0452 · 4.5Valuation of inventory

Cost and net realisable value

0:00Inventory means goods held for resale. Imagine a shop with damaged goods that will sell for less than their original purchase price. Recording those goods at their original amount would give an unrealistic value to what remains on the shelves. This video covers the valuation of inventory at the lower of cost and net realisable value. It then shows how to calculate the value of inventory and the effect of an incorrect valuation on profit, equity and assets.

0:24Financial statements are summaries that show a business's profit or loss for a period and what it owns and owes at a date. Revenue is the income a business earns from its main activity, such as selling goods or providing services. Expenses are the costs used up in running the business and earning revenue during a period. Inventory valuation affects both the calculation of expenses and the amount recorded for unsold goods.

0:47Opening inventory is the value of goods held for resale at the start of a financial period. The goods remaining at its end are called closing inventory. Businesses normally count their goods at the year end to establish the quantities remaining. A count made a few days later is adjusted back to the year end. Goods sold since the year end are added back, and goods received since then are taken off.

1:08Cost is the purchase price plus costs of bringing goods to their present location and condition. Carriage inwards is the cost of transporting purchased goods into the business. This delivery cost forms part of inventory cost because the goods must reach the shop before customers can buy them. The amount paid to the supplier is therefore not always the complete cost. Our examples use Nisha Homewares, a shop selling household goods.

1:29One lamp has a purchase price of thirty-six dollars and carriage inwards of four dollars. Thirty-six dollars plus four dollars equals forty dollars. Its inventory cost is forty dollars because both amounts were needed to bring it into the shop. Net realisable value is the expected selling price minus costs to complete and sell the goods. Repairs needed before sale are an example of completion costs. Selling costs might include delivery to the customer that the shop must pay.

1:53This calculation measures the amount the business expects to recover from selling the goods after those remaining costs. Inventory is valued at the lower of cost and net realisable value. Compare these two amounts for each item or product line separately, never for the totals. Choose the smaller amount, then add the selected values. Item-by-item comparison prevents a high expected selling price for one product from hiding a reduction in another product's recoverable amount.

2:18A figure recorded too high is overstated, and one recorded too low is understated. Prudence means that profits and assets are not overstated, and losses and liabilities are not understated. Assets are resources owned or controlled by a business that bring future benefit, while liabilities are amounts the business owes to others. Under prudence, a fall in the amount the goods will recover is recorded now, so their value is never kept unrealistically high.

2:43Profit is the amount by which revenue exceeds expenses for a period. When goods are expected to sell above cost, the additional profit has not yet been earned through a sale. We therefore keep their value at cost. When their net realisable value falls below cost, we recognise that reduction now because the original amount is no longer recoverable.

Worked inventory valuation

3:02Nisha Homewares has ten lamps left at the year end. Each lamp cost forty dollars and is expected to sell for sixty-five dollars. Lamps need no repairs, but selling costs are five dollars per lamp. The shop also has twenty mugs that cost fifteen dollars each. A mug should sell for fourteen dollars, with no repairs and two dollars of selling costs. Finally, Nisha holds five damaged mirrors that cost eighty dollars each.

3:24Each mirror could sell for one hundred and ten dollars after repairs. Repairs will cost thirty dollars per mirror, and selling costs will be ten dollars each. All the figures are per unit, so we must compare per-unit amounts before multiplying by the quantities remaining. For each lamp, sixty-five dollars minus zero dollars minus five dollars gives a net realisable value of sixty dollars. Compare sixty dollars with the cost of forty dollars.

3:47We select forty dollars because it is lower. Ten multiplied by forty dollars gives a lamp inventory value of four hundred dollars. The mugs have a net realisable value of fourteen dollars minus zero dollars minus two dollars. This equals twelve dollars per mug. Twelve dollars is lower than their cost of fifteen dollars, so we use twelve dollars. Twenty multiplied by twelve dollars gives an inventory value of two hundred and forty dollars.

4:11For each damaged mirror, subtract both the repair cost and the selling cost from the expected selling price. One hundred and ten dollars minus thirty dollars minus ten dollars equals seventy dollars. We choose seventy dollars because it is below the eighty-dollar cost. Five multiplied by seventy dollars gives three hundred and fifty dollars for the damaged mirrors. We now add the values selected for the separate product lines. Four hundred dollars plus two hundred and forty dollars plus three hundred and fifty dollars equals nine hundred and ninety dollars.

4:39That is the total closing inventory value. The lamps remain at cost, while the mugs and damaged mirrors are reduced to net realisable value. Comparing the totals instead gives a wrong answer. Adding the cost column gives four hundred plus three hundred plus four hundred dollars, which is eleven hundred dollars. Total net realisable value is six hundred plus two hundred and forty plus three hundred and fifty dollars. That makes eleven hundred and ninety dollars.

