Chapter 4: Determination of net realizable value

What is Net realizable value?

The cost of inventories may not be recoverable if those inventories are damaged if they have become wholly or partially obsolete, or if their selling prices have declined. The cost of inventories may also not be recoverable if the estimated costs of completion or the estimated costs to be incurred to make the sale have increased.

The practice of writing inventories down below cost to net realizable value is consistent with the view that assets should not be carried more than amounts expected to be realized from their sale or use.

Inventories are usually written down to net realizable value item by item. In some circumstances, however, it may be appropriate to group similar or related items. This may be the case with items of inventory relating to the same product line that have similar purposes or end uses, are produced and marketed in the same geographical area, and cannot be practicably evaluated separately from other items in that product line.

It is not appropriate to write inventories down based on a classification of inventory, for example, finished goods, or all the inventories in a particular operating segment.

• Estimates of net realizable value are based on the most reliable evidence available at the time the estimates are made, of the amount the inventories are expected to realize. These estimates take into consideration fluctuations of price or cost directly relating to events occurring after the end of the period to the extent that such events confirm conditions existing at the end of the period.
• Estimates of net realizable value also take into consideration the purpose for which the inventory is held.

For example, the net realizable value of the quantity of inventory held to satisfy firm sales or service contracts is based on the contract price. If the sales contracts are for less than the inventory quantities held, the net realizable value of the excess is based on general selling prices. Provisions may arise from firm sales contracts over inventory quantities held or from firm purchase contracts. Such provisions are dealt with under IAS 37 Provisions, Contingent Liabilities, and Contingent Assets.

Materials and other supplies held for use in the production of inventories are not written below cost if the finished products they will be incorporated are expected to be sold at or above cost.

However, when a decline in the price of materials indicates that the cost of the finished products exceeds net realizable value, the materials are written down to net realizable value. In such circumstances, the replacement cost of the materials may be the best available measure of their net realizable value.

A new assessment is made of net realizable value in each subsequent period. When the circumstances that previously caused inventories to be written down below cost no longer exist or when there is clear evidence of an increase in net realizable value because of changed economic circumstances, the amount of the write-down is reversed (i.e., the reversal is limited to the amount of the original write-down) so that the new carrying amount is the lower of the cost and the revised net realizable value.

This occurs, for example, when an item of inventory that is carried at net realizable value, because its selling price has declined, is still on hand in a subsequent period and its selling price has increased.

Measurement of net realizable value

IAS 2 defines net realizable value as “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”. The net realizable value of an item of inventory may fall below its cost for many reasons, including damage, obsolescence, a decline in selling prices, or an increase in the estimate of costs to complete and market the inventories.

The Standard highlights the distinction between net realizable value (as defined in the previous paragraph) and the fair value of inventory. It explains that fair value reflects “the price at which an orderly transaction to sell the same inventory in the principal (or most advantageous) market for that inventory would take place between market participants at the measurement date”.

Net realizable value is the net amount that an entity expects to realize from the sale of inventories in the ordinary course of business and is, therefore, an entity-specific value. Fair value is not an entity-specific value. The net realizable value of inventories may not equal their fair value and have fewer costs to sell. This will occur, for example, when the reporting entity has secured favorable binding sales contracts that have not been affected by more recent adverse market conditions.

Generally, estimates of net realizable value are made on an item-by-item basis. In some circumstances, however, it may be appropriate to group items of similar or related inventories. This may be the case when items of inventory:

• relate to the same product line and have similar purposes or end uses;
• are produced and marketed in the same geographical area; and
• cannot be practicably evaluated separately from other items in that product line.

When estimating the net realizable value of inventories, management should consider all of the facts relating to the inventories and the operating environment at the time the estimates are made. Estimates are based on the most reliable evidence available at that time as to the amount that the inventories are likely to realize.

