Valuation of Inventory (Copy)

4. Accounting Procedures

4.5 Valuation of Inventory

Definition and Importance of Inventory Valuation

• Inventory refers to goods held for resale or for use in production.
• Inventory must be accurately valued to:
  • Calculate cost of sales
  • Determine gross profit and net profit
  • Present a true and fair view of assets
• The correct valuation affects:
  • Profitability
  • Equity (capital)
  • Asset values in the statement of financial position

Principle of Valuation

Inventory is valued at:

Lower of:

1. Cost
2. Net Realisable Value (NRV)

This follows the prudence concept — avoid overstating profits or assets.

Cost of Inventory

• The cost includes:
  • Purchase price (after trade discount)
  • Transportation or carriage inwards
  • Import duties or taxes
  • Packaging costs (if directly related to goods)

Do not include:

• Carriage outwards (delivery to customer)
• Administration costs
• Selling costs

Net Realisable Value (NRV)

• The estimated selling price of inventory less any costs to complete or sell it.

Formula:
NRV = Expected Selling Price – Estimated Selling Costs

Example:

• Selling price: $200
• Estimated cost to complete and sell: $50
• NRV = $200 – $50 = $150

Valuation Rule:
If Cost = $180 and NRV = $150, then value inventory at $150

If Cost = $120 and NRV = $160, then value inventory at $120

Inventory Valuation Statement Format

Written and Compiled By Sir Hunain Zia, World Record Holder With 154 Total A Grades, 7 Distinctions and 11 World Records For Educate A Change O Level And IGCSE Accounting Full Scale Course

Effect of Incorrect Inventory Valuation

1. Overvalued Closing Inventory

If inventory is valued higher than correct value:

2. Undervalued Closing Inventory

If inventory is valued lower than correct value:

Worked Example: Overvaluation vs Undervaluation

Correct closing inventory = $5,000
Scenario 1: Inventory is overvalued at $6,000

• Cost of sales ↓ by 1,000
• Gross profit ↑ by 1,000
• Net profit ↑ by 1,000
• Assets and capital ↑ by 1,000

Scenario 2: Inventory is undervalued at $4,000

• Cost of sales ↑ by 1,000
• Gross profit ↓ by 1,000
• Net profit ↓ by 1,000
• Assets and capital ↓ by 1,000

Matching Principle and Prudence in Inventory Valuation

• Inventory valuation ensures expenses (cost of sales) are matched against revenue earned.
• It follows the prudence concept by not overstating assets or profit.

If NRV < Cost, reduce value → possible loss should be recognised
If NRV > Cost, retain cost → possible gain should not be anticipated

Impact on Financial Statements

Written and Compiled By Sir Hunain Zia, World Record Holder With 154 Total A Grades, 7 Distinctions and 11 World Records For Educate A Change O Level And IGCSE Accounting Full Scale Course

Common Errors in Inventory Valuation