How to Perform a Net Realizable Value (NRV) Analysis - Magnimetry (2023)

Accounting standards (IRFS and US GAAP) require us to use a conservative principle in the valuation of assets and transactions.

Net Realizable Value (NRV) is the amount we can realize on an asset less disposal costs. The method is most commonly used when valuing inventories and accounts receivable.

Entities normally recognize assets at cost (how much it costs to acquire the asset). Sometimes the entity cannot recover that amount and must report those assets at the lower of cost and net realizable value.

The NRV is a conservative method because it estimates the actual value of an asset after deducting the costs to sell or sell it.

Understanding Net Realizable Value

The use of the VRN method is a way of valuing inventories and accounts receivable prudently and in compliance with the provisions of accounting standards.

In the context of inventory, NRV represents the expected sales price in a regular transaction, less the estimated cost of delivery, completion, and disposal. This value can be very subjective and requires a certain amount of professional judgment to estimate. It is also important for internal and external auditors. Management often tries to show better results by playing around with the assumptions used to calculate the NRV.

For accounts receivable from customers, the NRV is the total balance of accounts receivable less the allowance for doubtful and delinquent debts for customers we expect to default. On most financial statements, you can see the balance sheet line read "Accounts Receivable, Net."

You can read more about deriving the Doubtful Debt Deduction (DDA).our article on customer age analysis.

NIIF y US GAAP

Accounting standards require that we present inventories and accounts receivable at the lowest cost and VRN. Both sets of rules refer to the VRN. However, there are some notable differences.

IFRS requires that the same assumptions and formulas be used to calculate NRVs for similar items, while US GAAP has no such requirement.

IFRS allows us to reverse depreciation on an item if its value increases over time. On the other hand, US GAAP does not allow such a review.

Under IFRS, we are required to present in thelower cost and NRV🇧🇷 US GAAP refers to another term that says we must account for assetslower acquisition and market value🇧🇷 Market value refers to the current replacement cost of the asset and has a defined upper and lower limit, although the lower limit can be subjective.

Net Realizable Value Calculation

Calculating the NRV is not as complicated as deriving the inputs for it. To get there we can follow these three steps:

1. Determine the expected sale price or market value of the asset.
2. Identify any costs associated with the sale (for example, marketing, delivery, insurance)
3. Calculate NRV as market value [1] minus disposal costs [2]

While the formula here applies to inventory, translating it to accounts receivable is relatively easy. We need to change the market value with the gross balance of the loss ratio and associated costs, with bad debt (DDA).

We typically calculate the NRV adjustment on a "per item" basis. However, in some cases where we have extensive inventory databases, this can become tedious and impractical. Also, our system does not always provide an easy way to book accommodation in such detail.

If we find ourselves in such circumstances, it is acceptable to book as full accommodation. Next, we need to track the calculation in a spreadsheet and keep track of finished goods sold and materials that went into production. This is vital because when we sell an item we need to amortize its cost and VRN allowance.

An alternative is to divide our inventory into groups of similar items and calculate net realizable value on an aggregate basis. It's important to note that we may have some "good" items that will offset the impact of those with VRN issues doing this. This can go so far that no depreciation is needed for this group. There are no further instructions for dividing inventory into groups, except that the items must be similar. What that means is a matter of professional judgment and a solid understanding of the business.

Regularly calculating the NRV of inventories and accounts receivable prevents overvaluation of assets on the balance sheet and helps us adhere to the principle of conservatism.

accounting

If we hold inventory in our accounting records at a value greater than its NRV, we must record it at the lower NRV.

Whenever we determine that a write-off is necessary, the next step is to recognize it as an expense on our income statement (profit and loss statement) and record the value of the inventory on our balance sheet.

In essence, we have not recorded a reduction directly in inventory. We recognize a provision of VRN in a separate credit account. We then use this account to offset the value of inventories in our financial statements.

