Lower of cost or net realizable value (LCNRV) is an accounting rule for measuring inventory. It requires a company to report inventory on its balance sheet at whichever is lower: its cost, or its net realizable value, which is the estimated selling price in the ordinary course of business less the reasonably predictable costs of completion, disposal and transportation. When net realizable value falls below cost, the inventory is written down and the loss is recognized in the period it occurs, not when the goods are eventually sold.
The rule is an application of conservatism: assets should not be carried at more than the business can expect to recover from them. It applies to stock that has been damaged, has become obsolete or out of fashion, or whose market price has fallen. Under IFRS the same principle has long been set out in IAS 2, while US GAAP adopted it for most inventory through ASU 2015-11, effective from 2017, replacing the older "lower of cost or market" test.
How the rule works
The comparison is:
Here is the amount determined under the company's cost flow method, such as first-in, first-out (FIFO) or weighted average, and is the expected selling price minus costs to complete and sell. The test is normally applied item by item, although it may be applied to groups of similar or related items. Under US GAAP, companies that use last-in, first-out (LIFO) or the retail inventory method still apply the older lower of cost or market rule, in which "market" is replacement cost limited by a ceiling and a floor.
Worked example
An electronics retailer holds three products at year end:
| Product | Cost | Expected selling price | Selling costs | Net realizable value | Carrying amount |
|---|---|---|---|---|---|
| Laptops | $80,000 | $110,000 | $6,000 | $104,000 | $80,000 |
| Older phones | $50,000 | $46,000 | $4,000 | $42,000 | $42,000 |
| Tablets | $30,000 | $33,000 | $2,000 | $31,000 | $30,000 |
Total cost is $160,000, but the inventory is reported at $152,000. The $8,000 write-down relates entirely to the older phones. The retailer records the loss by debiting cost of goods sold (or a separate inventory write-down expense) $8,000, and either crediting inventory directly or crediting a contra account such as an allowance to reduce inventory to net realizable value. The gains on laptops and tablets are not recognized, because inventory is never written up above cost.
US GAAP and IFRS differences
- Reversals: IFRS requires a write-down to be reversed, up to the original cost, if net realizable value later recovers while the goods are still held. US GAAP prohibits reversal; the written-down amount becomes the new cost.
- LIFO: IFRS does not allow LIFO, so the question of lower of cost or market does not arise. US GAAP keeps the older market test for LIFO and retail method users.
- Interim periods: US GAAP allows temporary declines within a year to be ignored at interim dates if they are expected to recover by year end.
Estimating net realizable value requires judgment about future selling prices and costs, so auditors look for evidence such as sales after the year end, price lists and slow-moving stock reports. Write-downs are a common source of earnings management: too small a write-down overstates assets and profit, while a "big bath" write-down in a bad year can flatter later results when the goods sell. Inventory write-downs differ from inventory shrinkage, which is a physical loss of goods through theft or error rather than a fall in value. The overall approach to measuring stock is described in the entry on inventory valuation, and the standard-setters' material is available from the Financial Accounting Standards Board and the International Accounting Standards Board.