Valuation of inventory

Cambridge IGCSE Accounting 0452 · Core and Extended

Syllabus points

• Explain the basis on which inventory is valued.
• Calculate the value of inventory at the lower of cost and net realisable value.
• Explain the effect of an incorrect inventory valuation on the financial statements.

The rule

Inventory is valued at the lower of cost and net realisable value.

• Cost is what the business paid, including carriage inwards and any cost of bringing the goods into a saleable condition.
• Net realisable value (NRV) is the expected selling price less any costs still to be incurred in selling: repairs, repackaging, delivery, selling expenses.

The rule comes from prudence. Do not overstate assets or profit. If goods can only be sold for less than they cost, the loss belongs to the year the value fell, not to the year they are eventually sold.

Notice what the rule does not say. Inventory is never valued at selling price, even when the goods are certain to sell at a profit, because that would record a profit before the sale has happened.

Apply it line by line

The comparison is made for each type of inventory separately, not on the total.

The inventory value is 3 200 plus 1 900 plus 1 400, which is $6 500.

Comparing totals instead gives a cost of $7 100 against an NRV of $7 400, so the lower is $7 100 and inventory is overstated by $600. The profit on the chairs would have been used to hide the loss on the tables, which prudence does not allow.

A worked net realisable value

Damaged goods cost $900. They can be sold for $750 once $120 of repairs are carried out.

The net realisable value is 750 minus 120, which is $630. That is lower than the cost of $900, so the goods are valued at $630 and a loss of $270 falls into this year.

Using $750 and forgetting the repair cost is the usual slip. Net realisable value is what will actually be left after selling, not the selling price.

Where inventory appears

Closing inventory shows up twice, and both places matter.

• In the income statement, deducted in the calculation of cost of sales, which increases gross profit.
• In the statement of financial position, as a current asset.

Closing inventory is not a ledger balance during the year: it comes from a physical count at the year end. That is why it does not appear in the trial balance, while opening inventory does.

What happens if the valuation is wrong

Because inventory appears in both statements, one wrong figure produces several wrong figures.

There is a further consequence that is often forgotten. This year's closing inventory is next year's opening inventory. So overvaluing it this year overstates this year's profit and understates next year's, because opening inventory is too high in the following calculation. Over two years the errors cancel, but neither year is right.

Other points examined

• Inventory is valued at the lower of the two figures, so an unrealised profit is never recorded, but a foreseeable loss always is. That is prudence working in one direction only.
• Goods on sale or return that the customer has not yet accepted still belong to the seller and are included in the seller's inventory at cost.
• Goods taken by the owner are removed from purchases and added to drawings, at cost, not at selling price.
• The consistency principle requires the same valuation basis year after year, so results can be compared.

Common mistakes

• Valuing inventory at selling price.
• Applying the lower of cost and net realisable value to the total instead of to each line.
• Forgetting to deduct the costs of selling when calculating net realisable value.
• Including closing inventory in the trial balance.
• Valuing goods taken by the owner at selling price.
• Stating the effect on profit but not on the current assets.
• Forgetting that this year's error reverses into next year's profit.