Adjustments for Inventory Valuation (Cambridge (CIE) AS Accounting): Revision Note

Adjustments for inventory valuation

What is the cost and net realisable value of inventory?

• The cost of inventory is the total cost to the business of obtaining goods

  • The purchase cost of the goods

  • Plus the cost for carriage inwards

• The net realisable value (NRV) of inventory is the net amount the business is likely to receive when selling the goods

  • The selling price of the inventory 

  • Minus any selling expenses

    • Such as the cost of repairing damaged goods

What is the basis for the valuation of inventory?

• Inventory is valued at the lower value between:

  • The cost

  • The net realisable value

• This method of valuation complies with the accounting principle of prudence

  • The value of the inventory (asset) is not overstated

  • The profit is not overstated

• For most inventory, the cost will be the lower of these values; however, there are some exceptions

  • Damaged goods might need to be repaired before they can be sold

  • Goods that are close to their expiration date might need to be sold at a lower price

  • The business might use lower prices to promote new products

How does an incorrect valuation of inventory affect profit?

• Inventory valuation affects both the gross profit and the profit for the year

  • Both are affected in the same way and by the same amount

• The opening inventory value is debited to the statement of profit or loss

  • The opening inventory is an expense that is matched to the current financial period’s revenue

  • It is added to the cost of sales for the current period

  • Therefore, opening inventory decreases the profit

• The closing inventory value is credited to the statement of profit or loss

  • The closing inventory is an expense that is matched to the next financial period’s revenue

  • It is subtracted from the cost of sales for the current period

  • Therefore, closing inventory increases the profit

• The table below shows how incorrect inventory valuation affects the gross profit and the profit for the year

  • The effects depend on whether it is the opening or closing inventory

How does an incorrect valuation of inventory affect capital and asset valuation?

• Inventory valuation affects both the capital and the asset valuation

• At the end of a financial period, the closing inventory is stated on the statement of financial position under current assets

  • Therefore, the valuation of the closing inventory directly affects the asset valuation

• The opening inventory is not stated on the statement of financial position

  • Therefore, the valuation of the opening inventory has no effect on the asset valuation

• The valuation of the closing inventory also affects the capital value in the statement of financial position

  • It affects the profit for the year, which is recorded as an element of capital in the statement of financial position

• The valuation of the opening inventory has no effect on capital at the end of the current period

  • The profit for the previous period would have been understated or overstated

    • This would mean the capital at the end of the previous period was incorrect

  • The profit for the current period would be understated or overstated

    • This would normally affect the capital at the end of the current year

  • However, the effects cancel each other out so that the capital at the end of the current year is unaffected

• The table below shows how incorrect inventory valuation affects capital and asset valuation

  • The effects depend on whether it is the opening or closing inventory