Question

Explain thoroughly why is the lower of cost and net realizable value rule required by accounting standards

Answer 1

In the case of inventory, a company may find itself holding inventory that has an uncertain future; meaning the company does not know if or when it will sell. Obsolescence, oversupply, defects, major price declines, and similar problems can contribute to uncertainty about the “realization” (conversion to cash) for inventory items. Therefore, accountants evaluate inventory and employ lower of cost or net realizable value considerations. This simply means that if inventory is carried on the accounting records at greater than its net realizable value (NRV), a write-down from the recorded cost to the lower NRV would be made. In essence, the Inventory account would be credited, and a Loss for Decline in NRV would be the offsetting debit. This debit would be reported in the income statement as a charge against (reduction in) income.

The lower of cost and net realizable value rule is used to ensure that inventory is not overvalued. Inventory cannot be valued at more than the entity would obtain from its sale. It is not permissible to revalue inventory upwards, above cost.