Determination of the net realizable value of an item of inventory with a long operating cycle – example An entity is engaged in the production of an item of inventory with a long operating cycle. Production of the item normally takes six years to complete. Costs are accumulated over time and recognised as inventory. At the end of the second year of production, a further four years of work is required for the inventory item to be completed. No relevant market exists for the inventory in its current state. When estimating the net realisable value of inventories at the end of the second year of production, management should consider all of the facts relating to the type of inventory and the operating environment at that time. Because no relevant market exists for the two-year work in progress, it may be the case that the entity uses as its starting point the current selling price for the inventory in its completed state, deducting expected holding costs (including finance costs), outstanding costs of conversion and costs to sell. An entity might alternatively use the forward price for sales of the completed inventory in four years’ time. When this approach is adopted, the cash flows associated with the net realisable value should be discounted at an appropriate rate to determine an estimate of the net realisable value of the inventory in its present location and condition, consistent with IAS 2 and IAS 36. Consequently, it will be necessary to adjust the forward price for the effect of the time value of money and also for outstanding costs of conversion and costs to sell. Estimates of net realisable value should take into consideration fluctuations in price or cost directly relating to events occurring after the reporting period to the extent that such events confirm conditions existing at the end of the reporting period.

Sales after the reporting period – example An item of inventory which cost CU100 is sold after the reporting period for CU80. A sale after the reporting period at a lower price generally provides evidence of the net realisable value of the inventories at the end of the reporting period and the closing inventories should therefore be carried at CU80 less any costs to sell. However, this will not always be the case. If, for example, further investigation shows that the decrease in sales price arose because of damage to the inventories that occurred after the reporting period, this would indicate that the CU80 sales price did not reflect conditions existing at the end of the reporting period and that the loss in value should not be accounted for until the next period. In these circumstances, it would be necessary to assess whether the item could have been sold undamaged for an amount at or in excess of its cost (CU100) plus any costs to sell. If so, no write-down would be required at the end of the reporting period.

Decrease in net realizable value after the end of the reporting period for inventories under development – example Entity P is a property developer. It is preparing its financial statements for the year ended 31 December 20X0, which will be authorised for issue on 31 March 20X1. At 31 December 20X0, Entity P holds a property as development work in progress. Costs incurred to date are CU20 million. Estimated costs to complete are CU10 million (therefore, total costs will be CU30 million). Completion and sale of the development are expected within 18 to 24 months. Entity P estimates net realisable value for development work in progress based on the projected sales price for the property when it is complete, discounted back to current value. Based on market information on sales prices for similar, finished properties at 31 December 20X0, net realisable value is estimated at CU32 million (implying a net development profit of CU2 million). However, property prices in the relevant market are falling. At 31 March 20X1 (date of authorisation of financial statements), the observed sales prices for similar, finished properties have declined to CU27 million (implying a net development loss of CU3 million). Estimated costs to complete (and other applicable factors) are unchanged since year-end. Entity P should recognise an inventory write-down in its 31 December 20X0 financial statements. The development property is not available for sale at the year-end. IAS 2 acknowledges that “fluctuations of price or cost directly relating to events occurring after the end of the period” are relevant to estimates of net realisable value “to the extent that such events confirm conditions existing at the end of the period”. Because Entity P estimates net realisable value based on projected sales prices of completed property, discounted back to current value, information received after the end of the reporting period (including revised sales price estimates) provides further evidence as to conditions that existed at the end of the reporting period, unless the changes in sales prices clearly relate to a separate event subsequent to the period end. When estimating the net realisable value of inventories, the purpose for which the inventories are held is taken into consideration. For example, if the inventories are held to satisfy firm sales contracts, the sales prices agreed in those contracts form the basis of the estimation. If the sales contracts are for less than the inventory quantities held, the net realisable value of the excess is based on general selling prices.

