IGCSE Valuation of Inventory
This lesson covers the rules for valuing inventory by understanding what does cost of inventory and net realisable value of inventory means. We also learn how to prepare the inventory valuation statement and the impact of incorrect valuation on gross profit, profit for the year, owner’s equity and asset valuation.
Related Lessons:
Basis of Valuation of Inventory
Inventory is valued at the lower of cost or net realisable value.
Cost of inventory is the total cost incurred to acquire the goods and is calculated by adding net purchase price to transportation related cost and preparation cost.
Example:
Original purchase price is $5,000
Trade discount is at 10%
Freight charges are $200
Insurance on transportation is $50
Cost to prepare inventory for resale is $80
Total cost of inventory = (5,000 x 90%) + 200 + 50 + 80 = $4,830
Net realisable value is the estimated selling price of the goods less all cost required to make the sale.
Example:
Estimated selling price is $8,000
Cost required for resale is $1,200
Net realisable value = 8,000 – 1,200 = $6,800
Where Cost is lower than Net Realisable Value, Inventory is valued at Cost.
Where Cost is higher than Net Realisable Value, Inventory is valued at Net Realisable Value.
Inventory Valuation Statement
For a business that sells various types of goods, the inventory valuation statement is prepared to show the total valuation of inventory of the business.
This statement lists each type of goods sold by the business. For each item, it clearly shows the total quantity, unit cost price, unit net realisable value, inventory value per unit, and the total value of inventory.
Effect of Incorrect Valuation on Closing Inventory
Effect on Gross Profit and Profit for the Year
Closing inventory is deducted from the total goods available for sale in the Income Statement.
When closing inventory is overstated, more goods are treated as unsold. This results in a lower cost of sales, which leads to an overstated gross profit. Consequently, the profit for the year is also overstated.
Effect on Asset
Closing inventory is recorded as a current asset. If it is overstated, current assets will be overstated, and this will also lead to an overstatement of total assets.
Effect on Equity
Profit for the year is added to capital to determine owner’s equity. Therefore, an overstated profit for the year will result in an overstated equity.
Effect of Incorrect Valuation on Opening Inventory
Effect on Gross Profit and Profit for the Year
Opening inventory is added to current year’s purchases to calculate the goods available for sale in the Income Statement.
When opening inventory is overstated, more goods are deemed available for sale. This results in a higher cost of sales, which leads to an understatement of the gross profit. Consequently, the profit for the year is also understated.
Effect on Asset
An incorrect opening inventory does not affect current assets, as it is treated as sold and therefore removed from current assets. Consequently, total assets are also not affected.
Effect on Equity
An overstated closing inventory in the previous accounting year is carried forward as an overstated opening inventory in the current year.
An overstated closing inventory in the previous accounting year resulted in an overstated profit for the year and thus an overstated capital amount is being brought over to the current year.
An overstated opening inventory leads to an understatement of profit in the current year.
When the current year’s understated profit is added to an overstated capital, the error offset each other. Therefore, the overall effect on equity is neutralised.