Why inventory is valued at the lower of cost and NRV

Closing inventory is valued at the lower of cost and net realisable value. The rule is short but carries a big idea, prudence. It decides both the profit for the year and the value of a current asset. Knowing why the rule exists makes it easier to apply under exam pressure. It turns a phrase students often memorise blindly into something they can reason about.

What the two figures mean

Cost is what the business paid to buy or make the goods, including the cost of bringing them in. Carriage inwards, import duties and any handling needed to get the goods ready for sale all count. Net realisable value is the estimated selling price of the goods, less any costs still needed to complete and sell them.

For most inventory, cost is lower, so inventory is valued at cost. The rule matters when goods have lost value. They may be damaged, out of fashion or replaced by a newer model. Or their selling price may have fallen below what the business paid.

Note the word “estimated”. Cost is usually a fact recorded in the books.

Net realisable value is a forward-looking judgement about what the goods can realistically fetch. That is why questions give you the ingredients, a selling price and some selling costs, and expect you to build the figure yourself.

Why the lower figure

The rule applies the prudence concept: profits and assets should not be overstated, and foreseeable losses should be recognised as soon as they are likely. If goods that cost RM1,000 can now only be sold for RM750, holding them at cost would pretend the business still has RM1,000 of value. Writing them down to RM750 recognises the loss now, in the period it became clear, and does not hide it until the goods are sold.

Think about who relies on the accounts. An owner deciding whether to draw profits, or a bank deciding whether to lend, needs figures that do not flatter the business.

Carrying obsolete inventory at full cost would inflate both the profit for the year and the assets on the statement of financial position. The disappointment would only arrive later, when the goods failed to sell. Prudence brings that bad news forward to the period that caused it.

A worked example

Here is an example with invented figures. A shop holds three lines of inventory at its year end:

• Line A: cost RM4,000; expected selling price RM6,000; selling costs RM300.
• Line B (water-damaged): cost RM2,500; expected selling price RM1,800; selling costs RM200.
• Line C: cost RM1,200; expected selling price RM1,500; selling costs RM100.

First find net realisable value for each line.

• Line A: RM6,000 - RM300 = RM5,700.
• Line B: RM1,800 - RM200 = RM1,600.
• Line C: RM1,500 - RM100 = RM1,400.

Now take the lower of cost and net realisable value for each line.

• Line A is valued at RM4,000 (cost is lower).
• Line B is valued at RM1,600 (net realisable value is lower, because the damage caused a real loss).
• Line C is valued at RM1,200 (cost is lower).

Closing inventory is RM4,000 + RM1,600 + RM1,200 = RM6,800. Only the damaged line was written down. The healthy lines stayed at cost. If you had wrongly used cost throughout, closing inventory would be RM7,700 and the RM900 loss on Line B would disappear from the accounts.

Apply it line by line

The comparison is made for each separate line of inventory, not for the total. You cannot offset goods worth more than cost against goods worth less.

In the example, Line A had a comfortable margin, but you may not use that spare value to prop up the damaged Line B. Take the lower figure for each line, then add them. Applying the rule to the total instead of line by line is a common error. It can hide a real loss, which is exactly what prudence is meant to reveal.

The effect on profit

Closing inventory is deducted in the cost of sales calculation. A lower closing inventory means a higher cost of sales and a lower gross profit. Valuing damaged goods at cost would overstate both closing inventory and profit.

The rule keeps profit honest and stops a business reporting gains it has not made. In the example, the RM900 write-down reduces closing inventory by RM900.

That raises cost of sales by RM900 and cuts gross profit by the same amount. The loss lands in this year’s income statement, where it belongs.

Where net realisable value comes in

Net realisable value is an estimate, so questions usually give the expected selling price and any selling costs. Deduct the selling costs from the selling price to get net realisable value, then compare with cost.

Students sometimes forget the selling costs and compare cost with the full selling price. That overstates net realisable value and can wrongly leave damaged goods at cost. Look for phrases like “costs to repair before sale” or “delivery to customer”. These are the selling and completion costs that must come off.

Common confusions

A frequent mix-up is thinking the write-down is a separate expense on its own line. It is not.

The loss is built in through the closing inventory figure. Choose the lower value, and the reduced inventory flows through cost of sales without an extra journal entry.

Another is expecting to write inventory back up if the goods recover in value. Even if goods could now sell for more than they cost, inventory is never valued above cost. Prudence does not allow a profit to be recognised before a sale makes it real.

Write down for losses, never write up for gains. This asymmetry is prudence in action, and it is worth stating in a theory answer.

How it connects to the wider concepts

Prudence, the matching concept and realisation pull the same way here. Recognise the loss when it is foreseeable.

Match costs to the period that earned the related revenue. Do not count a profit until a sale makes it real.

It also links to going concern. Inventory is valued on the assumption the business will keep trading and sell the goods in the ordinary course.

That is why net realisable value uses a normal selling price and not a forced-sale price. Seeing one rule as an expression of several concepts is the understanding examiners reward in longer theory questions.

If inventory valuation still causes confusion, one of our teachers can work through the rule and the prudence concept behind it with your child, using past-paper questions. Book a trial class

Syllabus reference: Cambridge 0452 and 0985, syllabus for 2027 to 2029, sub-topic 4.5 Valuation of inventory (page 15).