4.5 Valuation of inventory (3)
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1.
Explain the difference between the cost method and the current cost method of valuing inventory. Discuss the advantages and disadvantages of each method, considering the potential impact on a company's reported profit and financial position.
Cost Method: The cost method values inventory at its historical cost – the original purchase price plus any costs to bring it to its current condition. This method reflects the actual cost incurred by the business.
- Advantages: Provides a realistic view of the cost of goods sold. Generally accepted accounting principle (GAAP) compliant.
- Disadvantages: May not reflect the current market value of the inventory. Can lead to an underestimation of inventory value if market prices have increased.
Current Cost Method: The current cost method values inventory at its current market value – the price it could be sold for at the time of the balance sheet. This method reflects the most up-to-date value of the inventory.
- Advantages: Reflects the current economic reality of the inventory. Provides a more accurate representation of the company's financial position.
- Disadvantages: Can lead to fluctuations in reported profit due to changes in market prices. May not be acceptable under all accounting standards.
Impact on Profit and Financial Position:
| Method | Impact on Profit | Impact on Financial Position |
| Cost Method | Generally stable profit, reflects actual cost. | Inventory value may be understated, potentially understating assets. |
| Current Cost Method | Profit can fluctuate with market prices. | Inventory value reflects current market value, potentially overstating assets. |
2.
A company purchased goods for £25,000. The goods were subsequently sold for £30,000. However, the company incurred £5,000 in costs to complete and sell the goods. Calculate the net realisable value (NRV) of the inventory and explain how this value should be recorded in the company's financial statements.
Calculation of NRV:
| Selling Price: £30,000 | Less: Costs to complete and sell: £5,000 | Net Realisable Value (NRV): £25,000 |
Recording in Financial Statements:
The NRV of £25,000 should be recorded in the company's statement of financial position (Balance Sheet) as the carrying amount of the inventory. The original cost of £25,000 should be reduced by the impairment loss of £5,000, resulting in a reduced carrying value of £20,000. The £5,000 impairment loss should be recognised in the profit and loss account as a reduction in profit.
3.
Question 2
The opening inventory of a company is £8,500. A stocktake reveals the following details:
- Goods available for sale: £15,000
- Closing inventory: £6,200
Prepare a simple inventory valuation statement.
Inventory Valuation Statement
| Opening Inventory | £8,500 |
| Add: Purchases | £7,000 |
| Less: Closing Inventory | £6,200 |
| Total Inventory Valuation | £15,300 |