Audit Procedures for Net Realizable Value and Obsolescence Provisioning under IAS 2
Verify inventory NRV by matching unit costs against post-period sales invoices and net realization costs to prevent balance sheet overstatement under IAS 2.
Lower of Cost and Nrv
Meaning
The lower of cost and net realizable value rule governs inventory valuation by requiring production assets to be written down when market values drop beneath historical outlays. Operations managers face the readiness question of whether raw materials and finished goods still hold their recorded economic utility on the balance sheet. Financial auditors measure this through inventory aging schedules and physical count reconciliations during year end testing.
The boundary lies strictly at the point of sale, stopping where goods transfer ownership or where materials enter active assembly lines.
Valuation Mechanics
Accountants apply lower of cost and net realizable value to individual stock items or homogeneous inventory pools once production processes generate verifiable outlays. Teams calculate historical acquisition figures by summing direct material purchases, direct labor hours and allocated overhead expenses. Market ceilings take the estimated selling price, subtract completion costs and remove disposal fees to establish the net realizable value floor.
When replacement figures sit below historical expenditures, companies recognize an immediate inventory write down on financial statements.
Economic Exposure
Production facilities absorb direct margin contractions when lower of cost and net realizable value forces write downs on obsolete stock or unsold assemblies. Finance teams carry the risk of premature recognition if market drops prove temporary rather than structural. Operational managers must distinguish actual equipment capability from nominal factory capacity because idle plant overheads distort inventory cost pools.
Premature valuation adjustments destroy cash reserves by inflating current period expenses without generating corresponding revenue streams.
Audit Verification
Independent reviewers test lower of cost and net realizable value compliance by cross referencing recent sales invoices against ending inventory valuation sheets. Auditors verify supplier forecasts by demanding demonstrated delivery rates rather than relying on unconfirmed supplier promises. Production supervisors reconcile physical stock counts with perpetual inventory records to isolate damaged goods before accountants apply valuation rules.
Statistical sampling audits uncover valuation discrepancies across high volume warehouses where tracking manual errors distorts asset values.