the net realisable value method of valuing inventory

Cambridge IGCSE/A‑Level Business (9609) – Finance & Accounting Chapter

1. Syllabus Context

This chapter follows the order of the A‑Level Business syllabus (9609) – Section 10. It integrates the AS‑Level finance foundations (Topic 5) and shows cross‑topic links with Operations, Marketing, HRM and Strategic Planning.

Level	Topic No.	Title
AS‑Level	5.1‑5.5	Finance basics – working‑capital cycle, budgets, cash flow, break‑even, ratio analysis (intro)
A‑Level	10.1	Financial statements – inventory valuation (NRV, FIFO, weighted‑average), depreciation (straight‑line)
A‑Level	10.2	Ratio analysis – liquidity, profitability, efficiency, gearing, investment ratios
A‑Level	10.3	Investment appraisal – pay‑back, ARR, NPV, qualitative factors
A‑Level	10.4	Finance & accounting strategy – use of published accounts, limitations of ratios, strategic decisions

2. Financial Statements – What Students Must Know

• Statement of Profit or Loss (Income Statement) – shows revenue, cost of goods sold (COGS), gross profit, operating expenses, profit before tax, tax and profit after tax.
• Statement of Financial Position (Balance Sheet) – presents assets (non‑current & current), liabilities (non‑current & current) and owners’ equity.
• Both statements must be prepared in accordance with IAS 2 – Inventories (or UK GAAP FRS 102) and the “lower of cost or net realisable value” rule.
• Depreciation of non‑current assets is calculated using the straight‑line method (required under 10.1.4).

2.1 Straight‑Line Depreciation

Formula:

Journal entry each year:

Debit	Credit
Depreciation Expense	Accumulated Depreciation

3. Inventory Valuation – Net Realisable Value (NRV)

3.1 Definition & Formula

NRV is the estimated amount a business expects to receive from selling inventory, **after** deducting costs required to bring the inventory to a sellable condition and the costs of disposal.

3.2 Regulatory Framework

• IAS 2 (International Accounting Standard 2) – Paragraph 19: inventory must be measured at the lower of cost and NRV.
• FRS 102 (UK GAAP) – Section 13.14 mirrors IAS 2.
• Both standards embody the prudence (conservatism) principle: assets must not be overstated.

3.3 When to Apply NRV

• When NRV is **lower** than the recorded cost – a write‑down is required.
• Evidence of:
  • Obsolescence or physical damage
  • Technological change reducing marketability
  • Fall in market demand or selling price
• To satisfy the “lower of cost or NRV” rule on the balance sheet.

3.4 Step‑by‑Step Procedure

1. Determine the **cost** of each inventory item (or batch) using an accepted cost formula (FIFO, weighted‑average, etc.).
2. Estimate the **selling price** that could be obtained in the ordinary course of business.
3. Identify **costs of completion** (e.g., finishing, packaging, minor repairs).
4. Identify **costs of disposal** (e.g., sales commissions, transport, advertising).
5. Calculate NRV using the formula above.
6. Compare NRV with cost:
   • If NRV < Cost → write‑down inventory to NRV.
   • If NRV ≥ Cost → retain cost as the carrying amount.
7. Record the adjustment in the profit‑and‑loss account:
   • Write‑down = Cost – NRV (recognised as an expense).
   • If a previous write‑down is later reversed, recognise a gain **but never exceeding the original cost**.

3.5 Journal Entries

Transaction	Debit (Dr)	Credit (Cr)
Write‑down (Cost £12,000, NRV £9,500)	Loss on Inventory Write‑Down £2,500	Inventory £2,500
Reversal of previous write‑down (original cost £15,000, NRV now £14,800, previous NRV £14,000)	Inventory £800	Gain on Reversal of Inventory Write‑Down £800

3.6 Illustrative Numerical Examples

Example 1 – Single‑product write‑down

Company XYZ holds 1,000 units of Product A.

