The principle of valuation of inventory, based on the conservatism principle in accounting, dictates that inventory should be valued at the lower of its cost or its net realizable value (NRV).
Understanding the Principle in Detail
This principle aims to provide a more realistic and cautious view of a company's financial position. It ensures that inventory is not overstated on the balance sheet. Here's a breakdown:
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Cost: This refers to the original cost of acquiring or producing the inventory. It includes purchase price, freight, and other direct costs associated with getting the inventory ready for sale.
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Net Realizable Value (NRV): This is the estimated selling price in the ordinary course of business, less the estimated costs of completion and the estimated costs necessary to make the sale. In simpler terms, it's the amount the company expects to receive from selling the inventory, minus any costs to get it sold.
Why Use the Lower of Cost or NRV?
The use of the lower of cost or NRV is rooted in the principle of conservatism. This principle suggests that when there are two acceptable alternatives for valuing an asset, the alternative that results in a lower asset amount and net income should be chosen. This helps avoid overstating assets and profits.
Here's a simple example:
Suppose a company has inventory with a cost of \$10 per unit. Due to market changes, the company estimates it can only sell the inventory for \$8 per unit, with no further costs to be incurred. In this case, the inventory should be valued at \$8 (the NRV) because it's lower than the cost. A loss of \$2 per unit would be recognized in the current period, reflecting the decline in value. Conversely, if the NRV was \$12, the inventory would be valued at its original cost of \$10. Gains are not anticipated until they are realized through a sale.
Impact on Financial Statements
Applying this principle has the following impacts:
- Balance Sheet: Inventory is reported at a more realistic value, preventing overstatement of assets.
- Income Statement: A loss is recognized in the period when the NRV falls below the cost, resulting in a more accurate representation of profitability. This loss would be reflected as Cost of Goods Sold (COGS).
Practical Implications
Businesses must regularly assess the NRV of their inventory, especially if there are:
- Obsolescence: The inventory is outdated or no longer in demand.
- Damage: The inventory is physically damaged.
- Declining Market Prices: Market conditions have reduced the selling price.
- Increased Selling Costs: Costs to sell inventory have increased (e.g., increased marketing expenses or sales commissions)
Summary
The principle of valuation of inventory focuses on recognizing potential losses when the value of inventory declines below its cost, leading to a more prudent and accurate representation of a company's financial health.
