If your business ever ends up with product overstocked, you might want to find a buyer for your excess inventory. You start by estimating a value for the goods, how much it costs you to hold the extra stock, and how much you will likely spend to unload it. This gives you a rough idea of how much you can expect to pocket from the sale. This is called net realizable value.
Net realizable value is a key financial accounting concept used to value a business’s assets, particularly inventory and accounts receivable. Learn more about net realizable value and how it may apply in your business’s management and accounting.
What is net realizable value?
Net realizable value (NRV) is a method for valuing assets that a business expects to sell. It accounts for the costs of selling the asset, such as maintenance, storage, and transportation costs. NRV is most commonly used to estimate inventory valuation and accounts receivable, both of which are current assets often converted into cash within a year.
Net realizable value ends up being the money received from an asset sale, after any disposal costs the selling business incurred to complete the sale. Similar to how net income is the final value of a business’s profit after accounting for all expenses, NRV is the final value of an asset after accounting for all the expenses associated with selling it.
Why NRV matters
As a key measure under generally accepted accounting principles (GAAP) for companies in the United States and international financial reporting standards (IFRS) for companies outside the US, NRV is meant to prevent inflated asset values. Overstating asset valuations on the balance sheet, as well as understating liabilities, can inflate profitability and give a distorted picture of a business’s financial standing.
The driving principle behind net realizable value is conservatism in accounting. This principle holds that assets and revenue should be recognized only when it’s confirmed they will be received or realized, and that expenses and liabilities should be recognized as soon as possible. Conservative accounting and net realizable value mean that inventories are valued at the lowest they could likely be sold for, while accounts receivable are valued at the least that the business can expect to collect.
NRV vs. fair market value
Net realizable value and fair market value are related but distinct concepts. Fair market value is the expected sale price you would anticipate receiving from a buyer for your asset, such as your inventory or your accounts receivable. Net realizable value is the asset’s market value or sale price, minus selling costs, such as storage, preparation, and transportation of inventory.
How to calculate NRV
- Determine the expected selling price or fair market value of the asset
- Find all costs associated with selling the assets
- Subtract selling costs from the fair market value
Calculating net realizable value depends on a couple of things: a reliable estimate of the selling price or fair market value of an asset, an estimate of costs to sell it, and an estimate of any costs for maintaining or preparing it for sale. A simple formula for calculating NRV net realizable value looks like this:
NRV = Fair market value - selling costs
Calculate NRV by following these steps:
1. Determine the expected selling price or fair market value of the asset
Asset values are initially recorded at their original cost, but the value may decline due to changes in the economy or business conditions. For example, inventory value may decline because of weaker demand for the goods or because of spoilage. A decline in value below cost requires the decline to be recorded on the balance sheet, and should be included as an expense on the income statement.
2. Find all costs associated with selling the asset
Costs of selling can include storage and handling of inventory goods, as well as costs of delivering the inventory to the buyer. Costs associated with selling accounts receivable can include legal fees to pursue customers until the business decides to sell receivables, and any fees to a factor or financing company that agrees to buy the receivables.
3. Subtract selling costs from the fair market value
Although the NRV formula is simple, estimating inventory valuation and costs can be challenging because it requires analysis and judgment calls. For instance, determining a value for inventory requires market research and collecting pricing data because of changing economic conditions and demand for the goods. Once you have a reasonable assessment of the fair market value and selling costs, use the NRV formula: NRV = Fair market value - selling costs.
Inventory NRV example
Let’s say an ecommerce retail company plans to sell part of its inventory. The historical cost of the inventory—what the company paid for the goods—was $20,000. At the end of the latest quarter, it estimated the inventory’s fair market value was only $16,000 because of a sluggish economy and weaker demand. In addition, the company spends $500 to store and maintain the goods and expects to incur $200 in costs to ship the goods to the buyer, for a total of $700 in selling costs. The inventory’s NRV would be:
$16,000 - $700 = $15,300
Under the principle of recording an asset at either the historical cost or net realizable value, whichever is lower, the company writes down the inventory value by $4,700—the historical cost minus net realizable value. For bookkeeping purposes, the company debits the amount in a loss on writedown in the NRV account (an expense account on the income statement), and credits an offsetting amount in the related Inventory account (an asset account on the balance sheet). The journal entries would look like this:
| Debit | Credit | |
| Loss on writedown in NRV | $4,700 | |
| Inventory | $4,700 |
The writedown expense on the income statement reduces the company’s net profit.
