Realizable Value

Realizable value is the net consideration from sales proceeds of any assets in the normal course of business after deduction of incidental expenses like completion charges, brokerage, commission, carriage, etc. It is the most common method used to evaluate Inventories under International Financial Reporting Standards and other accepted accounting policies.

This principle of realizable value works on the conservatism concept, which says that all the foreseeable expenses or losses should be accounted for immediately. As soon as one finds out that the realizable value is less than the cost price, they must account for those losses in the books.

A realizable value in accounting is used in the context of inventory. It is the value that a set of assets are expected to generate in total. This amount obtained is adjusted to the costs and expenses, including taxes related to the sale and disposal.

When the net realization value is figured out, firms are able to conduct accurate inventory accounting. This valuation technique is used by both generally accepted accounting principles (GAAP) and international financial reporting standards (IFRS).

This valuation method fits in the GAAP restrictions, which require accounting professionals to adopt a conservative approach while reporting transactions. Being conservative in approach signifies not overstating profit figures, rather reflecting less profits than expected.

The inventory is valued at a lower cost or market price. Any increase or decrease in the value of Inventory helps identify any loss or profit we must take into consideration. The market price is nothing but the net realizable value.

The realization value is easily calculated if the three required figures are accurately calculated or derived from the transactional details available in the record books. The steps to follow to derive the net realization value are as follows:

• The first step is to figure out the expected value. This value is the amount that a firm expects to collect by the sale of all goods ready to sell. This amount is calculated by multiplying the number of units produced for sale and the unit selling price.
• Considering all costs associated with the items is the second step. These costs include production expenses along with the costs incurred in packaging and preparing the items for sale. Knowing the total expense helps firms to proceed with calculation.
• The third step is to subtract the total expenses related to the goods from the actual value of the goods. This provides the realization value of the products.

The calculation of realization value in accounting is done using the formula below:

Net Realization Value = Expected Selling Price - Total Production and Selling Costs

Let us consider the following two instances to understand the realization value meaning better along with its calculation:

Example #1

X Ltd. has inventory worth $1,500 at year-end; however, due to advancements in technologies, this product will be obsolete soon, and at this point, it can only fetch $900 in the market. As soon as X Ltd gets this information, it should write off the value of inventory by $600 ($1500 - $900) value by $600 ($1500 – $900) and show the inventory at $900 only.

The impact of this transaction is that the profit of X Ltd for the current year comes down by $600, and it does not have to pay tax on that money. Also, the books of accounts present the financial position more accurately.

Example #2

Another example is trade receivable, which includes sundry debtors, bills receivables and other notes receivable. In any organization, the receipt of money from debtors is a daily business. Almost every day, we receive money in the bank account from customers as per invoice dates. Whenever there is a default from any customer, the collection team contacts them and evaluates the recovery possibility.

If the recovery seems difficult even after taking all the efforts and sending notices and reminders, we must write off the balances of such debtors and receivables. Also, we should write off the balances in cases where debtors have gone bankrupt.

Nowadays, the organization sells its debts to collection agencies at a reduced value. In these cases, the reduction in receivable value should also be taken to the profit & loss account, and the net realizable value should be shown in the books as trade receivable.

Example #3

Let’s say Amazon Ltd. has a product A in stock, and it can sell it for $50. However, the cost price is $55. In this case, the product should be valued at $50. However, there is an option available to Amazon that if it adds certain features to the product by spending $12, it can sell the product for $70. The new cost price is $67 (50+12), and the realizable price is $70. So, if Amazon is willing to exercise the second option of adding certain features, it should show the product at $55 in the inventory.

Calculating realization value helps businesses plan their inventory properly for profits and make appropriate changes, if required. The list of benefits of this valuation metric is given below. Let us have a look at the same:

• These concepts help the organization show a true and fair financial position by showing the current market price as the realizable value.
• It avoids over or underpayments of taxes, i.e., it helps organizations in tax planning.
• It also identifies if the products are no longer in demand.
• Shows the current trend and customer behavior in the current scenario.

Besides having multiple advantages, these realization value estimates also put across some limitations. Let us have a quick at the disadvantages in detail below:

• The realization value ignores the time factor, leading to over or understating profit.
• It needs to consider economic, political, geographical, and other factors to reach the exact realisability in the current or future market.
•  Frequent technological changes might make an item obsolete overnight, which is difficult to catch and identify.

Realizable Value vs Fair Value

Realizable value and fair value are two widely used concepts in the context of valuation of assets and liabilities. Though the objective is similar, they differ in various other aspects. Some of the differences between them have been listed below:

• Realizable value is the net amount that firms expect items available for sell to generate after sale. It is adjusted to all associated costs for the products, be it the taxes or other expenses. On the contrary, fair value refers to the amount at which the items are made available to willing buyers.
• The realization value is an entity-specific figure, while the latter is not.
• The former, by definition, seems to depend on the fair value. However, it is not always the case. The realization amount is not always equal to the fair value minus the cost to sell.

This has been a guide to what is Realizable Value. We explain it with formula, examples, vs fair value, how to calculate it, advantages, and disadvantages. You can also learn more about it from the following articles-

• Net Realizable Value
• Accounting Terminology
• Accounting Concept
• Recoverable Amount