Final answer:
The lower of average cost or net realizable value is a principle in inventory valuation in accounting that prevents overstating the value of inventory on the balance sheet. It requires that inventory is recorded at the lower figure between the cost to acquire the inventory and the net amount expected to be received upon sale. If the net realizable value is lower, inventory is written down to reflect potential losses.
Step-by-step explanation:
The concept of comparing average cost to net realizable value is rooted in accounting principles, particularly inventory valuation. When assessing inventory, a company must determine the lower of the cost or net realizable value (LCNRV). This measure ensures that inventory is not reported at a value higher than what the company expects to realize upon sale.
Net realizable value is the estimated selling price in the ordinary course of business, minus the estimated costs of completion and the estimated costs necessary to make the sale. Meanwhile, average cost is the cost determined by dividing the total cost of goods available for sale by the total number of units available for sale.
If the net realizable value is lower than the average cost, the inventory is written down to this lower value. This is to prevent overstating the value of inventory and to reflect potential losses when the inventory is sold at a price below its cost.
For instance, if a firm's inventory was purchased at an average cost of $50 per unit but due to market conditions, the inventory can only be sold for $45 per unit after subtracting the cost to sell, the net realizable value will be taken into account and the inventory will be valued at $45 per unit on the balance sheet.
Illustrating through Figure 8.6, we can understand that if a firm's price is below its average cost, it might operate at a loss and need to decide whether to continue operations or shut down.