Inventory Valuation
Closing inventory is valued using one simple rule of prudence: never overstate what it’s really worth.
1. The Lower of Cost and Net Realisable Value
Net realisable value = the expected selling price, minus any further costs needed to complete or sell the item. This follows the prudence concept — never anticipate profits, but do provide for expected losses.
NRV = 600 − 150 = $450. Since NRV ($450) is lower than cost ($500), the inventory is valued at $450.
2. Effect of Incorrect Inventory Valuation
Closing inventory appears in both the statement of profit or loss (reducing cost of sales) and the statement of financial position (as a current asset). If closing inventory is overstated:
- Cost of sales is understated → gross profit is overstated
- Profit for the year is overstated
- Equity (capital) is overstated
- Current assets are overstated
If closing inventory is understated, every one of these effects is reversed.
- Valuing inventory at selling price rather than the lower of cost and NRV — this would recognise profit before the sale actually happens, breaking the prudence concept.
- Forgetting that NRV isn’t just the selling price — it’s the selling price MINUS any further costs to complete or sell the item.
- Applying the lower-of-cost-and-NRV rule to the inventory total as a whole, rather than comparing cost and NRV item by item (or category by category).
Key Vocabulary Recap
Syllabus Reference
Practice questions
Inventory Valuation — Practice
Covers: the lower-of-cost-and-NRV rule, and effects of misvaluation. 10 questions.
State the rule used to value closing inventory.
Define net realisable value.
An item of inventory cost $500. It is expected to sell for $600, but requires a further $150 of processing costs. Calculate the value at which this item should be shown in the accounts.
An item of inventory cost $300. It is expected to sell for $450, with no further costs to sell. Calculate the value at which this item should be shown in the accounts.
Explain why inventory is not valued at its expected selling price.
Explain the effect of overstating closing inventory on gross profit for the year.
Explain the effect of overstating closing inventory on the statement of financial position.
Explain the effect of understating closing inventory on profit for the year.
Explain which accounting concept underlies the lower-of-cost-and-NRV rule.
An item of inventory cost $800. Due to damage, it can now only be sold for $500, after $50 of repair costs. Calculate the value at which this item should be shown in the accounts.
Worked solutions
Show worked solutions
Inventory Valuation — Practice: Solutions
Rule for valuing closing inventory.
Define net realisable value.
Cost $500, sells $600, processing $150.
Cost $300, sells $450, no further costs.
Why not value at selling price?
Effect of overstating closing inventory on gross profit.
Effect of overstating closing inventory on SOFP.
Effect of understating closing inventory on profit.
Which concept underlies the rule?
Cost $800, damaged, sells $500, repair $50.
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