5:03Taking the lower total of eleven hundred dollars would overstate inventory by one hundred and ten dollars.

Closing inventory and profit

5:09Cost of sales is the cost of inventory sold during a period. We calculate it as opening inventory plus purchases minus closing inventory. Opening inventory plus purchases gives the goods available for sale during the period. Subtracting the goods still held leaves the cost of the goods that were sold. The statement of profit or loss is the financial statement that shows the revenue, expenses and profit or loss for a period.

5:31Its first profit figure is gross profit, which is revenue minus cost of sales. Profit for the year is the amount by which revenue exceeds expenses over one financial year. An incorrect closing inventory figure changes cost of sales, so it also changes both profit figures. Consider a separate accounting period for Nisha Homewares. Opening inventory is two thousand dollars, and purchases are eleven thousand dollars. Two thousand dollars plus eleven thousand dollars equals thirteen thousand dollars available for sale.

5:59The correct closing inventory is three thousand dollars, but the shop reports three thousand eight hundred dollars. Using the correct figure, thirteen thousand dollars minus three thousand dollars gives cost of sales of ten thousand dollars. The reported calculation subtracts three thousand eight hundred dollars instead. Thirteen thousand dollars minus three thousand eight hundred dollars equals ninety-two hundred dollars. Too much has been treated as unsold, so too little has been charged as cost of sales.

6:26Revenue is eighteen thousand dollars in both calculations. Eighteen thousand dollars minus ten thousand dollars gives correct gross profit of eight thousand dollars. Using reported cost of sales, eighteen thousand dollars minus nine thousand two hundred dollars gives eight thousand eight hundred dollars. The incorrect inventory figure has therefore overstated gross profit. Other expenses are four thousand five hundred dollars and remain unchanged. Eight thousand dollars minus four thousand five hundred dollars gives correct profit for the year of three thousand five hundred dollars.

6:54The reported calculation is eight thousand eight hundred dollars minus four thousand five hundred dollars. This gives four thousand three hundred dollars. Three thousand eight hundred dollars minus three thousand dollars gives an inventory overstatement of eight hundred dollars. Cost of sales is understated by that amount, while gross profit and profit for the year are overstated by eight hundred dollars. The error affects both profit figures equally because the other expenses have not changed.

Effects on assets and equity

7:20Current assets are assets expected to be turned into cash or used up within twelve months. A statement of financial position shows assets, liabilities and owner's equity at a particular date. Closing inventory appears there as a current asset. An overstatement of eight hundred dollars therefore makes current assets and total assets eight hundred dollars too high. Owner's equity, also called capital, is the owner's investment in the business, or the amount the business owes the owner.

7:45Profit for the year is added to the owner's capital at the year end. In our example, owner's equity is therefore overstated by eight hundred dollars as well. The accounting equation states that assets equal liabilities plus owner's equity. It still balances, because assets and owner's equity are both eight hundred dollars too high. An understated closing inventory produces the reverse effects. Subtracting too little makes cost of sales too high, so gross profit and profit for the year are understated.

8:11Current assets, total assets and owner's equity are also understated. Follow the subtraction in the cost of sales calculation rather than trying to recall an isolated list of effects. One year's closing inventory becomes the following year's opening inventory. If the eight-hundred-dollar overstatement is carried forward, the following year's opening amount is too high. With that year's closing inventory correctly valued, cost of sales will be overstated by eight hundred dollars.

8:36Gross profit and profit for the year will therefore be understated by eight hundred dollars in the following year. Over the two years together, total profit is correct, but each single year is wrong.

Key rules and exam application

8:45Carriage inwards always belongs in cost. Net realisable value is found after deducting all necessary completion and selling costs. Compare cost and net realisable value separately for each product line, and only then add the selected values. Also check whether the question concerns opening or closing inventory, because their effects on cost of sales are opposite. Paper One contains forty multiple-choice questions, while Paper Two contains five compulsory structured questions.

9:12You may need to calculate a valuation or identify the effects of an error. Calculate means work out from given figures, state means express in clear terms, and explain means give reasons why and how, supported by evidence. Apply those instructions to the eight-hundred-dollar closing inventory overstatement at Nisha Homewares. Gross profit, profit for the year, current assets and owner's equity are each overstated by eight hundred dollars. Overstated closing inventory reduces cost of sales by eight hundred dollars.

9:40Gross profit is therefore eight hundred dollars too high. Inventory valuation begins with the quantities remaining at the year end. Calculate cost and net realisable value, choose the lower amount for each product line, and add the results. Closing inventory is subtracted when calculating cost of sales and recorded as a current asset. An incorrect valuation therefore affects gross profit, profit for the year, equity and asset valuation.