Lower of Cost and Net Realizable Value

Updated for the 2026-2027 CFA® Level I curriculum.

Inventory cannot sit on the balance sheet at a value higher than what it can actually generate for the company. The lower of cost and net realizable value (LCNRV) rule forces companies to write inventory down when its expected recovery drops below cost. This shows up on the Level I exam as a calculation question, a financial statement effect question, or an IFRS versus US GAAP comparison.

Key Takeaways

• LCNRV requires inventory to be reported at the lower of its original cost or net realizable value.

• NRV equals estimated selling price minus estimated costs to complete minus estimated selling costs.

• A write-down happens when NRV drops below carrying cost. It reduces the inventory balance and increases cost of goods sold.

• IFRS allows reversing a prior write-down, up to the original cost, if NRV recovers. US GAAP does not allow any reversal.

• Write-downs reduce gross profit, net income, and total assets, and they typically raise the inventory turnover ratio.

• Most US GAAP inventory outside of LIFO and the retail inventory method now uses the same NRV test as IFRS.

What You Need to Know for CFA Level I

• The LOS asks you to describe the measurement and its implications. Expect conceptual and applied questions, not multi-step inventory costing problems.

• Know the NRV formula well enough to calculate it from a selling price and two cost deductions.

• Understand that IFRS applies the NRV test to all inventory, while US GAAP applies a separate "lower of cost or market" test only to LIFO and retail-method inventory.

• Know that IFRS permits reversing a write-down up to the original cost. US GAAP prohibits reversals entirely, even if NRV later recovers.

• This note stops at measurement and financial statement impact. Cost formulas (FIFO, LIFO, weighted average) belong to Inventory Valuation Methods. Disclosure requirements belong to Inventory Disclosures and Analyst Considerations.

• The most common trap is getting the direction of the income statement effect backward, or applying IFRS reversal rules to a US GAAP company.

What Is Net Realizable Value?

Net realizable value is the amount a company actually expects to collect from selling its inventory, after accounting for what it still needs to spend to get the inventory ready and sold.

NRV = Estimated selling price - Estimated costs to complete - Estimated selling costs

where:

• Estimated selling price: the price the company expects to receive in the ordinary course of business,

• Estimated costs to complete: remaining production or finishing costs needed before the inventory is ready for sale, and

• Estimated selling costs: costs directly tied to the sale, such as commissions, shipping, or marketing tied to that sale.

NRV is not the same as market value or replacement cost. It is specific to what the company can realize from selling the inventory it already holds.

Applying the Lower of Cost and NRV Rule

The rule compares the inventory's carrying cost to its NRV, usually item by item or by group of similar items.

1. Determine the inventory's current carrying cost (already set using FIFO, LIFO, or weighted average).

2. Calculate NRV using the formula above.

3. Compare cost to NRV.

   • If cost is less than or equal to NRV, no adjustment is needed.

   • If cost is greater than NRV, write the inventory down to NRV.

4. The write-down amount becomes an expense, and NRV becomes the reduced carrying amount. Under IFRS, reassess NRV and reverse an eligible prior write-down when recovery warrants it, up to the original cost.

IFRS vs US GAAP Treatment

Since the US GAAP simplification under ASU 2015-11, most companies use the same NRV test as IFRS. The older replacement-cost approach with a ceiling and floor still applies only to inventory measured using LIFO or the retail inventory method.

Financial Statement and Ratio Implications

A write-down affects both statements in the period it occurs.

Balance sheet: Inventory decreases by the write-down amount. Total assets fall, and retained earnings fall through the net income effect.

Income statement: The write-down is recognized as an increase to cost of goods sold, or occasionally as a separate loss line. Net income decreases. Gross profit decreases when the charge is included in cost of goods sold; separate presentation can affect that subtotal differently.

Ratios affected:

A write-down lowers gross profit margin in the period it is recognized. Because it raises cost of goods sold while lowering average inventory, it also tends to raise inventory turnover, which can make the company look more efficient even though the cause was a value decline, not stronger sales activity.

If NRV later recovers and the company reports under IFRS, the reversal decreases cost of goods sold and increases net income in the recovery period, limited to the original cost. A US GAAP company recognizes no such benefit, even if the identical recovery occurs.

Working Example

Setup: Caldwell Parts Co. holds 10,000 units of a component with a carrying cost of $40 per unit. At year-end, a shift in demand means each unit is now expected to sell for $45. Caldwell still needs to spend $5 per unit to finish the units and expects $4 per unit in selling costs. Caldwell reports under IFRS.

Step 1: Calculate NRV.

Step 2: Compare to cost.

Cost ($40) is greater than NRV ($36), so the inventory must be written down.

Step 3: Calculate the write-down.

Step 4: Record the effect.

Inventory falls from $400,000 to $360,000. Cost of goods sold increases by $40,000, and pretax income falls by $40,000 in the current period.

Caldwell's gross margin compresses this period because of the write-down, not because of weaker sales. An analyst should flag whether this reflects a one-time demand shift or an early sign of ongoing obsolescence risk in this product line.

Follow-up (reversal): The next year, selling price recovers to $50, with completion and selling costs unchanged. New NRV equals $50 - $5 - $4 = $41, which exceeds the written-down carrying value of $36. Under IFRS, Caldwell reverses the eligible write-down, but only up to the original cost of $40, not the new NRV of $41. The reversal is limited to $4 per unit, or $40,000 total, which decreases cost of goods sold and increases net income that period. If Caldwell reported under US GAAP instead, no reversal would be permitted regardless of the recovery.

Applying the US GAAP Market Ceiling and Floor

Consider a separate inventory item measured using LIFO. Its cost is $100 per unit, NRV is $90, replacement cost is $65, and the normal profit allowance is $15 per unit.

Replacement cost is below the $75 floor, so designated market is $75. The company compares cost of $100 with market of $75 and records a $25 write-down per unit.

If replacement cost were $85, market would be $85 because it falls between the floor and ceiling. If replacement cost were $95, market would be capped at $90. In every case, determine market first and then compare that amount with cost.

Under the lower-of-cost-and-NRV model, the same $100 cost and $90 NRV would instead produce a $10 write-down. The different answer reflects the applicable measurement rule. Identify the reporting framework and inventory method before selecting a calculation; replacement cost is not an extra input to the ordinary NRV test.

Common Exam Traps

Reversing the income statement direction

Candidates sometimes assume a write-down raises net income because it "reduces" an asset. A write-down always increases cost of goods sold and decreases net income in the period recognized.

Applying IFRS reversal rules to a US GAAP company

US GAAP prohibits reversing any inventory write-down, even when NRV fully recovers. Only IFRS allows a reversal, and only up to the original cost.

Confusing NRV with market value or replacement cost

NRV is specific to estimated selling price minus completion and selling costs. Replacement cost is a separate US GAAP concept used only for LIFO and retail-method inventory.

Forgetting one of the two cost deductions

Some candidates subtract only completion costs or only selling costs from selling price, which overstates NRV and can lead to missing a required write-down.

Mixing LCNRV with cost formulas

LCNRV is a measurement ceiling applied after cost has already been determined by FIFO, LIFO, or weighted average. It does not replace those cost formulas.

Practice Question

At year-end, Harbor Components Inc. holds inventory with a cost of $28 per unit. The estimated selling price is $32 per unit, estimated costs to complete are $3 per unit, and estimated selling costs are $2 per unit. Harbor reports under IFRS. What is the effect, if any, on Harbor's inventory carrying value?

1. No adjustment is needed because NRV exceeds cost.

2. Inventory is written down to $27 per unit.

3. Inventory is written down to $29 per unit.

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