Inventory is a current asset and is reported on the balance sheet. Normally, we record inventory based on what we paid for it (the historical cost). There is an additional step that may be required. We may need to make an adjustment to the amount reported on the balance sheet, because GAAP requires companies to report inventory at the lower of cost and net realizable value. This is the lower of: 1) cost or 2) net realizable value.
Net realizable value is the net amount estimated to be received from the sale of the inventory. The net realizable value equals the expected selling price less any associated selling costs. Calculating net realizable value for inventory is beyond the scope of the material covered in this course.
One of our accounting conventions is conservatism, which suggests that a company should always choose to report items in a way that does not overstate assets or profits. Accountants are expected to anticipate no profit but provide for all possible losses. What this means is that it is important to be cautious when providing information to others that might not be accurate. If there is a chance of a loss, it must be addressed—but if there is a chance of a gain, that must be ignored. We would make the adjustment to report inventory at the lower of cost or net realizable value because we do not want to overstate assets (overstate inventory) or overstate net income (understate the cost of goods sold). It is important not to mislead stakeholders when we report the cost of our inventory.
We will not be recording the adjusting entry required to report inventory at the lower of cost and net realizable value in this course.