line by line to a manufacturer's huge inventory is time-consuming and costly, and for fast-moving, low-value stock the benefit may not justify the effort. Fourth, for internal decision-making (as opposed to published accounts), managers may legitimately use other information — such as expected future selling prices or replacement cost — rather than the prudent book value, because decisions are about the future.

Weighing it up (criterion). Whether a business should always use the rule depends on the purpose of the valuation. For published financial statements, prudence, reliability, comparability and legal compliance mean the lower-of rule should essentially always be applied — there is little defensible alternative. For internal management decisions, the picture is different: the rule gives a prudent record but not necessarily the most decision-useful figure, so managers may supplement it with forward-looking information.

Judgement. A business should almost always use the lower of cost and NRV for its financial statements, because prudence, reliability and compliance demand it and the cost of getting it wrong (overstated profit and assets) is high. So for external reporting the answer is 'to a very large extent'. However, the rule should not be treated as the only relevant value: it relies on estimates, can understate genuinely valuable stock, and is not always the best basis for internal decisions, which are future-focused. The most defensible conclusion is that the lower-of rule should be applied consistently in the accounts, but understood as a prudent record that managers may look beyond when making forward-looking decisions.