Item	Cost per unit (£)	Selling price per unit (£)	Completion cost (£)	Disposal cost (£)
Product A	17.00	18.00	1.00	0.50

NRV per unit = 18.00 – 1.00 – 0.50 = £16.50**

Since NRV (£16.50) < Cost (£17.00):

• Write‑down per unit = £0.50
• Total loss = £0.50 × 1,000 = £500

Journal entry:

Dr Loss on Inventory Write‑Down   £500
Cr Inventory                     £500

Example 2 – Multiple items with mixed outcomes

Company ABC inventory at 31 December:

Item	Units	Cost per unit (£)	Selling price (£)	Completion (£)	Disposal (£)
Widget X	500	12	14	0.5	0.2
Widget Y	300	9	8	0.3	0.1
Gadget Z	200	20	22	1.0	0.5

Calculations:

1. Widget X: NRV = 14 – 0.5 – 0.2 = £13.30 > Cost (£12) → no write‑down.
2. Widget Y: NRV = 8 – 0.3 – 0.1 = £7.60 < Cost (£9) → write‑down per unit = £1.40.
   Total loss = £1.40 × 300 = £420.
3. Gadget Z: NRV = 22 – 1.0 – 0.5 = £20.50 > Cost (£20) → no write‑down.

Journal entry for the only required write‑down:

Dr Loss on Inventory Write‑Down   £420
Cr Inventory                     £420

Example 3 – Reversal of a previous write‑down

Year 1: 400 units of Item Q written down from cost £10 to NRV £8 (loss £800).

Year 2: NRV rises to £9.50.

• Maximum reversal allowed = (Original cost – Current carrying amount) = (£10 – £8) × 400 = £800.
• Reversal amount = (New NRV – Current NRV) × units = (£9.50 – £8.00) × 400 = £600.

Journal entry:

Dr Inventory                     £600
Cr Gain on Reversal of Inventory Write‑Down   £600

3.7 Comparison with Other Inventory Valuation Methods

Method	Basis of Valuation	Typical Use	Interaction with NRV
FIFO (First‑In, First‑Out)	Cost of earliest purchases	Industries with rising prices; tax advantage in some jurisdictions	Cost from FIFO is compared with NRV for the “lower of” test.
Weighted‑average cost	Average cost of all units available	Manufacturing with homogeneous items	Average cost is the “cost” figure tested against NRV.
NRV	Selling price less completion & disposal costs	When market conditions suggest cost may over‑state value	Used *instead of* cost only when NRV is lower.

4. Ratio Analysis (Section 10.2)

Students must be able to calculate, interpret and explain the impact of inventory changes on the main categories of ratios.

4.1 Liquidity Ratios

• Current Ratio = Current Assets ÷ Current Liabilities
  Effect of inventory write‑down*: reduces current assets → ratio falls, indicating lower short‑term solvency.
• Quick (Acid‑Test) Ratio = (Current Assets – Inventory) ÷ Current Liabilities
  Inventory write‑down does not affect the quick ratio because inventory is excluded.

4.2 Profitability Ratios

• Gross‑margin ratio = (Revenue – COGS) ÷ Revenue
  Write‑down increases COGS → gross margin falls.
• Net‑profit margin = Profit after tax ÷ Revenue
  Same direction as gross margin, but also reflects the expense recorded.
• Return on Capital Employed (ROCE) = Profit before interest & tax ÷ (Total assets – Current liabilities)
  Lower profit due to write‑down reduces ROCE.

4.3 Efficiency (Activity) Ratios

• Inventory Turnover = COGS ÷ Average inventory
  A write‑down reduces average inventory, potentially increasing turnover (appears favourable) but masks the underlying loss.
• Days’ Stock on Hand = 365 ÷ Inventory turnover

4.4 Gearing Ratios

• Debt‑to‑Equity Ratio = Total debt ÷ Equity
  A loss reduces retained earnings, lowering equity and raising the ratio.

4.5 Investment Ratios (link to 10.3)

• Pay‑back period, Accounting Rate of Return (ARR) and Net Present Value (NPV) all use profit figures that are affected by inventory write‑downs.

4.6 Example – Impact of a Write‑down on Ratios

Assume before write‑down:

• Current assets £150,000 (incl. inventory £30,000)
• Current liabilities £75,000
• Revenue £200,000, COGS £120,000, profit before tax £30,000

Write‑down of inventory £5,000 (recorded as expense).

Metric	Before	After
Current Ratio	150,000 ÷ 75,000 = 2.0	(150,000‑5,000) ÷ 75,000 = 1.93
Gross‑margin ratio	(200,000‑120,000) ÷ 200,000 = 40%	(200,000‑125,000) ÷ 200,000 = 37.5%
Inventory Turnover	120,000 ÷ 30,000 = 4.0	125,000 ÷ 25,000 = 5.0

5. Investment Appraisal (Section 10.3)

Students must be able to apply three quantitative techniques and discuss qualitative factors.

