Valuation of inventory

Paper 1 – Multiple ChoicePaper 2 – Structured Written Paper

The Lower of Cost and Net Realisable Value Rule

Why do we value inventory this way?

Accounting follows the prudence concept, which states that assets should not be overstated. If inventory is damaged, obsolete, or market prices have fallen, its value to the business has decreased. We must record this loss immediately rather than waiting until the item is actually sold.

Therefore, at the end of each reporting period, every item of inventory must be compared against two values:

Cost: What it cost to buy or make the item.
Net Realisable Value (NRV): What we expect to get from selling it, minus any costs to sell it.

The rule is simple: Value the inventory at the LOWER of these two amounts.

Applying the Rule:

Scenario	Cost	NRV	Valuation to Use	Reason
Normal	100</td> <td style="text-align:left">120	100 (Cost)</strong></td> <td style="text-align:left">The asset is worth more than it cost. We do not write up assets under IFRS/GAAP principles.</td> </tr> <tr> <td style="text-align:left"><strong>Decline</strong></td> <td style="text-align:left">100	80</td> <td style="text-align:left"><strong>80 (NRV)	The asset has lost value. We must recognize the loss now to avoid overstating assets.

Building on previous concepts: This valuation directly impacts the Income Statement. If Cost > NRV, the difference is an expense called 'Inventory Write-down' or 'Loss on Inventory', which reduces Gross Profit.

Cost

Cost includes all expenditure incurred in bringing the inventory to its present location and condition. This typically includes:

Purchase price (less trade discounts)
Import duties and non-refundable taxes
Transport and handling costs
Direct labour and production overheads (for manufactured goods)

Note: To determine 'Cost', you must first apply a cost formula such as FIFO (First-In, First-Out) or Weighted Average Cost. These methods assume how the specific units flow through the business.

Net Realisable Value (NRV)

NRV is the estimated selling price in the ordinary course of business, less the estimated costs of completion and the estimated costs necessary to make the sale.

\text{NRV} = \text{Estimated Selling Price} - \text{Costs to Complete/Sell}

Example: If you plan to sell a handbag for 100, but you must pay a5 commission to the salesperson and 2 for packaging, the NRV is93 (100 -5 - 2).

Calculating Inventory Value (Learning Objective 2)

Step 1: Determine the Quantity
Count the physical units remaining at year-end.

Step 2: Determine the Cost per Unit
You must use a cost formula. Cambridge accepts FIFO or Weighted Average. You cannot use LIFO (Last-In, First-Out).

FIFO Method: Assumes the first goods bought are the first ones sold. Therefore, the closing inventory consists of the most recently purchased units.
Weighted Average Method: Calculates an average cost per unit based on all purchases during the period.

Step 3: Calculate Total Cost
\text{Total Cost} = \text{Quantity} \times \text{Cost per Unit (from FIFO/Avg)}

Step 4: Determine NRV per Unit
Take the estimated selling price and subtract any direct costs to sell (e.g., commissions, cleaning, repairs).

Step 5: Compare and Value
For each item (or batch), choose the lower of Step 3 and Step 4. Sum these values for the total inventory valuation.

Worked Example: Valuation with Damaged Goods

Scenario:
Logan has 100 handbags in inventory.

Cost: Purchased at 50 each.</li> <li>Condition: They are slightly damaged. To sell them, Logan must spend5 per bag for cleaning/repairs.
Selling Price: The normal selling price is 80 per bag.</li> </ul> Calculation: <ol> <li>Cost per unit:50
NRV per unit:
\text{NRV} = \text{Selling Price} - \text{Cost to Repair/Sell}
\text{NRV} = 80 - 5 = 75
Comparison:
- Cost: 50</li> <li>NRV:75
- Lower of the two: 50</li> </ul> </li> </ol> Valuation: Since Cost (50) is lower than NRV (75), we value the inventory at Cost. No write-down is needed. <hr /> Alternative Scenario (Price Drop): Suppose the market crashes. The selling price drops to40, and cleaning costs remain 5. <ol> <li>Cost per unit:50

⚠︎ Incorrectly Calculating NRV

The Error: Students often forget to deduct the costs of completion or selling from the estimated selling price.

Correct Understanding:
NRV is not just the selling price. It is the net amount you actually get to keep. If goods are damaged, you must subtract the cost of repairs/cleaning from the selling price before comparing it to the original Cost.

Example: If Selling Price = 100 and Repair Cost =10, NRV is 90, not100.

Explaining Inventory Write-downs

When to use this phrase:
When asked to explain why inventory is valued at a reduced amount or why an expense is recorded.

Examiner Acceptance:
Examiners look for the keyword prudence (or conservatism). You should state: 'Inventory is written down to net realisable value in accordance with the prudence concept, ensuring assets are not overstated.'

Why this works:
This directly addresses the underlying accounting principle. Simply saying 'it's cheaper' is insufficient; you must link it to the prudence concept which dictates that losses are recognized as soon as they are anticipated.

