Walk into almost any warehouse and you will find a corner nobody talks about: the pallet of last season's product, the box of components for a model you discontinued, the case of goods that arrived water-damaged and never made it back to the supplier. On the books, all of it is still carried at full cost. On the shelf, it is worth a fraction of that — if it is worth anything at all.
That gap between what inventory cost you and what it can actually fetch is the entire reason the lower of cost or net realizable value rule exists. It is one of accounting's oldest guardrails, and it does a simple, unglamorous job: it stops your balance sheet from telling a story that is more flattering than the truth.
What "Lower of Cost or Net Realizable Value" Actually Means
Inventory normally sits on your balance sheet at cost — what you paid for it, plus the costs to get it ready to sell. That works fine right up until the inventory loses value. Once goods are damaged, obsolete, or simply unsellable at the price you planned, cost stops being an honest number.
The lower of cost or net realizable value rule (often abbreviated LCNRV) handles this. At each reporting date, you compare two figures for your inventory:
- Cost — what the inventory is currently recorded at.
- Net realizable value (NRV) — what you can realistically expect to get for it, net of the costs to finish and sell it.
You report the inventory at whichever number is lower. If NRV has fallen below cost, you write the inventory down to NRV and book the difference as a loss. If NRV is still at or above cost, you do nothing — you never write inventory up above cost.
This is a conservatism principle in action. Accounting deliberately leans toward recognizing losses early and gains late, because an overstated asset can mislead lenders, investors, and owners far more dangerously than an understated one.
LCNRV replaced "lower of cost or market"
If you learned this rule years ago, you may remember it as lower of cost or market (LCM), a more complicated test that involved a "market" value bounded by a ceiling and a floor. In 2015, the Financial Accounting Standards Board issued ASU 2015-11 and simplified the whole thing. For most companies, "market" became a single, intuitive number: net realizable value.
There is one carve-out worth knowing. The simplified LCNRV rule applies to inventory measured with FIFO or average cost. Companies using LIFO or the retail inventory method still apply the older lower-of-cost-or-market test. Most small and mid-sized businesses use FIFO or average cost, so LCNRV is the rule that will govern your year-end inventory.
How to Calculate Net Realizable Value
NRV is not a guess about what inventory is "kind of worth." It has a defined formula:
NRV = Estimated selling price − Estimated costs to complete − Estimated costs to sell
Break that into three steps.
Step 1: Estimate the selling price. This is the price you can realistically achieve in the ordinary course of business — not the original list price, and not a hopeful number. If a product is selling on clearance at $40, that is the price, even if the tag still says $90.
Step 2: Subtract costs to complete. If the item is work-in-process or needs repair, reconditioning, or repackaging before it can sell, subtract those costs. Finished goods that are ready to ship have no completion cost.
Step 3: Subtract costs to sell. Sales commissions, shipping, delivery, packaging, and disposal costs all come out. What is left is the cash the inventory will genuinely put in your pocket.
A worked example
Say you run an electronics retailer and you are holding 200 units of a smart speaker.
- Recorded cost: $60 per unit
- A newer model has launched; you can only sell the old units on promotion at $48 each
- Shipping and payment processing cost roughly $6 per unit
- No completion costs — the units are finished goods
NRV = $48 − $0 − $6 = $42 per unit
Cost is $60. NRV is $42. Because NRV is lower, you write each unit down by $18.
Total write-down = 200 units × $18 = $3,600
The inventory now sits on the balance sheet at $42 per unit, and $3,600 has been recognized as a loss this period.
Recording the Write-Down
The accounting entry is straightforward. To write down the $3,600 in the example above:
Debit: Loss on inventory write-down (or COGS) $3,600
Credit: Inventory (or Inventory reserve) $3,600You have two reasonable choices for where the loss lands:
- Direct to cost of goods sold. Common when the amount is small and routine. The write-down simply blends into COGS and reduces gross margin.
- A separate loss line. Preferred when the write-down is large or unusual, because burying a big number inside COGS hides it from anyone reading the income statement. A distinct "loss on inventory write-down" line keeps the disclosure honest.
For the credit side, you can reduce the inventory account directly or use a contra-asset account — often called an inventory reserve or allowance for obsolescence. The reserve approach keeps the original cost visible while netting the write-down against it, which makes it easier to track how much of your inventory you have flagged as troubled.
The write-down is permanent
Here is the rule that surprises people most: under U.S. GAAP, once you write inventory down, the new lower figure becomes its cost basis — permanently. If market conditions improve and that inventory becomes valuable again before you sell it, you do not write it back up. Reversals of prior write-downs are prohibited under ASC 330.
(This is one of the genuine differences between U.S. GAAP and IFRS. International standards do allow a write-down to be reversed if NRV recovers. If you report under IFRS, track your write-downs so you can reverse them when warranted.)
