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Lower of Cost or Net Realizable Value

Inventory is normally carried at what it cost you — but what if the goods are now worth less than that? When the market turns against your stock, accounting refuses to keep pretending. This guide shows how a write-down works, why IFRS and US GAAP measure the floor differently, and the one rule on which they sharply part ways.

When cost stops telling the truth

Everything so far in this rung has rested on one quiet assumption: that your inventory is worth at least what you paid for it. You bought goods, you costed them with FIFO, LIFO, or weighted-average, and whatever sat unsold at period-end you carried on the balance sheet at that cost. The cost of goods sold formula took care of the rest. But the world is not always so kind. Sometimes the goods on your shelves are now worth *less* than you paid — phones a generation old, fashion two seasons stale, food creeping toward its expiry. What then?

Recall the historical cost principle: assets are recorded at what you paid, and accounting normally does *not* chase them up and down with the market. That rule is a feature, not a bug — it keeps the books anchored to something verifiable rather than to a parade of opinions about value. But it leans in one direction only. When an asset's value *rises*, you usually keep quiet and leave it at cost; you do not write it up just because you got lucky. When an asset's value *falls below* cost, accounting refuses to look away. Inventory you can no longer sell for what it cost you is no longer worth its cost, and a balance sheet that still says otherwise is telling a comforting lie.

Conservatism: the rule that only flinches downward

The principle behind all of this has a name you have already met in passing on the receivables guide: the [[conservatism-principle|conservatism principle]]. Its instinct is simple and a little gloomy — when in honest doubt, lean toward the version of events that does *not* flatter you. Recognise likely losses as soon as you can see them coming, but do not recognise gains until they are real and earned. It is the accountant's habit of preferring an unpleasant truth now to a pleasant surprise that might never arrive.

Applied to inventory, conservatism produces a memorable instruction: carry your stock at the lower of its cost or its current market value — never the higher of the two. If the goods are still worth their cost or more, leave them at cost and say nothing. If they have slipped below cost, mark them down to that lower figure. This is a one-way ratchet: it can drag the carrying value *down* toward a sober reality, but it will not let you ratchet it back *up* above cost just because you feel optimistic. The asset is allowed to look worse than cost, never better.

What is 'market'? Net realizable value versus the old rule

Everything hinges on one slippery word: *market*. Lower of cost or what, exactly? Today, under IFRS and increasingly under US standards too, the answer is [[net-realizable-value-inventory|net realizable value]] (NRV) — the price you could realistically sell the goods for, minus the costs still needed to finish and sell them. It is the cash you would honestly net if you pushed the stock out the door. If a coat that cost you 120 can now be sold for only 90, and it would take 5 in shipping and selling costs to move it, its NRV is 90 − 5 = 85. Cost is 120; NRV is 85; you carry it at the lower, 85.

Older US GAAP used a clunkier yardstick called [[lower-of-cost-or-market|lower of cost or market]] (LCM), and the word *market* there did *not* mean selling price — it meant replacement cost, what it would cost you to buy the item again now, fenced in by a ceiling (NRV) and a floor (NRV minus a normal profit margin). It was a fiddly sandwich of three numbers, born in an era more worried about wholesale buying prices than retail selling prices. In 2015 the US standard-setters simplified it: for companies using FIFO or average cost, 'market' was redefined to mean net realizable value, bringing US practice much closer to the rest of the world. (Companies still on LIFO kept the old LCM rule.)

Writing it down: where the loss lands

So the value has fallen — how does it actually hit the books? You record a write-down: a journal entry that lowers the inventory asset to its new, lower carrying value and recognises the drop as an expense in the same period. The bookkeeping is the mirror image of the situation. Inventory, an asset, must come down, so you credit it (or a contra account beside it). The other side, the debit, is a loss that flows straight to the income statement, shrinking this period's profit. The economics and the entry agree: you are poorer now, and the books admit it now.

Cost of the coats on hand ............ 120,000
Net realizable value of those coats ...  85,000
Write-down needed (120,000 - 85,000) .. 35,000

Journal entry at period-end:
  Dr  Loss on inventory write-down ... 35,000   <- expense, hits profit now
      Cr  Inventory ..................... 35,000   <- asset falls to NRV

Balance sheet after:  Inventory  85,000  (was 120,000)
Income statement:     35,000 loss recognized this period
A write-down in one entry. The debit is the loss that lowers this period's profit; the credit pulls the inventory asset down to its net realizable value. Many companies route the debit through cost of goods sold instead of a separate loss line — either way, the goods now sit at 85,000 and the 35,000 hit lands in this period, not the one when the coats finally sell.

Notice the timing, because it is the whole point. Without a write-down, the 35,000 loss would stay hidden inside inventory and only surface later, as a fat slice of cost of goods sold in the period the coats are finally dumped at a discount. The write-down drags that loss *forward* into the period when the value actually evaporated. That is conservatism keeping its promise: recognise the bad news the moment it becomes visible, not in some kinder future quarter. A profit figure that ignores stock gone stale is a profit figure that flatters the present at the future's expense.

Can a write-down be undone? Where IFRS and US GAAP split

Here is the question that genuinely divides the two great rulebooks. Suppose you wrote those coats down to 85,000 last winter — and now spring arrives, demand revives, and they are worth 110,000 again. Can you write them back *up*? Under IFRS, yes, but only partway: you may reverse a previous write-down up to the original cost if the net realizable value recovers, never a cent above the 120,000 you actually paid. Under US GAAP, no: a write-down establishes a new cost basis, and that lower figure is permanent — the recovery is simply ignored until the goods are eventually sold.

Why the split? It is the same conservatism, weighted differently. US GAAP is more wary of letting a reversal pump profit back up — a recovery can be argued into existence, and once you allow write-ups you have handed management a lever to smooth earnings. So it bolts the door: down is allowed, back up is not. IFRS trusts that if the original loss is gone, clinging to it understates a real asset, so it permits the reversal — but caps it firmly at the original cost so it can never become a stealthy revaluation gain. Both refuse to let inventory rise *above* cost; they disagree only on whether a value that fell and then recovered may climb back to where it started.

One last practical note on scope. The comparison of cost to NRV can be done item by item, or by groups of similar goods — and IFRS generally insists on the item-by-item view, because lumping a sinking product in with a thriving one lets a hidden loss masquerade as no loss at all. And whether you carve the write-down out as its own loss line or simply fold it into cost of goods sold, the bottom-line effect is identical: profit falls now, and the inventory on the balance sheet tells the truth about what it is really worth today, not what you once hopefully paid for it.