Effect of Incorrect Valuation (Learning Objective 3)

How does an inventory error ripple through the financial statements?

Inventory is part of Current Assets. The closing inventory figure is used to calculate Cost of Sales:

\text{Cost of Sales} = \text{Opening Inventory} + \text{Purchases} - \text{Closing Inventory}

Notice that Closing Inventory is subtracted. This means:

If Closing Inventory is Overstated (too high), Cost of Sales is Understated (too low).
If Closing Inventory is Understated (too low), Cost of Sales is Overstated (too high).

The Chain Reaction:

Gross Profit:
\text{Gross Profit} = \text{Revenue} - \text{Cost of Sales}
- If Cost of Sales is too low, Gross Profit is Overstated.
- If Cost of Sales is too high, Gross Profit is Understated.
Profit for the Year (Net Profit):
Since Gross Profit flows into Net Profit, the same direction applies:
- Overstated Inventory → Overstated Profit for the Year.
- Understated Inventory → Understated Profit for the Year.
Equity (Retained Earnings/Net Assets):
At the end of the year, Profit for the Year is transferred to Equity (specifically Retained Earnings).
- Therefore, an Overstated Profit leads to an Overstatement of Equity.
- An Understated Profit leads to an Understatement of Equity.
Asset Valuation:
Since Inventory is an Asset:
- Overstated Inventory → Overstated Total Assets (and Net Assets).
- Understated Inventory → Understated Total Assets (and Net Assets).

Connecting the Balance Sheet: Remember that \text{Assets} = \text{Liabilities} + \text{Equity}. If Assets are overstated, Equity must also be overstated to keep the equation balanced.

Error Type	Effect on Closing Inventory
Effect on Cost of Sales
Effect on Gross Profit
Effect on Profit for the Year
Effect on Equity (Retained Earnings)
Effect on Assets (Net Assets)

Overstated Inventory	Understated	Overstated	Overstated	Overstated	Overstated
Understated Inventory	Overstated	Understated	Understated	Understated	Understated

⚠︎ Confusing the Direction of Cost of Sales

The Error: Students often think that if Inventory is too high, Cost of Sales is also too high.

Correct Understanding:
Closing Inventory is subtracted in the Cost of Sales formula. Therefore, the effect on Cost of Sales is the opposite of the effect on Inventory.

High Inventory → Low Cost of Sales.
Low Inventory → High Cost of Sales.

Describing the Effect on Equity

When to use this phrase:
When asked to explain the impact of an inventory error on the Statement of Financial Position or Owner's Equity.

Examiner Acceptance:
Use precise language: 'The overstatement of closing inventory leads to an overstatement of profit for the year, which is closed to retained earnings, thereby overstating total equity.'

Why this works:
It explicitly links the Profit for the Year to Retained Earnings/Equity. Examiners require you to show that you understand the flow of profits into the balance sheet. Simply saying 'equity is wrong' is often insufficient; specify that it is an overstatement/understatement due to the profit link.

Past Paper Style Questions

A company has inventory with a cost of 50,000. The estimated selling price is45,000 and the costs to sell are $2,000. What value should be shown in the Statement of Financial Position?

43,000. NRV =45,000 - 2,000 =43,000. Since NRV (43,000) is lower than Cost (50,000), inventory is valued at NRV.

Explain the effect on gross profit if closing inventory is overstated.

Gross profit will be overstated. This is because closing inventory is subtracted from cost of sales; therefore, an overstatement of closing inventory results in an understatement of cost of sales, leading to a higher gross profit.

Calculate the value of inventory if 100 units remain. The first 60 were bought at 10 each and the next 40 at12 each. The NRV is $9 per unit.

1,000. Using FIFO, closing inventory consists of the most recent purchases. However, we must check NRV. Cost of last 40 units = 40 *12 = 480. NRV = 40 *9 = 360. Lower is360.
Cost of next 20 units (from the 10 batch) = 20 *10 = 200. NRV = 20 *9 = 180. Lower is180.
Total Value = 360 +180 = 540? Correction for standard FIFO valuation without item-by-item NRV check in simple MCQs: Usually, if NRV < Cost for the batch, write down. Let's stick to the basic rule: Compare Total Cost vs Total NRV or Item by Item. Item 1 (60 units): Cost600, NRV 540 -> Value540.
Item 2 (40 units): Cost 480, NRV360 -> Value 360. Total =900.
Note: In many Cambridge questions, if NRV is uniformly lower, you value all at NRV.
Correct Answer for standard exam logic: If NRV (9) < Cost (10 and 12), value all 100 units at NRV. Value = 100 *9 = $900.

How does an understatement of closing inventory affect the equity section of the Statement of Financial Position?

Equity is understated. An understatement of closing inventory leads to an overstatement of cost of sales, which reduces profit for the year. Since profit is transferred to retained earnings (equity), equity is also understated.