Depending on the nature of the operations that a business runs in order to produce its revenues, that business can acquire its products intended for sale through purchase, manufacturing or a combination of both. In any case, the purchased and/or completed products intended for sale are collected in an account called inventory. Inventory represents the products that a business has on hand and intends to sell in order to produce revenue. It is considered a short-term asset since it is assumed that the products in inventory are likely to be sold off within a year’s time.
One of the most fundamental accounting principles is the cost principle, the rule that transactions should be recorded at their purchase price. For example, a piece of equipment that the business spent $2,000 on to purchase should be recorded on its accounts as possessing $2,000 in value. Cost principle does not apply in all cases, but circumstances that trump its general applicability are rare and unusual – net realizable value ties into one of those exceptions.
Fair Value and Market Value
Cost principle is used because of the concept of fair value. Fair value is the value of a resource that is determined to be an accurate and a reasonable assessment of the costs and benefits from owning that resource. In most cases, so long as the transaction takes place in an open market where both participants are consenting and do not possess information advantages over one another, market price is considered a reasonable assessment of fair value.
Net Realizable Value
Net realizable value is equal to the value of the business’s inventory once sold minus the costs of completing unfinished units of products and then selling them. In sum, net realizable value is what the business can recoup from its inventory once it completes and sells all units of its products. For example, if a business had 20 units of its product on hand that it can sell at $100 each and five more incomplete units that need $20 each to complete, assuming no selling costs, that business’s inventory has a net realizable value of $2,400.
Lower of Cost or Net Realizable Value
Businesses are obligated by generally accepted accounting principles, or GAAPs, to list the values of their inventories at the lower of their cost and net realizable values. Cost refers to the purchase cost of the inventory while net realizable value is as described above. This policy is done because the value of inventory listed on the accounts should reflect its fair value. Net realizable value is a reasonable approximation of fair value because it is an excellent estimate of both the costs and benefits of owning the inventory – the costs being completion and selling costs and the benefits being the revenues for which the products can be sold.
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