The usual accounting basis for stock valuation is the LOWER of cost & Net realizable value.
What is cost? Cost as mentioned in my other article is the price that the enterprise has paid the suppliers to acquire the goods (historical cost concept)
Whilst, Net Realisable Value (NRV) is the total received from sales after deducting all expenditure to be incurred on or before disposal.
Factors that may result in net realizable value being lower than historical cost include the following:
- A fall in selling price due to a fall in demand
- A fall in selling price as a marketing strategy to undercut competitors
- Physical deterioration of stocks
- Obsolescence of the stocks
- Change in fashion
- Cheaper substitutes in the market
For stock valuation, a company needs to compare by individual category of stock and apply the rule of the ” lower of cost & net realisable value”. By doing so, one category might be valued at cost and another category B might be at net realisable value. Ultimately, both category A & B are added up to show the ultimate valuation of the stock.
Why do we need to adhere to this basis of valuation?
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Main reason for valuing stock at the lower of cost or net realizable value: |
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To be in line with the principle of prudence which recognizes all unrealized losses but not all unrealized gain. |
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Illustrations: |
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1. Mr A owned an antique business. During the year, he bought 6 antiques costing $10,000 each. Later, he discovered 1 fake antique. He managed to sell off 4 antiques leaving 1 real antique and 1 fake antique behind. For the faked antique, his customers will only offer him the highest price of $1,000. Year end is approaching, he needs to close the accounts. How will Mr A value this 2 units of antiques? Based on valuing stock at the lower of cost or net realizable value , in this case, for the 1 good unit of antique, he should still value it at historical cost of $10,000 and for the faked antique, he should value it at the current market price or better called net realizable value which is $1,000 only. 2. Mr B a fashion boutique shop owner bought $20,000 of stock. Due to a sudden change of consumer taste, he can no longer sell it at this price. He managed to find a customer who is willing to take it up for a total price of $10,000 in mid Jan 2007. However, the customer would want Mr B to deliver the goods to his warehouse and do some cleaning and repacking. Mr B’s accounting period ends at 31 st December 2006 Question: How should he value the stock at 31 st December 2006? Firstly, Mr B needs to incur the following additional costs of $3,000:- Transport cost to deliver the stock to the customer’s warehouse $2,000 and Cleaning and repacking costs $1,000
So, the net realizable value in this case is $7,000 which is $10,000 ( selling price to customer) deducted $2.000+$1,000(estimated additional cost).
At year end, Mr B should only value the stock at the lower of cost and net realizable value Therefore he should only value the stock at $7,000 (net realizable value) which is lower than the original historical cost of $20,000
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