Adjustments for Inventory Valuation (Cambridge International A-Level Accounting)

Spec point — how to calculate and record the adjustments needed and the effect on financial statements in respect of: – inventory valuation

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

Worked Example Chen purchased an item of inventory for $15 and paid an extra $3 for delivery charges.

Chen accidentally damages the item. If he spent $8, he could sell it for $24.

What is the value of the item of inventory?

Answer:

• Find the total cost of the item by adding the delivery charge to the purchase cost

$15 + $3 = $18

• Find the net realisable value by subtracting the repair cost from the selling price

$24 - $8 = $16

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

Final answer: The inventory is valued at $16

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

Worked Example Qays ends his financial year at 31 March each year.

On 31 March 2023, Qays incorrectly values his inventory at its net realisable value. For each item, the net realisable value is higher than the cost price.

Which of the following is not true?

A	The gross profit for the year ended March 2023 was understated.
B	The profit for the year ended March 2024 was understated.
C	The total assets at 31 March 2024 was not affected.
D	The capital at 31 March 2023 was overstated.

Answer:

The inventory should be valued at the lower of cost and net realisable value. Therefore the inventory has been overstated.

Qays' value is used for the closing inventory for the year ended 31 March 2023, therefore for that year:

• The gross profit and the profit for the year have been overstated
• The total assets have been overstated
• The capital has been overstated

Qays' value is used for the opening inventory for the year ended 31 March 2024, therefore for that year:

• The gross profit and the profit for the year have been understated
• The total assets and capital are not affected

Final answer: Therefore, the correct answer is A.