Estimating net realizable value – inventories held to meet firm sales contracts – example Entity A is a supplier of office equipment. At the reporting date, it holds 1,000 printers with a cost of CU150 per unit. In the past, these printers sold for CU200 per unit. Due to recent changes in technology and the imminent arrival of a new model, it is estimated that at the reporting date these printers could only be sold in the market for CU130 per unit. However, before the year end, Entity A secured a firm sales contract with a local education authority to supply 500 printers at CU170 per unit which will be fulfilled by delivery of the printers in the next reporting period. Assume that selling costs are nil. For those printers to be supplied to the education authority, the net realisable value is CU170 per unit, which is higher than cost. Consequently, at the reporting date, these units continue to be measured at their cost of CU150 per unit (500 × CU150 = CU75,000). For the remaining inventory of 500 printers, the net realisable value reflects the current market price of CU130 per unit, which is lower than cost. Entity A writes these printers down by CU10,000 (500 units × CU20) to their net realisable value of CU65,000 (500 units × CU130). Therefore, the total carrying amount of printer inventories at the reporting date is CU140,000.

Treatment of writing inventories down to net realizable value

When the net realizable value of an item of inventory is less than its cost, the excess is written off immediately in profit or loss.

Items of inventory are generally written down on an item-by-item basis. IAS 2 indicates that it is generally inappropriate to write down entire classifications of inventories, such as finished goods, or all of the inventories in a particular operating segment.

Materials and other supplies held for use in the production of inventories are not written below cost if the finished products they will be incorporated are expected to be sold at or above cost. However, when a decline in the price of materials indicates that the cost of the finished products will exceed the net realizable value, the materials are written down to net realizable value. In such circumstances, the replacement cost of the materials may be the best available measure of their net realizable value.

Net realizable value – costs to sell The costs necessary to make the sale should be determined in a manner consistent with the definition of ‘costs of disposal’ in IAS 36, which states that these are “incremental costs directly attributable to the disposal of an asset, excluding finance costs and income tax expense”. An incremental cost is one that would not be incurred if the activity was not undertaken. General overheads, therefore, may not be allocated for the purposes of determining costs to sell. Direct transaction costs must be allocated for the purposes of determining costs to sell. This guidance does not reflect the agenda decision of the IFRS Interpretations Committee in June 2021 in respect of ‘Costs Necessary to Sell Inventories’.

Reversals of write-downs

Net realizable value estimates are made at the end of each reporting period. When subsequent evaluations show that the circumstances that previously caused inventories to be written down below cost no longer exist, or when there is clear evidence of an increase in net realizable value because of changed economic circumstances, write-downs of inventories previously recognized are required to be reversed.

This occurs, for example, when an item of inventory that is carried at a net realizable value because its selling price had declined is still on hand in a subsequent period and its selling price has increased (though it would still be necessary, if the item had been on hand for a long time, to consider whether there might be obsolescence issues).

The amount of the write-down should be reversed through profit or loss so that the new carrying amount is the lower of the cost and the revised net realizable value. Therefore, the amount of the reversal is limited to the amount of the original write-down.

What is the difference between net realizable value and fair value? Fair values are the appropriate measurement bases for broker-traders, because they have access to ready markets. Net realizable value is appropriate for producers, because they might not have such access. Where inventories are measured at fair value, that fair value must be measured in accordance with IFRS 13. For example, an entity holds mineral inventories. The current market price is C10 per ton. The entity is in a forward contract to sell the stock at C12 per ton. In this situation, fair value is C10 per ton, but net realizable value is C12 per ton.

What factors should be taken into account when calculating a write-down to reduce inventory from cost to net realizable value? The initial calculation of a write-down to reduce inventory from cost to net realizable value might often be made by the use of formulas based on predetermined criteria. The formulas normally take account of the age, movements in the past, expected future movements and estimated scrap values of the inventory, as appropriate. Whilst the use of such a formula establishes a basis for making a write-down that can be consistently applied, it is still necessary for the results to be reviewed in the light of any special circumstances that cannot be anticipated in the formula, such as changes in external market information or in the state of the order book.

