What is 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 for valuation of 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 we find out that realizable value is less than the cost price, we must account for those losses in the books. For example, Inventory is valued at lower of cost or market price. The market price is nothing but the net realizable value. Any increase or decrease in the value of Inventory helps in the identification of any loss or profit we must take into consideration.
Realizable Value Examples
Example #1
X Ltd. has inventory worth $1,500 at year-end; however due to advancement in technologies this product is going to 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) 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.
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Example #2
Another example is that of 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 evaluate 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, in cases where debtors have gone bankrupt, we should write off the balances.
Nowadays, the organization also sell their debts to collection agencies at a reduced value. In these cases, also the reduction in receivable value should be taken to profit & loss account, and 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 in the product by spending $12, then it can sell the product is $70. Now we see the new cost price is $67 (50+12) and realizable 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.
Advantages
- These concepts help the organisation in showing 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 organisations in tax planning.
- It also identifies if the products are no longer in demand in the market.
- Shows the current trend and customer behaviour in the current scenario.
Disadvantages
- Sometimes it ignores the time factor which leads to over or understatement of profit.
- Needs to consider economic, political, geographical and various other factors to reach the exact realizable in the current or future market
- Frequent changes in the technologies might make an item obsolete overnight, which is difficult to catch and identify.
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