IGCSE Accounting Ch 14: Valuation of Inventory

Cambridge IGCSE Accounting

Valuation of Inventory

This chapter explains what inventory means, how closing inventory is valued, how cost and net realisable value are compared, how inventory affects cost of sales, and how inventory errors affect profit, assets and the following year.

InventoryClosing inventoryCost vs NRVPrudenceCost of inventoryCost of salesError effectsExam rules

Inventory types for traders and manufacturers

Topic 1: What Inventory Means

Inventory is goods held for resale that remain unsold at the end of the accounting period.

1. What is Inventory?

Inventory means goods held by a business for resale but which remain unsold at the end of the accounting period.

For a trader, inventory mainly consists of goods bought for resale.

For a manufacturer, inventory may include:

Type	Meaning
Raw materials	Materials not yet used in production.
Work in progress	Goods partly completed.
Finished goods	Completed goods not yet sold.

Closing inventory is the inventory counted at the end of the year. This year's closing inventory becomes next year's opening inventory.

Correct inventory valuation is important because inventory affects both cost of sales and current assets.

Topic 2: Lower of Cost and Net Realisable Value

Inventory must be valued at the lower of cost and net realisable value, item by item.

2. How Should Inventory Be Valued?

Inventory must be valued at: Lower of Cost and Net Realisable Value (NRV)

This follows the prudence principle, which prevents assets and profits from being overstated.

Inventory is valued at the lower of cost and net realisable value

Example 1

Cost of inventory = $500
NRV = $650

Use lower figure: $500

Example 2

Cost = $500
NRV = $420

Inventory value: $420

3. What is Cost of Inventory?

The cost of inventory includes the purchase price plus costs necessary to bring the goods into a saleable condition.

Included in Cost	Example
Purchase price	Cost of goods
Carriage inwards	Transport to bring goods to the business
Import duties	Duties paid when importing goods
Packaging and handling	Necessary costs to prepare goods

Example
Goods purchased = $5,000
Carriage inwards = $300
Import duty = $200

Cost of inventory$5,000 + $300 + $200$5,500

4. Net Realisable Value

Net realisable value (NRV) is the estimated selling price of inventory less the costs necessary to complete and sell it.

NRV = Estimated Selling Price − Costs of Completion and Sale

Example
Damaged goods can be sold for $700, but repairs costing $150 are required before they can be sold.

NRV$700 − $150$550

If the goods originally cost $800:
Cost = $800
NRV = $550
Therefore, inventory value = $550 because NRV is lower.

5. Why Might NRV Fall Below Cost?

NRV can fall below cost when goods become:

DamagedBroken furniture

DefectiveFaulty electronics

ObsoleteOld technology

Out of fashionLast season's clothing

OversuppliedToo much stock available

Affected by falling pricesMarket price falls sharply

6. Each Inventory Item Must Be Valued Separately

You must compare the cost and NRV of each type of inventory separately.

Item	Cost $	NRV $	Value Used $
A	500	560	500
B	400	230	230
C	240	170	170
Total inventory			900

For each item, choose the lower amount. It is incorrect to add all costs together and compare them with the total NRV.

Topic 3: Inventory and Cost of Sales

Closing inventory is deducted when calculating cost of sales, so valuation errors directly affect profit.

7. Cost of Sales and Closing Inventory

Closing inventory is used when calculating cost of sales.

Cost of sales formula showing opening inventory plus net purchases plus carriage inwards minus closing inventory

Cost of Sales = Opening Inventory + Net Purchases + Carriage Inwards − Closing Inventory

Example
Opening inventory = $5,000
Purchases = $30,000
Carriage inwards = $1,000
Closing inventory = $6,000

Cost of sales$5,000 + $30,000 + $1,000 − $6,000$30,000

8. Effect of Overvaluing Closing Inventory

Suppose actual closing inventory is $4,000, but it is incorrectly recorded as $5,000.

Closing inventory is overvalued by$5,000 − $4,000$1,000

Closing inventory too high→Cost of sales too low→Profit too high

Item	Effect
Cost of sales	Understated
Gross profit	Overstated
Profit for the year	Overstated
Current assets	Overstated
Total assets	Overstated
Owner's equity	Overstated

Easy Example
Correct: Sales = $20,000, Cost of sales = $15,000, Gross profit = $5,000.
If closing inventory is overvalued by $1,000, cost of sales may incorrectly fall to $14,000. Incorrect gross profit = $20,000 − $14,000 = $6,000. Gross profit is therefore overstated by $1,000.

9. Effect of Undervaluing Closing Inventory

If closing inventory is valued too low, the opposite happens.

Closing inventory too low→Cost of sales too high→Profit too low

Item	Effect
Cost of sales	Overstated
Gross profit	Understated
Profit for the year	Understated
Current assets	Understated
Total assets	Understated
Owner's equity	Understated

Overvalued and undervalued closing inventory effects

Closing inventory too high → Profit too high
Closing inventory too low → Profit too low

Topic 4: Following Year Effects and Exam Application

An error in closing inventory affects two accounting years because it becomes the next year's opening inventory.

10. Effect on the Following Year

This year's closing inventory becomes next year's opening inventory. Therefore, an error in closing inventory affects two accounting years.

If Closing Inventory Was Overvalued

This year: Profit is overstated.

Next year: opening inventory is also overvalued. Opening inventory is added to cost of sales, so cost of sales becomes too high and next year's profit becomes understated.

If Closing Inventory Was Undervalued

This year: Profit is understated.

Next year: opening inventory is understated. Therefore, cost of sales becomes too low and next year's profit becomes overstated.

11. Quick Exam Table

Error in Closing Inventory	Current Year's Profit	Following Year's Profit
Overvalued	Overstated	Understated
Undervalued	Understated	Overstated

12. Full Numerical Example

Product A

A shop has 100 units of Product A.

Cost per unit = $20
Selling price per unit = $25
Selling costs per unit = $3

NRV per unit$25 − $3$22

Compare: Cost = $20, NRV = $22. Use $20.

Value100 × $20$2,000

Product B

Product B has 50 units.

Cost = $18 each
Selling price = $17 each
Selling costs = $2 each

NRV per unit$17 − $2$15

Compare: Cost = $18, NRV = $15. Use $15.

Product B value50 × $15$750

Total inventory = $2,000 + $750 = $2,750

This is the method expected when several different inventory items are given.

13. NRV and NBV are Different

Do not confuse these two terms:

NRV — Net Realisable Value

Used mainly for inventory.

Selling price − costs needed to complete/sell.

NBV — Net Book Value

Used for non-current assets.

Cost − accumulated depreciation.

The textbook specifically warns students not to confuse these two terms.

Key Terms

InventoryGoods held for resale but not yet sold.

Closing inventoryInventory remaining at the end of the accounting period.

Net realisable valueEstimated selling price less costs needed to complete and sell the goods.

Cost of salesCost of the goods that were sold during the accounting period.

PrudenceAccounting principle that helps prevent assets and profits from being overstated.

Remember

Inventory valuationLower of Cost and NRV

NRVSelling Price − Costs of Completion/Sale

Closing Inventory ErrorOvervalued closing inventory → Profit overstated
Undervalued closing inventory → Profit understated

Following YearOvervalued opening inventory → Profit understated
Undervalued opening inventory → Profit overstated

Always: Value each class/item of inventory separately at the lower of cost and NRV.