Net realizable value analysis is a way to check estimated selling prices of goods and services. It is a standard valuation method used chiefly in inventoryaccounting. Accountants use it to ensure the value of any product is balanced.
It's used to calculate products in inventory and helps in cost accounting. With this article, businesses can understand what is net realizable value, its uses, advantages, disadvantages, and how it affects businesses.
What Do You Mean by Net Realizable Value (NRV)?
Net realizable value is the value of an asset which is how much cost will receive on sale minus the selling cost. It maintains the correct value for the product and helps accountants from overstating assets' value. It is a helpful tool in inventory management and cost accounting.
NRVs are used in generally accepted accounting principles (GAAP) and international financial reporting standards (IFRS). It is a more complex way of accounting and depends on many assumptions made by the department.
It is the total amount of money an asset generates upon sale.
Net Realizable Value Explained
To understand NRV better, companies must start with understanding inventory management better. The cost of each product depends on its demand in the market, and damage and spoilage are negative impacts affecting product quality, reducing its overall value.
Inventory management is essential to maintain balanced information about products' value, and overstating inventory assets can significantly affect business. In inventory accounting, NRV estimates the current value of investments, which compares existing assets to current liabilities.
Companies' profits depend on lenders and creditors and their liquidity to borrow money. With Correct NRV estimates the losses and gains for the upcoming future and prevents further damage from overstating assets.
Formula and Calculation of Net Realizable Value
The net realizable value formula is NRV = Expected selling price - Total production and selling costs
The expected selling price is the number of units produced multiplied by the unit selling price. It results in a reduction in gross revenue.
The total production and selling costs are expenses required to trade. Cost accounting helps to separate payments for each unit of goods.
To find the value of inventory item using the formula for net realizable value, follow these steps:
- Determine the market value of the asset
- Add all costs like final production cost, testing, and preparation costs.
- Subtract selling cost from market value to get NRV.
Net Realizable Value Examples
Imagine XYZ corporation has a product with a cost of 100rs. The market value of the product is 250rs. The cost to prepare the product is 40rs.
Cost of NRV = Market value- Cost-cost to prepare (250-100-40).
Hence NRV is 110rs. As the product price is less than the net reliable value, the company continues the price at 100rs.
Now if the market value of the product reduces in the coming year to 200rs, the NRV is 60 rs. So the company will have a 40 rs loss, which is the difference between cost and net realizable value. It will reduce the cost of the product to 60rs.
Net Realizable Value and Its Application
NRV is a common approach used by many companies to estimate the value of their assets. These assets usually include value estimation for inventory, accounts receivable, and cost accounting. It includes various costs of products and processes for its production and preparation.
Inventory
To calculate a value for inventory assets, companies calculate raw materials, labor, and other direct costs. The selling costs of initial sales are based on historical prices.
With changes in market conditions and profit achieved with previous sales, sometimes target goals must be attainable. Products usually lose their value with time. Therefore, NRV analysis is essential for inventory.
Cost Accounting
It is a type of accounting that works specifically for each product. In this, NRV is used to estimate the value of multiple products.
The relative price sale of many finished products reduces separable costs and production costs. It just helps businesses to understand the production of which products are making more profits than others. And to increase profits, companies must produce more.
Accounts Receivable (AR)
Net realizable value of accounts receivable usually deals with customer liquidity problems. Businesses must reduce the carrying value of AR to show their NRV to avoid bankruptcies and poor economic conditions.
Accounts Receivable Net Realizable Value
An accounts receivable balance is the total amount of charges that companies will receive according to the NRV. It is the gross amount of AR minus any payment for doubtful accounts.
The amount of allowance for doubtful accounts is the dollar amount of bills the company calculates as bad debt.
What Affects Net Realizable Value?
Four factors affect a business's net realizable value, collectability, economic conditions, market demand, and obsolescence.
1. Collectability
One of the company's main objectives is to find out how many accounts receivable and how many they will collect. That's why they prioritize customers with higher credit strength, as they have higher NRV.
2. Market Demand
It depends on the customer's choice to select the product. Even if the product is not trendy, various broad markets use products as substitutes or cheaper alternatives.
3. Technology
With advanced technology, products lose their charm quickly. Companies must manage to stay connected with present technology to reach consumers.
4. Economic Conditions
With inflation and changes in market conditions, customers might lose interest due to high prices. High prices and unemployment also reduce product sales, affecting the company.
Advantages and Disadvantages of Net Realizable Value
The advantages of NRV are:
- It balances the value of assets and manages prices by not overstating the value of products.
- Economic benefits for better future estimates of the value of inventory
- It is helpful for a wide range of products in stock rather than a category or group.
Disadvantages of NRV are:
- It is based on many assumptions from management about future sales of products.
- NRV assumptions can lead to incorrect valuations of products.
- The application of NRV and its analysis is complex.
- Companies are exposed to different risks if NRV applications are not applied accurately.
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FAQs on Net Realizable Value
1. What do you understand about the net realizable value method?
The net realizable value method accounts for the value of assets that companies receive upon their sale after subtracting the selling costs.
2. How to calculate net realizable value?
To calculate the net realizable value, companies use formulas. Expected costs minus the prep costs and production costs from the market value of the product obtain the NRV.
3. What do you mean by inventory valued at NRV?
Inventory valued at net realizable value is those assets in inventory that include the expected selling price minus the total production cost.
4. What is accounting conservatism?
It is the principle that company accounts be prepared for possible losses and deal with great caution and a high degree of verification.
5. What is fair market value?
Fair market value is the price an asset would sell in the market when particular conditions are fulfilled.
6. What are the factors NRV considers to measure value?
NRV considers two factors to measure an asset's value: a fair market value and costs to sell or obtain that value.
7. When do companies usually perform NRV?
Companies perform an NRV analysis at intervals. For some companies, NRV is done annually or quarterly, sometimes when economic conditions require it.
8. What is the formula of NRV?
The formula of NRV is the market value minus production and preparation costs.