Impact of post balance sheet events in determining the net realizable value of inventory An entity supplies car parts to a major manufacturer. At the year end, it had inventories of parts and the carrying value was C1 million. However, after the year end the manufacturer changed the models of the cars and, as a result, the inventories became obsolete (the parts were not interchangeable between models). Should the entity provide against the inventories at the year-end? IAS 10 gives examples of events that require an adjustment to amounts recognized at the balance sheet date. One such example, given in IAS 10, refers to the sale of inventories after the balance sheet date as giving evidence of the net realizable value at the balance sheet date. IAS 2 states: “Estimates of net realizable value are based on the most reliable evidence available at the time the estimates are made, of the amount the inventories are expected to realize. These estimates take into consideration fluctuations of price or cost directly relating to events occurring after the end of the period to the extent that such events confirm conditions existing at the end of the period”. This raises the question of whether the condition existed at the year-end. It might be argued that the change of model by the manufacturer is a condition that did not exist at the year-end, and so the loss is a post balance sheet event. However, it is likely that the manufacturer would have been considering the change over a long period (including the period prior to the year-end), even if it did not announce the change until after the year end. In addition, the high inventory levels might have indicated slow demand from the manufacturer. This is confirmed by the post balance sheet announcement confirming the over-supply at the year-end. The condition (that is, the likelihood that the models would change and the resultant potential loss) is likely to have existed at the year-end, and so the post balance sheet confirmation of the change of model and the resultant loss should be reflected in the carrying value of the inventories at the year-end.

How should the net realizable value of material inventories to be incorporated into finished goods be determined? An entity manufactures telecommunication equipment in three stages. There is a market for the semi-finished product for each stage, but the entity only sells the completed product. The following are details of the cost structure of the telecommunication equipment as at 31 December 20X2 (financial year end). Cost/unit         Selling price/unit C C Stage 1 150 120 Stage 2 – conversion costs 40 90 190 210 Stage 3 – conversion costs 60 70 250 280 Assuming that the selling costs are immaterial, what is the net realizable value of the semi-finished product in stage 1 as at 31 December 20X2? Although the selling price per unit at stage 1 is C120, the calculation of the net realizable value of work in progress should consider the expected selling price of the finished products in which it will be incorporated. The profit margin on the estimated cost of completion should, therefore, be considered when calculating the net realizable value of work in progress if the entity has the ability to dispose of the finished product at a price that exceeds the production cost. Therefore, the net realizable value of the semi-finished product at stage 1 is: Selling price of completed product                                                        280 less stage 3 conversion costs                                                                   (60) less stage 2 conversion costs                                                                   (40) Net realizable value at stage 1                                                                180

Should a purchaser accrete interest on long-term pre-payments for inventory? The IFRS IC has considered the issue of whether a purchaser should accrete interest on long-term pre-payments for inventory by recognizing interest income, resulting in an increase in the cost of inventories. The IFRS IC has noted that the time value of money should be considered where there is a long-term pre-payment for long-term supply. The financing element of the long-term pre-payment should be identified and recognized separately. Hence the long-term prepayment would be recognized at the amount paid, and interest would accrete on the long-term pre-payment until the inventory is received. However, where premiums are already included in the purchase price to secure a fixed price of supply, it is not necessary to accrete interest on these payments, because these premiums are not considered financing in nature.

How should rebates that are only received once a year be allocated to items of inventory? A car distributor values its items of inventory at the year-end. Rebates are only received from the car manufacturers once a year and are only known after the year end, but relate to purchases in the current period. Should the rebates be taken through the income statement as a deduction in the cost of sales, without allocation to the items in inventory at the balance sheet date, or should a proportion of the rebates be allocated to the inventory items at the year-end? IAS 2 states that trade discounts, rebates and other similar items are deducted in determining the cost of purchase of inventory. A proportion of the rebates should be allocated to inventory items at the year-end. For example, if purchases during the year are 100 and there is inventory with a cost of C10 at the year-end, 10% of the rebate should be applied to the inventory items at the year-end and 90% should be taken through the income statement as a deduction in the cost of sales. The reasoning is that the rebates cannot be allocated to particular items in the year, so they should be spread over all the items purchased during the year, whether sold or unsold.