Accounts receivable NRV example
Now let’s look at accounts receivable, indicating payments due from customers. The total accounts receivable is $15,000. Included in the total is a $2,000 bill for customer X, who has already exceeded 60-day payment terms. The company estimates it may not be able to collect $1,000 of the amount due, and expects to spend $250 on collection efforts. The NRV of accounts receivable is reduced to:
$15,000 - $1,000 - $250 = $13,750
Bookkeeping entries to recognize the net realizable value include a debit for bad debt (an income statement expense account), and an offsetting credit for allowance for doubtful accounts (an asset account on the balance sheet). The journal entries would look like this.
| Debit | Credit | |
| Bad debt expense | $1,250 | |
| Allowance, doubtful accounts | $1,250 |
This similarly reduces the company’s net profit.
How businesses use net realizable value
Businesses use net realizable value in a variety of ways, including the following:
Financial statements
A business uses net realizable value to prepare an accurate balance sheet and account for the true value of all its assets, as well as its liabilities. This affects the income statement because declines in asset values are recognized as expenses against revenue.
Cost accounting
Net realizable value figures in cost accounting when determining per-unit costs for different goods that share some production processes. This involves splitting the joint costs based on each good’s proportion of total NRV for all goods, adding to each item’s direct costs, then dividing by production volume. Per-unit cost analysis is used to decide on pricing and to determine potential profit margins for products.
Business valuation
Net realizable value contributes to an accurate accounting of a business’s net worth, or owners’ equity, which is determined by subtracting total liabilities from total assets. Net worth is a starting point for owners and investors in estimating the market value of a business when used together with income and cash-flow projections. It is also used when analyzing market values for comparable businesses.
Pros of NRV
Calculating net realizable value has a key benefits for your business:
Accurate financial reporting
Using the net realizable value is a conservative way to assess asset values and avoid overstatement. This gives all stakeholders in a business an accurate representation of a company's financial condition and its profitability.
Compliance
NRV complies with GAAP, which publicly traded US companies must follow in their financial reporting. Furthermore, it is a regulatory requirement for public companies to apply NRV in their financial statements.
Decision-making
NRV helps managers make informed decisions by relying on accurate and realistic financial data. For example, an ecommerce retailer has inventory marked down to NRV of $300,000 from an original cost of $500,000. In this case, it might decide to modify or delay an expansion plan. Or, a wholesale distributor with accounts receivable marked down due to delinquent payments might scale back its credit terms or demand cash payment from customers.
Cons of NRV
Despite its necessity, NRV does come with challenges:
Complicated process
A business must first review and test the value of an asset to establish if the current value has fallen below cost, which requires accounting adjustments. Then it needs to factor in any costs for selling or disposing of the asset.
Requires frequent updating
Because economic volatility and fluctuating market conditions can affect the value of current assets, companies may need to make many adjustments to their NRVs. This can be expensive and time-consuming.
Based on estimates
The net realizable value recorded may not reflect the asset’s true value because it is based on estimates. For example, an inventory of goods might fetch more or less than what NRV suggested; a doubtful account receivable might yield more or less recovery than what a business estimated.
Net realizable value FAQ
How do you calculate NRV?
Net realizable value, or NRV, is calculated by estimating the expected selling price of an asset and subtracting any costs associated with the sale, such as storage and shipping inventory.
What if NRV is lower than cost?
When an asset’s NRV is lower than its cost, the business must record it on its balance sheet to recognize the decline in value. The decline is reported as an expense on the income statement.
Is NRV a fair market value?
NRV is the fair market value or expected selling price of an asset, minus the costs of selling or disposing of the asset.
