4.5 Valuation of Inventory
Definition and Explanation
Inventory: Goods held by a business for resale. They may be in the form of raw material, semi finished goods, finished goods
Inventory valuation: It is the process of determining the value of inventory at the end of an accounting period. It is essential to value inventory correctly as it impacts the cost of sales (COS), gross profit, and overall financial health of the business.
Inventory Valuation Statement: A report including the different valuation for each type of inventory held by a business
Lower of Cost and Net Realisable Value (NRV): Inventory should be valued at the lower of its cost or its net realisable value.
Cost: This includes all costs incurred to bring the inventory to its present location and condition, such as purchase price, import duties, transport, handling, and any other costs directly attributable to the acquisition.
Net Realisable Value (NRV): This is the estimated selling price in the ordinary course of business minus any estimated costs of completion and costs necessary to make the sale.
Why Valuation at Lower of Cost and NRV?
Prudence Concept: Ensures that assets are not overstated and profits not overstated.
Matching Principle: Ensures expenses are matched with revenues in the period they are incurred.
*Later you will study in detail about Accounting Concepts and Principles in Unit 7.1
Importance of Correct Inventory Valuation
Gross Profit: Incorrect inventory valuation affects the cost of sales, thereby impacting the gross profit.
Profit for the Year: Incorrect valuation can overstate or understate the profit for the year.
Equity: The value of inventory affects the value of assets, which in turn impacts the owner's equity.
Asset Valuation: Accurate inventory valuation ensures the statement of financial position reflects a true and fair view of the company's assets.
Scenario-Based Inventory Valuation Example
Scenario:
Imagine a company, ABC Traders, dealing in electronic gadgets. At the end of the financial year, they need to value their inventory for accounting purposes. The details of their inventory are as follows:
Cost of Inventory: $15,000
Estimated Selling Price: $18,000
Estimated Costs to Complete and Sell: $4,000
NRV Calculation:
NRV=Estimated Selling Price−Estimated Costs
NRV=18,000−4,000=14,000
Valuation:
Since the cost of the inventory ($15,000) is higher than the NRV ($14,000), the inventory should be valued at $14,000.
Explanation:
Cost of Inventory: This includes all expenses incurred to bring the inventory to its present condition and location, which is $15,000 in this case.
Estimated Selling Price: This is the price at which the inventory is expected to be sold, which is $18,000.
Estimated Costs to Complete and Sell: These are the additional costs required to make the sale, amounting to $4,000.
Comparison:
Cost: $15,000
NRV: $14,000
As per the prudence concept in accounting, inventory should be valued at the lower of cost or NRV to prevent overstatement of assets and profits.
Importance of Accurate Inventory Valuation
Impact on Financial Statements:
Statement of financial position (balance sheet): An overvalued inventory will overstate assets.
Statement of profit or loss (Income Statement): An overvalued inventory will understate the cost of goods sold (COS), leading to an overstated gross profit and net profit.
Equity: Overvaluation inflates the equity of the business.
Decision Making:
Accurate inventory valuation provides a true picture of the business’s financial health, aiding in better decision-making by management and stakeholders.
Explanation of Recording Inventory at Lower Cost with Example (Detailed)
When valuing inventory, a business uses the lower of cost or net realizable value (NRV) principle to ensure that inventory is not overstated on financial statements. This principle aligns with the conservatism concept in accounting, which advises caution in financial reporting to prevent overestimation of assets and income.
Example: i-tech ltd sells laptops to the customers, they buy incomplete laptops from suppliers. I-tech ltd then assemble, pack and ship finished laptops to the customers.
I-tech ltd provided the following information.
Cost of Inventory: $50,000
Estimated Selling Price: $70,000
Estimated Costs to Complete and Sell:
Assembly Costs: $10,000
Packaging Costs: $2,000
Shipping Costs: $3,000
Sales Commission: $1,000
Advertising Costs: $1,000
Total Estimated Costs to Complete and Sell: $17,000
NRV Calculation:
NRV=Estimated Selling Price − Estimated Costs to Complete and Sell
NRV= 70,000 − 17,000
NRV =53,000
Valuation:
Since the cost of the inventory ($50,000) is lower than the NRV ($53,000), the inventory should be valued at $50,000.
Does it mean i-tech is simply ignoring the higher cost $17000?
Addressing the Additional $17,000 Cost:
Valuing the inventory at $50,000 does not mean the business ignores the $17,000 estimated costs to complete and sell. These costs are considered when calculating NRV but are not recorded in the inventory value on the statement of financial position. Instead, they are accounted for as expenses when incurred, impacting the statement of profit or loss accordingly.
Illustration with Financial Statements:
Statement of Financial Position (Balance Sheet):
Inventory will be listed at $50,000 under current assets.
Statement of Profit or Loss (Income Statement):
When the additional costs are incurred (assembly, packaging, shipping, etc.), they will be recorded as expenses.
Revenue from the sale of the completed laptops will be recorded when sales occur.
The difference between the revenue and the total costs (including the initial inventory cost and additional costs) will determine the gross profit.
Benefits of Valuing Inventory at the Lower Cost:
Avoids Overstatement of Assets: By valuing inventory at the lower cost, i-tech Ltd avoids inflating its assets on the statement of financial position. This conservative approach ensures that the financial statements present a realistic view of the company's financial position.
Prevents Overstated Profits: Overstating inventory would lead to lower cost of sales (COS) and higher profits. By valuing inventory at $50,000, the company maintains an accurate representation of its profit margins, thus avoiding future corrections that could impact investor confidence.
Aligns with Accounting Standards: Adhering to the lower of cost or NRV principle ensures compliance with accounting standards like International Financial Reporting Standards (IFRS) and Generally Accepted Accounting Principles (GAAP), which require this conservative approach to inventory valuation
