Valuation of Inventory (Copy)
VALUATION OF INVENTORY — COMPLETE O LEVEL & IGCSE ACCOUNTING GUIDE
BASIC DEFINITIONS
| Concept | Detailed Explanation | Common Mistakes | Examiner Expectations |
|---|---|---|---|
| Inventory | Goods held for resale by a business. | Including non-current assets. | Must mention resale purpose. |
| Closing Inventory | Inventory remaining unsold at end of accounting period. | Confusing with purchases. | End-of-year inventory important. |
| Opening Inventory | Inventory held at beginning of accounting period. | Mixing with closing inventory. | Beginning balance required. |
| Cost of Sales | Cost of inventory sold during the year. | Using sales value instead of cost. | Must use inventory cost figures. |
INVENTORY VALUATION PRINCIPLE
| Principle | Explanation | Common Errors |
|---|---|---|
| Lower of Cost and Net Realisable Value | Inventory valued at whichever is lower. | Choosing higher value |
| Prudence Principle | Expected losses recognised immediately. | Ignoring possible losses |
| Historical Cost | Inventory initially recorded at purchase cost. | Using selling price |
COST OF INVENTORY
| Included in Cost | Not Included in Cost |
|---|---|
| Purchase price | Carriage outwards |
| Carriage inwards | Selling expenses |
| Import duty | Administration expenses |
| Direct buying expenses | Distribution costs |
NET REALISABLE VALUE (NRV)
| Concept | Explanation | Common Mistakes |
|---|---|---|
| NRV | Expected selling price less selling/completion costs. | Forgetting selling expenses |
| Formula | Selling Price − Selling Costs | Using purchase price |
| Purpose | Prevents overstating inventory value | Weak explanation |
FORMULA FOR COST OF SALES
text{Cost of Sales} = text{Opening Inventory} + text{Purchases} + text{Carriage Inwards} – text{Closing Inventory}
COST OF SALES FORMAT
| Â | $ |
|---|---|
| Opening Inventory | XXXX |
| Add Purchases | XXXX |
| Add Carriage Inwards | XXXX |
| Goods Available for Sale | XXXX |
| Less Closing Inventory | (XXXX) |
| Cost of Sales | XXXX |
Written and Compiled By Sir Hunain Zia (AYLOTI), World Record Holder With 154 Total A Grades, 11 World Records and 7 Distinctions, Educate A Change.
METHODS OF INVENTORY VALUATION
FIFO (FIRST IN FIRST OUT)
| Feature | Details | Common Mistakes |
|---|---|---|
| Meaning | Oldest inventory assumed sold first. | Selling newest first |
| Closing Inventory | Latest purchases remain in inventory. | Wrong cost assignment |
| Suitable For | Perishable goods/businesses | Weak explanation |
| Effect During Rising Prices | Higher closing inventory and higher profit | Wrong profit effect |
AVCO (AVERAGE COST METHOD)
| Feature | Details | Common Mistakes |
|---|---|---|
| Meaning | Inventory valued using average cost per unit. | Averaging selling prices |
| Formula | Total Cost ÷ Total Units | Using wrong totals |
| Purpose | Smooths price fluctuations | Weak explanation |
| Effect | Moderate inventory valuation | Incorrect comparisons |
FIFO FORMAT
| Date | Units In | Cost Per Unit | Units Out | Balance Units | Balance Cost |
|---|
AVCO FORMAT
| Total Units | Total Cost ($) | Average Cost Per Unit ($) |
|---|---|---|
| XXXX | XXXX | XXXX |
LOWER OF COST AND NRV RULE
| Situation | Inventory Value Used |
|---|---|
| Cost lower than NRV | Use cost |
| NRV lower than cost | Use NRV |
| Both equal | Either accepted |
EXAMPLE OF LOWER OF COST AND NRV
| Item | Cost ($) | NRV ($) | Value Used ($) |
|---|---|---|---|
| A | 100 | 90 | 90 |
| B | 80 | 95 | 80 |
| C | 70 | 70 | 70 |
REASONS FOR NRV FALLING BELOW COST
| Reason | Explanation |
|---|---|
| Damage | Goods lose value |
| Obsolescence | Outdated inventory |
| Falling Selling Prices | Market value declines |
| Deterioration | Inventory quality reduces |
Written and Compiled By Sir Hunain Zia (AYLOTI), World Record Holder With 154 Total A Grades, 11 World Records and 7 Distinctions, Educate A Change.
INVENTORY IN FINANCIAL STATEMENTS
| Financial Statement | Treatment |
|---|---|
| Income Statement | Deducted in cost of sales |
| Statement of Financial Position | Current asset |
DOUBLE ENTRY FOR CLOSING INVENTORY
| Debit Entry | Credit Entry |
|---|---|
| Closing Inventory Account | Income Statement/Trading Account |
INVENTORY ACCOUNT FORMAT
| Debit (Dr) | Inventory Account | Credit (Cr) |
|---|---|---|
| Opening Inventory | Â | Income Statement |
| Balance c/d | Â | Â |
EFFECT OF INVENTORY ERRORS ON PROFIT
| Error | Effect on Profit |
|---|---|
| Closing inventory overstated | Profit overstated |
| Closing inventory understated | Profit understated |
| Opening inventory overstated | Profit understated |
| Opening inventory understated | Profit overstated |
EFFECT OF INVENTORY ERRORS ON SOFP
| Error | Effect on Assets |
|---|---|
| Closing inventory overstated | Assets overstated |
| Closing inventory understated | Assets understated |
COMMON EXAM MISTAKES
| Mistake | Why It Loses Marks |
|---|---|
| Including carriage outwards in inventory cost | Selling expense only |
| Using selling price instead of cost | Inventory recorded at cost/NRV |
| Choosing higher value instead of lower | Breaks prudence principle |
| Wrong FIFO sequence | Incorrect inventory valuation |
| Forgetting selling costs in NRV | NRV overstated |
| Using average selling price in AVCO | Must use cost |
FREQUENTLY TESTED TRAPS
| Trap | Correct Handling |
|---|---|
| Carriage inwards | Included in inventory cost |
| Carriage outwards | Excluded from inventory cost |
| Damaged goods | Use NRV if lower |
| Obsolete goods | NRV may fall below cost |
| Closing inventory | Current asset |
| Opening inventory | Included in cost of sales |
Written and Compiled By Sir Hunain Zia (AYLOTI), World Record Holder With 154 Total A Grades, 11 World Records and 7 Distinctions, Educate A Change.
ADVANTAGES AND DISADVANTAGES OF METHODS
| Method | Advantages | Disadvantages |
|---|---|---|
| FIFO | Realistic closing inventory values | Profit may fluctuate |
| AVCO | Smooths price changes | Less realistic in some situations |
HIGH-SCORING EXAM TECHNIQUES
| Question Type | Best Approach |
|---|---|
| Inventory valuation | Apply lower of cost and NRV carefully |
| FIFO questions | Remove oldest inventory first |
| AVCO questions | Calculate average accurately |
| Theory questions | Mention prudence principle |
| Inventory errors | Analyse effect on profit and assets separately |
QUICK REVISION SUMMARY
| Item | Key Point |
|---|---|
| Inventory | Goods for resale |
| NRV | Selling price − selling costs |
| Inventory Rule | Lower of cost and NRV |
| FIFO | Oldest inventory sold first |
| AVCO | Average cost method |
| Carriage Inwards | Included in inventory cost |
| Carriage Outwards | Excluded from inventory cost |
Written and Compiled By Sir Hunain Zia (AYLOTI), World Record Holder With 154 Total A Grades, 11 World Records and 7 Distinctions, Educate A Change.