Accurately valuing your current raw materials, accounts receivable, and finished goods is crucial for small-scale manufacturing enterprises to be able to make financially sound decisions. Net Realizable Value (NRV) and fair value are the two regular techniques that can be used to discover the real worth of your assets. However, when it comes to ascertaining whether to apply Net Realizable Value (NRV) or Fair Value, it might be a confusing situation. These two methods represent different strategies, and the choice of the right one may change how your financial health is perceived. In the absence of a proper understanding of these valuation techniques, businesses risk misstating their assets, which can result in bad decision-making and economic drawbacks. So, which method is truly better for your business?
This blog educates us about both net realizable value and fair value, helping to boost our financial planning and increase gains in our production business.
Overview of Net Realizable Value (NRV)
The plain net realizable value definition is the sum you can acquire by selling your goods after deducting the costs accrued in production and shipments. Understanding this meaning helps you apply this technique to improve your accounting processes. You write NRV in your balance sheets to evaluate the decreased values of your goods, allowing you to make educated financial decisions about your business.
NRV in Inventory
Calculating the net realizable value of inventory goods is a normal procedure in manufacturing businesses.
- It helps you estimate the actual costs of your inventory products by estimating whether they are outdated or impaired.
- You can scrutinize net realizable value inventory registers to detect processes that help to reduce the value of your products over time.
- It assists in listing the realistic valuation of your products and enhances visibility over your business’s profitability.
NRV in Accounts Receivable
Not all customers pay the total amounts they are due for, so you apply the net realizable value in accounting to boost visibility over your accounts receivable. It displays the actual amount you hope to receive from your customers. Let’s illustrate this with an example of accounts receivable with a net realizable value. Suppose you have dispatched finished goods worth Rs. 60,000 to a customer, but you don’t expect to receive the full amount. Suppose the doubtful amount is Rs. 15,000. Let’s know how to compute the net realizable value of accounts receivable with this formula.
Total outstanding amount = Rs. 60,000
Doubtful amount = Rs. 15,000
Utilize the net realizable value of accounts receivable formula: NRV of account receivable = total outstanding amount – doubtful amount.
NRV of accounts receivable = 60,000 (total outstanding amount) – 15,000 (doubtful amount) = 45,000
Your accounts receivable net realizable value is Rs. 45,000, which you expect realizing from your customer.
Calculation of NRV
The NRV calculation is straightforward and provides an accurate valuation of your assets.
Let’s know how to calculate the net realizable value with easy steps.
Identify the expected amount you can get by vending your products.
Calculate the costs involved in the production, packaging, and dispatching of those products.
Utilize the net realizable value formula: NRV = expected selling price – total production and shipment charges.
Here are examples of how to compute NRV for inventory.
Suppose the expected selling price of a specific inventory item in your warehouse is Rs. 6,000
The costs involved in the manufacture and dispatch of that product are Rs. 1800
Place the data in the formula: NRV = 6,000 – 1800 = 4,200
The NRV of that inventory product is Rs. 4200.
Overview of Fair Market Value
Fair market value closely resembles fair value and refers to the price at which a property could be sold or purchased in the open market. The price is figured out by looking at the demand, current value, and different market conditions so that the deal is fair for both the buyers and the sellers. You won’t find a single fair market value formula that will give you the exact result of your calculation. Nevertheless, you can apply separate methods rather than applying the fair market value formula accounting to assess accurate prices. Let’s understand this with a fair market value example. Suppose you control a manufacturing company and need to determine the fair market value of your machinery, which isn’t traded often. You can use multiple methods to calculate a fair price.
- You could match the price of similar machines in the market (market approach).
- Otherwise, you could assess the future income that the machine will create (income approach).
- Or, compute the cost of substituting the machinery with similar equipment (cost approach).
These three methods can aid you in calculating the fair market value in accounting and improve visibility over your investment in that start-up firm.
Fair Value in Inventory
The fair market value of inventory is the cost of your goods in warehouses that you can acquire by selling them in line with the current market conditions. If customer claims and market trends change, the fair market value of your inventory goods also transforms. Suppose varies from the NRV of inventory, which generally stays stable in the wake of market highs and lows. You can compute the fair value of inventory to boost accuracy in the current deal. On the contrary, you can value your inventory at lower costs by utilizing NRV to make prudent financial decisions for your business.
Fair Value of Accounts Receivable
The fair value of accounts receivable denotes the prices you can receive if you sell your receivables to another person. To compute this value, you can assess the amount of money you can gather from your receivables in the future. You then reduce it to the current value, taking into consideration the market interest charges and other conditions. You can also corroborate this value with what other buyers would spend for your receivables for better accuracy.
Calculation of Fair Value
In order to come up with a precise, equitable value, it is necessary to take a thorough look at the market trends and the future demand for properties. First of all, find out the going rates in the market in order to calculate the fair value of your stock and accounts receivable. In the event there is no market price available, resort to different methods such as cost, income, and market approaches. The fair value can thus be determined through the following formula:
Fair value = [Price {1 + interest rate (duration of expiry/360)} – revenue]
Key Differences between NRV and Fair Value
The NRV vs. fair value comparison helps you determine the accurate worth of your accounts receivable, inventory, and other assets. The following are the significant differences between net realisable value and fair value.
| Aspect | Net Realisable Value (NRV) | Fair Value |
| Basis | Costs less than expected costs | Market participant assumptions and conditions |
| Subject | Highlights of the expected net cash inflow from the sale | Mirrors the exit price in an orderly transaction |
| Meaning | Estimated selling price minus costs to sell | Market-related measurement of the property/liability |
| Purpose | Used primarily for inventory valuation | Utilized for the measurement of multiple assets and liabilities |
| Usage in Accounting | Inventory valuation under the expense or NRV principle. Ensures that assets are not overvalued. | Valuation of assets/liabilities and financial reporting. Values your properties in the current situation. |
| Values your inventory goods at reduced costs to boost visibility over your profits | Values your inventory items as per market conditions, and can be more than the original expenses | |
| It can be beneficial for damaged and outdated products | Can be helpful to enhance accuracy in current deals | |
| Displays the realistic amounts in financial statements that you can receive for your inventory and accounts receivable. | Can display higher amounts in financial statements for your inventory and accounts receivable if the market is buoyant. |
The distinction is very important for both accounting and financial reporting to allow for proper asset valuation that is in line with standards like GAAP and IFRS.
Bottom Line
Understanding the subtle differences in methods of valuation is hardly just a study of theory; it is a necessary and indispensable skill for people working with the financial side of the business. The difference between net realisable value and fair value may affect the business deeply, causing such areas as tax planning, financial reporting, regulatory compliance, and investor relations to be influenced in a significant way. Knowing the advantages and drawbacks of each method, stakeholders can navigate the economic landscape with greater confidence and precision.