5.1 Pay‑back Period

• Formula: Pay‑back = Initial investment ÷ Annual cash inflow (simple) or cumulative cash‑flow method (more common).
• Ignores the time value of money – a limitation.

5.2 Accounting Rate of Return (ARR)

• Formula: ARR = Average annual accounting profit ÷ Average investment
• Uses profit figures from the income statement – therefore inventory write‑downs affect ARR.

5.3 Net Present Value (NPV)

• Formula: NPV = Σ (Cash inflow_t – Cash outflow_t) ÷ (1 + r)^t – Initial investment, where *r* = discount rate.
• Considers the time value of money; a positive NPV indicates a value‑adding project.

5.4 Qualitative Factors

• Strategic fit, brand impact, environmental/social considerations, legal/regulatory issues, risk, and impact on staff.

5.5 Example – Simple Pay‑back & ARR

Project: purchase of new packaging equipment costing £50,000. Expected additional profit (after tax) £12,000 per year for 5 years. No salvage value. Discount rate 10 % (used only for NPV).

• Pay‑back = £50,000 ÷ £12,000 ≈ 4.2 years.
• Average investment = (£50,000 + £0) ÷ 2 = £25,000.
  ARR = (£12,000 ÷ £25,000) × 100 = 48 %.
• NPV (rounded):
  Σ £12,000/(1.10)^t (t = 1‑5) = £44,500 – £50,000 = **‑£5,500** (unacceptable).

Interpretation: although ARR looks attractive, the NPV is negative, indicating the project would reduce wealth when the cost of capital is considered.

6. Finance & Accounting Strategy (Section 10.4)

This section shows how published accounts and ratio analysis support strategic decision‑making, and it highlights their limitations.

6.1 Using Published Accounts

• Annual report components: Directors’ Report, Audited Financial Statements, Notes to the Accounts, Management Commentary.
• Key data extracted for strategy:
  • Profit trends → product line profitability.
  • Asset composition → capacity utilisation, need for investment.
  • Liquidity position → ability to fund expansion.

6.2 Limitations of Ratio Analysis

• Historical nature – does not predict future performance.
• Different accounting policies (e.g., inventory valuation) can distort comparisons.
• Ratios ignore qualitative factors such as market reputation, brand value, or employee morale.
• Seasonal businesses may need adjustments for period‑to‑period comparability.

6.3 Strategic Decisions Informed by Accounts

Strategic Issue	Relevant Financial Information	Typical Decision
Product line continuation	Segment profit, inventory NRV, contribution margin	Discontinue unprofitable line or run clearance sales.
Make‑or‑buy	Cost of production, inventory holding costs, depreciation of plant	Outsource if external supplier offers lower total cost.
Expansion of capacity	Current asset utilisation, cash‑flow forecasts, debt ratios	Invest using retained earnings or seek external finance.
Pricing strategy	Gross‑margin ratio, market price trends, NRV of stock	Adjust price upward if inventory is scarce; discount if NRV falls.

7. Cross‑Topic Links (Operations, Marketing, HRM, Strategy)

• Operations Management – Accurate NRV informs optimal stock‑holding levels, reduces waste, and supports Just‑In‑Time (JIT) systems.
• Marketing – NRV highlights when a product is becoming obsolete, prompting promotional or clearance campaigns.
• HRM – Changes in inventory levels affect workforce requirements in warehousing, production planning and order fulfilment.
• Strategic Planning – NRV analysis feeds into SWOT (weaknesses) and informs decisions on diversification or product rationalisation.

8. Advantages & Disadvantages of the NRV Method

Advantages

• Provides a realistic, market‑based valuation of inventory.
• Ensures compliance with the prudence principle – prevents over‑statement of assets and profit.
• Particularly useful for fast‑moving, fashion‑or technology‑driven industries where obsolescence risk is high.

Disadvantages

• Relies heavily on estimates of selling price and disposal costs – can be subjective.
• Frequent re‑valuation may increase administrative workload and cost.
• Potential for manipulation if estimates are not independently verified.

9. Key Points to Remember

• Inventory is recorded at the lower of cost or NRV on the balance sheet.
• NRV = Selling price – Completion costs – Disposal costs.
• Write‑downs are recognised as an expense in the period the decline occurs.
• Reversals are allowed only up to the original cost; any excess gain is not recognised.
• Depreciation of non‑current assets is calculated using the straight‑line method.
• Ratio analysis, investment appraisal and strategic decisions all depend on the correct valuation of inventory.

10. Decision Flowchart – Applying NRV