Reserve vs. Write-Off: Three Different Things
These terms get used interchangeably, and that sloppiness causes real bookkeeping errors. They are not the same.
A write-down reduces the carrying value of inventory you still own and may still sell — just at a lower price. The goods stay on your shelf and on your books, at a reduced number.
A write-off removes inventory entirely. The goods are unsellable, period — destroyed, expired, or stolen — and they leave both the shelf and the books. A write-off is essentially a 100% write-down.
A reserve is an estimate made in advance. You may not yet know which specific units will go bad, but experience tells you some will. If history shows roughly 2% of your inventory becomes obsolete each year, you can carry a 2% reserve for obsolescence — recognizing the expected loss before you can point to the exact pallet.
The distinction matters because reserves reflect anticipated risk while write-downs and write-offs reflect realized loss. Confusing the two leads to double-counting or to losses that never get recognized at all.
When You Must Recognize a Write-Down
GAAP does not let you choose your timing. The moment evidence shows NRV has dropped below cost, the loss belongs in the current period. Triggers include:
- Physical damage — water, breakage, contamination.
- Deterioration or spoilage — perishables past their window, materials that degrade.
- Obsolescence — a newer model launches, a design changes, demand evaporates.
- Price declines — the market price of a commodity input falls below what you paid.
- Excess quantity — you simply have more than you can plausibly sell before the goods age out.
You cannot spread a write-down across several quarters to soften the blow, and you cannot defer it to a future period because this quarter already looks weak. Both inventory write-downs and write-offs are recognized immediately and in full.
The Tax Side: Book and Tax Don't Match
A write-down that is correct for your financial statements may give you no immediate tax deduction. This trips up a lot of business owners.
For tax purposes, the IRS generally will not let you deduct a loss on inventory until the item is actually sold or otherwise disposed of. Simply deciding something is obsolete and writing it down on your books is not enough.
There are recognized paths to a tax deduction, but each requires real evidence:
- The 30-day offering rule. For "subnormal goods" — items unsellable at normal prices due to damage, style changes, or defects — the IRS expects you to actually offer them for sale at the reduced price within 30 days of your inventory date. Doing so substantiates the lower valuation.
- Sell to a liquidator or salvage buyer. Recovering something is still a disposal, and the unrecovered cost becomes deductible.
- Donate it. Inventory donated to a qualified charity can generate a deduction, sometimes an enhanced one if the goods serve the ill, needy, or infants.
- Casualty losses. Inventory destroyed by theft or disaster is reported separately on Form 4684 and may yield a larger deduction.
The practical takeaway: your books and your tax return will often disagree on inventory, and that is normal. The difference is a timing difference that reverses when the goods finally leave. Document every write-down — the IRS puts the burden of proof on you, and weak documentation can cost the entire deduction.
Where Businesses Get LCNRV Wrong
A handful of mistakes show up again and again:
- Carrying dead stock at full cost. The most common error and the most damaging. Inventory nobody will ever buy stays on the books at cost, inflating both assets and net income and giving owners and lenders a falsely rosy picture.
- Saving it all for year-end. Owners who ignore obsolescence all year face one giant write-down in the fourth quarter. It can erase a quarter's profit overnight and shake anyone reading the statements. Review inventory regularly so adjustments stay small and routine.
- Using list price as selling price. NRV uses the price you can actually get today, net of selling costs — not the optimistic tag.
- Forgetting selling and completion costs. NRV is a net figure. Skip the commissions, freight, and disposal costs and you will overstate it.
- Trying to reverse a U.S. GAAP write-down. Once it is down, it stays down. Writing it back up is not allowed.
Build a Routine, Not a Year-End Scramble
LCNRV is far less painful as a habit than as an annual event. A workable rhythm:
- Run an aging report each quarter so slow-moving and stale inventory is visible early.
- Flag at-risk items — anything damaged, superseded by a new model, or sitting well past its normal sell-through window.
- Calculate NRV for the flagged items: realistic price, minus completion costs, minus selling costs.
- Compare to cost and record a write-down for anything where NRV is lower.
- Document the evidence — the discounted price, the reason, the date — for both your auditor and the IRS.
Done quarterly, write-downs become small, expected, and unremarkable. Done once a year in a panic, they become the surprise that wrecks an otherwise solid quarter.
Keep Your Inventory and Your Books Honest
The lower of cost or net realizable value rule comes down to a single discipline: your balance sheet should reflect what your inventory is genuinely worth, not what you once hoped it would be. That discipline depends entirely on having clean, current records — accurate costs, traceable adjustments, and a clear history of every write-down you took and why.
That is exactly where plain-text accounting earns its keep. Beancount.io gives you transparent, version-controlled books where every inventory adjustment is a readable, auditable entry — no black boxes, no guessing how a number was derived. You can see the full history of a write-down the same way you see a code change. Get started for free and keep your inventory values — and the rest of your financial story — grounded in the truth.