Implications of Valuing Inventory at Net Realizable Value

Under IFRS, whenever the value of inventory declines below the carrying amount on the balance sheet, the inventory carrying amount must be written down to its net realizable value. Most importantly, the loss must be recognized as an expense on the income statement.

Analysts need to consider the possibility of an inventory write-down because its impact on a company’s financial statements and ratios could be significant.

Implications of Valuing Inventory at Net Realizable Value

Write-downs reduce the value of inventory, and the loss in value (expense) is generally reflected in the income statement in the cost of goods sold. An inventory write-down will also reduce both profit and the carrying amount of inventory on the balance sheet. consequently, it will hurt profitability, liquidity, and solvency ratios.

For example, net profit margin and gross profit margin will both be lower because of a higher cost of sales (assuming that the inventory write-downs are reported as part of the cost of sales).

Activity ratios such as inventory turnover and total asset turnover will be positively affected because the asset base is reduced (due to a decrease in the average inventory balance, and the higher cost of sales).

Question 1

If a company values its inventory at the net realizable value, this will most likely:

1. Improve the company’s profitability.
2. Decrease the company’s inventory turnover.
3. Lead to any loss being recognized as an expense on the company’s income statement.

Solution

The correct answer is C.

When a company’s inventory carrying amount is written down to its net realizable value, the loss is recognized as an expense on the income statement.

A and B are incorrect. If a company values its inventory at the net realizable value, its profitability will decrease as its inventory turnover increases.

Question 2

An inventory write-down reversal has a negative effect on:

1. Activity ratios.
2. Solvency ratios.
3. Neither activity nor solvency ratios.

Solution

The correct answer is A.

An inventory write-down reversal would increase a company’s assets (inventory), which is the denominator of all the activity ratios. The increase of the denominator of a ratio decreases the value of that ratio.