Accounting principles determine rules which really need to be followed to be able to are the cause of business transactions properly as well as provide fair and reliable facts about the business activities on the users of the financial statements. Inventory accounting is really a major area of the accounting theory and exercise, therefore it is important to comprehend the main accounting principles to become placed on inventory accounting. One of them is definitely an use of the net realizable value concept.
Usually inventory is acquired or produced together with the purpose to be sold to earn profit. So most of inventory will be sold at a cost beyond acquisition or manufacturing cost. Nonetheless it might happen that element of inventory will be sold at a cost lower than acquisition or manufacturing cost of inventory. Causes of that are these:
inventory is damaged
inventory is obsolete which is unachievable to promote it or else utilize in the activities from the business inventory sales charges are influenced by technological changes, so that it becomes not possible to sell the inventory in the price which had been charged certain time ago changes on the market, i.e. lowering demand, changing consumer preferences, competitive products and a lot of other aspects might impact sales price of inventory
Accounting principles require that in the event sales expense of inventory business has on hand is less than its acquisition or manufacturing price, such inventory has to be worth net realizable value. Net realizable value is definitely an estimated proceeds in the sale of inventory reduced by costs being incurred to prepare inventory available for sale and marketing, selling and distribution expenses directly relevant to the inventory. So just in case inventory is valued at the acquisition or manufacturing cost and sales price is less than this cost, value of inventory must be reduced.
Business could have several types of inventory, i.e. raw materials, goods purchased for resale, manufactured goods for resale, operate in progress. Net realizable value estimation and inventory value reduction rule is used to all types of inventory. This is important to reflect fair importance of all inventory types inside the financial statements of your entity.
In case value of inventory must be reduced, the reduction impact is included as expenses and also the following accounting entry is made:
D Expenses $1000
C Inventory $1000
This is accomplished at the conclusion of each accounting period.
Imagine that in May, 2010 an organization has acquired 100 inventory items for resale. Acquisition price was $5 per item. The business designed to sell inventory at a cost of $15 per item.
The subsequent entry is made from the accounting books:
D Inventory $500
C Cash $500
At the conclusion of April because of changes in the marketplace sales expense of one item fell to $3. At the end of April price of inventory needs to be reduced to $3, i.e. to $300. These entry will need to be made:
D Expenses $200
C Inventory $200
After this is done the price of inventory from the company will likely be comparable to $300.