IGCSE Accounting 0452 - 4.5 Valuation of Inventory

Objective

Understand the basis of the valuation of inventory at the lower of cost and net realisable value (NRV).

Introduction

Inventory represents the value of goods held for sale by a business. Accurately valuing inventory is crucial for preparing the financial statements, as it directly impacts the profit or loss account and the balance sheet. This section focuses on the rule of valuing inventory at the lower of cost and net realisable value (NRV).

Cost of Inventory

The cost of inventory includes all the costs incurred to acquire the goods and bring them to a presentable condition for sale. This typically includes:

• Purchase price
• Transport costs
• Insurance costs
• Storage costs
• Any other direct costs associated with obtaining and holding the inventory

Net Realisable Value (NRV)

Net Realisable Value (NRV) is the estimated selling price of the inventory less any costs relating to its completion and sale.

The calculation for NRV is:

$$NRV = Estimated\, Selling\, Price - Costs\, to\, Complete\, and\, Sell$$

The Lower of Cost and NRV Rule

The accounting rule requires that inventory is valued at the lower of its cost and its net realisable value. This principle is known as the 'lower of cost and NRV' rule.

This rule is based on the matching principle, which states that expenses should be recognised in the same period as the revenues they help to generate. If the NRV is lower than the cost, it indicates that the inventory is likely to be sold at a loss, and therefore, the inventory should be written down to its NRV.

When to Apply the Rule

The lower of cost and NRV rule is applied when:

• Inventory has become obsolete (outdated or no longer in demand).
• Inventory has been damaged.
• Market prices for the inventory have fallen.
• There are other reasons why the inventory is unlikely to be sold at its original cost.

Example

A business purchased a batch of goods for $1000. The estimated costs to complete and sell these goods are $100. The estimated selling price is $1200.

Calculation of NRV:

$$NRV = \$1200 - \$100 = \$1100$$

In this case, the NRV ($1100) is higher than the cost ($1000). Therefore, the inventory should be valued at $1100.

However, if the estimated selling price was only $900, the calculation would be:

$$NRV = \$900 - \$100 = \$800$$

In this scenario, the NRV ($800) is lower than the cost ($1000). Therefore, the inventory should be valued at $800.

Accounting Treatment

When inventory is written down to NRV, the following journal entry is made:

Account	Debit	Credit
Inventory
Inventory Valuation Adjustment (or Loss on Sale)
(To reduce inventory to NRV)

This entry reduces the carrying amount of the inventory on the balance sheet and reduces the profit or loss account by the amount of the loss.

Importance of the Rule

Applying the lower of cost and NRV rule ensures that the financial statements present a realistic view of the company's financial position. It prevents overstating the value of inventory and provides a more accurate assessment of profitability.