How should costs of inventories be determined using FIFO and weighted average cost valuation methods? Assume that opening inventory on 1 March 20X9 is nil. All inventory is finished good and is of the same type. Details of the inventory received and sent out are as shown below. Quantity unit            Unit cost C Batch 1 received on 1 March 20X9 2 3.00 Batch 2 received on 15 March 20X9 4 4.50 On 25 March 20X9 the entity sold 5 units (5) Closing inventory on 31 March 20X9 1   Quantity unit      Unit cost Value C C (a) FIFO 1 4.50(a) 4.50 (b) Weighted average 1 4.00(b) 4.00 (a) FIFO: all units of batch 1 have been sent out first, then three units from batch 2 were dispatched. One unit from batch 2 remains at C4.50. (b) Weighted average: the average unit cost of all units received is C4.00 ((2 × C3) + (4 × C4.50))/ (2 + 4).

Cost formulas and implications

The combination of the previous version of IAS 2 and SIC-1 Consistency—Different Cost Formulas for Inventories allowed some choice between first-in, first-out (FIFO) or weighted average cost formulas (benchmark treatment) and the last-in, first-out (LIFO) method (allowed alternative treatment). The Board decided to eliminate the allowed alternative of using the LIFO method.

The LIFO method treats the newest items in inventory as being sold first, and consequently, the items remaining in inventory are recognized as if they were the oldest. This is generally not a reliable representation of actual inventory flows.

The LIFO method is an attempt to meet a perceived deficiency of the conventional accounting model (the measurement of cost of goods sold expense by reference to outdated prices for the inventories sold, whereas sales revenue is measured at current prices). It does so by imposing an unrealistic cost flow assumption.

The use of LIFO in financial reporting is often tax-driven because it results in a cost of goods sold expense calculated using the most recent prices being deducted from revenue in the determination of the gross margin. The LIFO method reduces (increases) profits in a manner that tends to reflect the effect that increased (decreased) prices would have on the cost of replacing inventories sold. However, this effect depends on the relationship between the prices of the most recent inventory acquisitions and the replacement cost at the end of the period. Thus, it is not a truly systematic method for determining the effect of changing prices on profits.

The use of LIFO results in inventories being recognized in the balance sheet at amounts that bear little relationship to recent cost levels of inventories. However, LIFO can distort profit or loss, especially when ‘preserved’ older ‘layers’ of inventory are presumed to have been used when inventories are substantially reduced. It is more likely in these circumstances that relatively new inventories will have been used to meet the increased demands on inventory.

The Board decided to eliminate the LIFO method because of its lack of representational faithfulness in inventory flows. This decision does not rule out specific cost methods that reflect inventory flows similar to LIFO.

The Board recognized that, in some jurisdictions, using the LIFO method for tax purposes is possible only if that method is also used for accounting purposes. It concluded, however, that tax considerations do not provide an adequate conceptual basis for selecting an appropriate accounting treatment and that it is not acceptable to allow an inferior accounting treatment purely because of tax regulations and advantages in particular jurisdictions. This may be an issue for local taxation authorities.

IAS 2 continues to allow the use of both the FIFO and the weighted average methods for interchangeable inventories.

The cost of inventories is recognized as an expense in the period

The Exposure Draft proposed deleting paragraphs in the previous version of IAS 2 that required disclosure of the cost of inventories recognized as an expense in the period because this disclosure is required in IAS 1 Presentation of Financial Statements.

Some respondents observed that IAS 1 does not specifically require disclosure of the cost of inventories recognized as an expense in the period when presenting an analysis of expenses using a classification based on their function. They argued that this information is important to understand the financial statements. Therefore, the Board decided to require this disclosure specifically in IAS 2.