Let's illustrate accounting with an example. We have some parts in our warehouse that we have reserved with an acquisition cost of €20,000. Recently, manufacturers of these components have adopted a new production technology. This reduced the realization value of the items to €15,000. To reflect this value change in our financial records, consider the following journal entry:

At some point we still have parts in stock when manufacturers start producing a new and better part and we can no longer keep up with what we have in stock. Management decides to cancel the components. We record this with the following entry:

If we managed to sell them for €12,000 before they became obsolete, we would record the transaction as follows:

And if the new production method fails and the value of our parts returns to €20,000, we will adjust it as follows:

Note that while this is allowed under IFRS, US GAAP does not allow write-downs if the value of the inventory subsequently increases.

Net realizable value analysis

Companies regularly conduct VRN assessments to assess whether they need to adjust the amount by which they record inventory and accounts receivable. We generally review once a year to present correct balances in our financial statements. It is also common to combine it with the analysis of slow moving and obsolete inventories. Whenever possible, managers try to schedule the annual inventory closer to the end of the year, as this is the process by which the company identifies damaged, spoiled, and obsolete items.

By adjusting the amounts in a timely manner, we avoid carrying forward losses into future periods. However, this is also where management sometimes feels pressure to hide issues with the VRN in order to get better results and achieve their goals. If not addressed over time, this behavior can become a serious problem for the company.

This analysis is part of almost all audits, since overestimation of inventories and accounts receivable presents a greater risk. If auditors find significant VRN issues, the company must adjust its records or accept a qualified audit report.

NRV analysis example

I want to show you how to approach an inventory NRV analysis in a real world situation. First, we need a breakdown of the items. As part of our annual closing process, we will review the balance sheet as of December 31, 2020.

Now that we have our inventory on hand at the end of the year, we need to compare its cost to the estimated retail price. Since we typically do this analysis at the end of next year, let's assume we're now at the end of the first quarter of 2021. This means we can do this instead of estimating sales prices and looking at list prices (which many companies don't). make). dont do). I have). take as reference the actual sales in the period between December 31, 2020 and March 31, 2021.

Since our sales team offers discounts for various reasons, we also calculate the net sales of each item.

The next step is to prepare our working file. Take the inventory breakdown on December 31, 2020 and calculate the average cost per item (V-end / Q-end).

so we useVLOOKUPto bring in the quantity and value of net sales for the first quarter of 2021 to calculate an average net sales price. It is important to consider net sales rather than gross sales, since the discount is part of our cost of sales of the items. We do not take shipping costs into account, as our customers arrange delivery on their own.

We calculate the average cost as follows:

And then comes the average price, based on net sales:

Now that we have the average cost and average sales price, we can compare them to identify potential VRN issues. Since we may not have sales for some of our inventory items, we add another check and return "no sales" if the quantity sold is zero. We are seeing an NRV issue on items we sell where the average price is below the average cost.

Since our NRV emissions column only shows the difference between prices when the cost exceeds the sales price, we can calculate our NRV adjustment value by multiplying it by the amount as of December 31, 2020.

It is important to remember that we are performing our analysis on December 31, 2020, so we applied the problem to the balance of that date.

However, if you scroll through the archive, you'll see that around 20% of our items had no sales in Q1 2021. There are several ways to approach calculating the NRV for them. It would be better to use a price list or some confirmed offers for customers. If those options are not feasible, you would typically calculate the average NRV adjustment percentage by stock group. We need to make sure that our inventory groups are homogeneous and that the items within them work in a similar way to apply this approach.

To put this into practice, we created a pivot table from our previous analysis and excluded the "no sales" items.

We then calculate the average percentage of the VRN adjustment value from the final value (the value as of December 31, 2020).

We can now bring the average NRV fit percentages into our SLOOKUP analysis of the group codes. We only do this if the item has no "sales" to avoid double VRN adjustments.

The application of these percentages to the terminal value of the stock split provides the additional adjustment to the expected NRV.

Whether the total NRV adjustment that the Company records in its accounting records includes this additional amount is a matter of professional judgment and knowledge of the Company.

Conclution

We use net realizable value to reflect that assets are sometimes worth less than on paper.

The NRV is a conservative accounting approach that complies with the principle of conservatism. The method helps prevent overvaluation of inventories and accounts receivable.

Analysts use the NRV to verify that companies follow accounting standards and correctly value their assets.

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