What is the purpose of valuing inventory at the lower of cost and net realizable value?

Valuing inventory at the lower of cost and net realizable value is primarily guided by conservative accounting principles. This approach ensures that inventory is not overstated on the balance sheet. By recording inventory at the lower of these two values, businesses adopt a more cautious stance, which prevents unrealistic profit projections based on inflated inventory values.

The rationale behind this method stems from the idea that if the market value of inventory drops below its cost due to factors such as obsolescence or reduced demand, it is prudent to recognize this decline in value promptly. By doing so, companies align income with actual realization of economic benefits, reducing the risk of reporting excessive profits that may not be realized.

Incorporating this principle into the financial statements reflects a balanced view of assets and earnings, contributing to the credibility and reliability of the financial reporting process. Thus, adhering to conservative accounting principles fosters trust among stakeholders regarding the financial position of the company.