Concept of Realizable Value & Replacement Value03/09/2022 0 By indiafreenotes
Net realizable value (NRV) is a valuation method, common in inventory accounting that considers the total amount of money an asset might generate upon its sale, less a reasonable estimate of the costs, fees, and taxes associated with that sale or disposal.
Net realizable value (NRV) is the value for which an asset can be sold, minus the estimated costs of selling or discarding the asset. The NRV is commonly used in the estimation of the value of ending inventory or accounts receivable.
The net realizable value is an essential measure in inventory accounting under the Generally Accepted Accounting Principles (GAAP) and the International Financing Reporting Standards (IFRS). The calculation of NRV is critical because it prevents the overstatement of the assets’ valuation.
NRV and Lower Cost or Market Method
Net realizable value is an important metric that is used in the lower cost or market method of accounting reporting. Under the market method reporting approach, the company’s inventory must be reported on the balance sheet at a lower value than either the historical cost or the market value. If the market value of the inventory is unknown, the net realizable value can be used as an approximation of the market value.
How to Calculate the NRV
The calculation of the NRV can be broken down into the following steps:
- Determine the market value or expected selling price of an asset.
- Find all costs associated with the completion and the sale of an asset (cost of production, advertising, transportation).
- Calculate the difference between the market value (expected selling price of an asset) and the costs associated with the completion and sale of an asset. It is a net realizable value of an asset.
Realizable Value = Expected Selling Price – Total productions and Selling costs
The term replacement cost or replacement value refers to the amount that an entity would have to pay to replace an asset at the present time, according to its current worth.
In the insurance industry, “Replacement cost” or “replacement cost value” is one of several methods of determining the value of an insured item. Replacement cost is the actual cost to replace an item or structure at its pre-loss condition. This may not be the “market value” of the item, and is typically distinguished from the “actual cash value” payment which includes a deduction for depreciation. For insurance policies for property insurance, a contractual stipulation that the lost asset must be actually repaired or replaced before the replacement cost can be paid is common. This prevents over insurance, which contributes to arson and insurance fraud. Replacement cost policies emerged in the mid-20th century; prior to that concern about over insurance restricted their availability.
If insurance carriers honestly determine replacement cost, it becomes a “win-win” for both for the carriers and the customers. However, when a replacement cost determination is made by the carrier (and, perhaps, its third party expert) that exceeds the actual cost of replacement; the customer is likely to be paying for more insurance than necessary. To the extent that the carrier has knowingly or carelessly sold excessive (i.e. unnecessary) insurance, such a practice may constitute consumer fraud.
Replacement cost coverage is designed so the policy holder will not have to spend more money to get a similar new item and that the insurance company does not pay for intangibles. For example: when a television is covered by a replacement cost value policy, the cost of a similar television which can be purchased today determines the compensation amount for that item. This kind of policy is more expensive than an Actual Cash Value policy, where the policyholder will not be compensated for the depreciation of an item that was destroyed. The total amount paid by an insurance company on a claim may also involve other factors such as co-insurance or deductibles. One of the champions of the replacement cost method was the Dutch professor in Business economics Théodore Limperg.
As part of the process of determining what asset is in need of replacement and what the value of the asset is, companies use a process called net present value. To make a decision about an expensive asset purchase, companies first decide on a discount rate, which is an assumption about a minimum rate of return on any company investment.
A business then considers the cash outflow for the purchase and the cash inflows generated based on the increased productivity of using a new and more productive asset. The cash inflows and outflow are adjusted to present value using the discount rate, and if the net total of all present values is a positive amount, the company makes the purchase.
While arriving at the replacement cost of expensive assets, well-managed firms create a capital expenditure budget to plan for both future acquisitions of assets and how the firm will generate cash inflows to pay for the new assets.
Budgeting on the purchase of assets is vital as it needs replacing assets to run the company. For example, a manufacturer has budgeted for equipment and machine replacement, and retailer budgets that update each store look.