Accounting (0452) | Valuation of inventory

Accounting Procedure: Valuation of Inventory (Stock)

Hey there, future accountant! This chapter on Valuation of Inventory is absolutely vital. Why? Because the value we place on our unsold goods directly impacts how much profit we think we’ve made and how rich our business looks on paper. Getting this wrong can lead to serious errors!

Don't worry if this seems tricky at first—we only need to learn one main rule, and it's built on a concept you already know: being careful (prudent).

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1. What is Inventory? (A Quick Recap)

Inventory (sometimes called 'Stock') refers to the goods a business holds for resale. In Accounting (0452), we mainly focus on two types of inventory figures:

• Opening Inventory: The inventory the business had at the start of the accounting period. (This was the closing inventory from the previous year).
• Closing Inventory: The inventory remaining unsold at the end of the accounting period (the date of the Statement of Financial Position).

The entire goal of this chapter is figuring out the correct monetary value to assign to the Closing Inventory.

2. The Golden Rule of Inventory Valuation

To ensure our financial statements are reliable and cautious, we must follow an international accounting standard. This standard is known as the:

The Lower of Cost and Net Realisable Value (LCNRV)

This means that for every item of inventory, we must calculate two values: its Cost and its Net Realisable Value. We then choose the lower of the two figures as the final value to use in the accounts.

2.1 Why this Rule? (The Prudence Concept)

This rule is a direct application of the Prudence Concept (or Conservatism Principle). What does prudence mean in accounting?

• We must anticipate all potential losses and record them immediately.
• We should only recognise profits when they are actually earned (or realised).

Analogy: Imagine you bought 100 shirts for $5 each. If suddenly the style becomes unpopular and you can only sell them for $3 each, you have lost $2 per shirt. Prudence requires you to record that $2 loss *now* by lowering the inventory value, rather than waiting until you actually sell them.

3. Defining the Two Values

3.1 Defining Cost

Cost is the amount spent to get the inventory ready and in its current location.

The cost includes:

• The original purchase price.
• Any expenses incurred to bring the goods to the premises (e.g., carriage inwards, import duties, insurance while shipping).

The cost specifically excludes expenses incurred after the goods arrive, such as selling costs or carriage outwards (delivery costs to the customer).

Did you know? Accounting standards prohibit the use of methods like FIFO (First In, First Out) or LIFO (Last In, First Out) to determine cost in this syllabus. We just need to use the actual specific cost paid for the goods.

3.2 Defining Net Realisable Value (NRV)

Net Realisable Value (NRV) is the estimated selling price of the inventory, minus any estimated costs necessary to complete the sale.

Think of NRV as the amount of cash you realistically expect to pocket from selling the item.

The calculation is:

\(\text{NRV} = \text{Estimated Selling Price} - \text{Estimated Costs to Completion and Sale}\)

Example: A tailor has a roll of fabric that could be sold for $500, but he needs to spend $50 on cleaning and $20 on packaging before it can be shipped to a customer.

\(\text{NRV} = \$500 - (\$50 + \$20) = \$430\)

4. Preparing Simple Inventory Valuation Statements

The syllabus requires you to prepare a simple valuation statement, often presented in a table format. You simply calculate the NRV (if given the components) and then select the lowest figure for the final valuation column.

Step-by-Step Example

A shop holds 50 units of Product X and 100 units of Product Y on 31 December.

Table 1: Valuation Statement

Item	Quantity (Units)	Cost per Unit (\$)	NRV per Unit (\$)	Value Chosen (LCNRV) (\$)	Total Closing Inventory Value (\$)
Product X	50	12	15	12 (Lower)	600 (50 x 12)
Product Y	100	5	4	4 (Lower)	400 (100 x 4)
Total Closing Inventory Value					1,000

Key Takeaway: Notice how we valued Product Y at $4, even though we paid $5 for it. The $1 loss per unit (a total loss of $100) is included in the current year’s accounts by reducing the inventory asset value.

5. The Importance and Impact of Inventory Valuation

Why is getting the closing inventory figure correct so crucial? Because it directly influences the calculation of your profit and the presentation of your assets.

5.1 Impact on the Income Statement (Profit)

Remember that the **Cost of Sales** figure determines Gross Profit. Closing inventory is subtracted when calculating Cost of Sales:

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

Look carefully at the formula:

If you increase the value of Closing Inventory, you decrease the Cost of Sales.
If you decrease the value of Closing Inventory, you increase the Cost of Sales.

Since Gross Profit = Revenue – Cost of Sales, the chain reaction is:

• If Closing Inventory is Valued TOO HIGH: Cost of Sales is reduced, leading to Gross Profit and Profit for the Year being TOO HIGH.
• If Closing Inventory is Valued TOO LOW: Cost of Sales is increased, leading to Gross Profit and Profit for the Year being TOO LOW.

This is one of the most common exam questions! Be sure to memorise this relationship.

5.2 Impact on the Statement of Financial Position (Assets and Equity)

Closing Inventory is classified as a Current Asset in the Statement of Financial Position.

• If Closing Inventory is valued TOO HIGH, the total **Current Assets** (and therefore total Assets) will be overstated.
• Since Assets = Liabilities + Owner's Equity, overstating assets means the **Owner's Equity** (Capital) will also be overstated, because the Profit for the Year (which is too high) gets added to the Capital account.

Common Mistake to Avoid!

The biggest mistake is accidentally using cost when NRV is lower. Always check both figures and choose the *lowest* one to be prudent.

5.3 The Effect of Incorrect Valuation on the Next Year

The Closing Inventory figure from Year 1 automatically becomes the Opening Inventory figure for Year 2.

If Closing Inventory for Year 1 was overstated (leading to an overstated Profit in Year 1), what happens in Year 2?

In Year 2, the **Opening Inventory** is too high. A high Opening Inventory increases the Cost of Sales (see formula above). This results in the **Profit for Year 2 being UNDERSTATED** (too low).

The effect cancels out over two years, but each individual year's profit is incorrect! This highlights why strict adherence to LCNRV is essential every single year.