Valuation of Inventory

The fundamental rule: inventory must be valued at the lower of its cost and its net realisable value (NRV).

Why? The prudence concept prevents overstating assets. If inventory can only be sold for less than it cost, the loss in value should be recognised NOW (in the current period) rather than deferred to when the inventory is eventually sold.

Cost of inventory includes:

• The purchase price (net of trade discounts)
• Import duties and taxes
• Carriage inwards (freight costs to bring goods to the warehouse)
• Other directly attributable costs

Cost does NOT include: settlement discounts (cash discounts for early payment), abnormal wastage, selling costs, or storage costs after arrival.

Net Realisable Value (NRV): $\text{NRV} = \text{Estimated selling price} - \text{Estimated costs to complete and sell}$

Example:

• 100 units in inventory; cost per unit = $8.00; NRV per unit = $6.50.
• Since NRV ($6.50) < cost ($8.00), value inventory at NRV: 100 × $6.50 = $650.
• If NRV were $9.00, value at cost: 100 × $8.00 = $800.

Application: Apply the lower-of rule to EACH LINE of inventory separately (not the total), as some items may be above cost and others below.

FIFO (First In, First Out) assumes that the oldest inventory purchased is the first to be sold. The inventory remaining at year-end is therefore made up of the MOST RECENTLY purchased goods.

Inventory record (FIFO):

Data: Opening inventory 100 units @ $5.00. Purchases: 200 units @ $6.00, then 150 units @ $7.00. Sales: 300 units.

Transaction	Units In	Cost $	Units Out	Cost $	Balance
Opening					100 @ $5.00
Purchase 1	200	@$6.00			100@$5, 200@$6
Sales: 300 units out			100@$5, 200@$6	$1 600	0 units
Purchase 2	150	@$7.00			150@$7.00

Closing inventory = 150 units × $7.00 = $1 050 (at most recent prices).

FIFO cost of sales: Cost of sales = Opening inventory + Purchases − Closing inventory = $500 + ($1 200 + $1 050) − $1 050 = $1 700

Key FIFO characteristics:

• Closing inventory is at the MOST RECENT (newest) prices.
• In a period of RISING prices, closing inventory is HIGHER → Cost of sales is LOWER → Gross profit is HIGHER.
• In a period of FALLING prices, the reverse applies.

AVCO (Weighted Average Cost) calculates a new average cost per unit after EVERY purchase. All units of inventory are then valued at this average cost.

Formula for new average cost:

$\text{New average cost} = \frac{\text{Total value of inventory after purchase}}{\text{Total units in inventory}}$

Inventory record (AVCO) — using same data as FIFO example above:

Transaction	Units In	Unit Cost $	Total Value $	Units Balance	Avg Cost $	Total Value $
Opening				100	5.00	500
Purchase 1	200	6.00	1 200	300	5.67	1 700
Sales 300				0	5.67	0
Purchase 2	150	7.00	1 050	150	7.00	1 050

New average after Purchase 1: ($500 + $1 200) ÷ 300 = $1 700 ÷ 300 = $5.67

After selling 300 units: balance = 0.

After Purchase 2: 150 units @ $7.00 → closing inventory = $1 050.

Note: If there were remaining units before Purchase 2, the new average would blend the old and new prices.

AVCO characteristics:

• Smooths out price fluctuations.
• Results in a closing inventory value BETWEEN FIFO and the most recent cost.
• In rising prices: AVCO gives LOWER closing inventory than FIFO → lower gross profit than FIFO.

The choice between FIFO and AVCO affects the value of closing inventory, which directly affects cost of sales and therefore gross profit.

Cost of sales formula: $\text{Cost of sales} = \text{Opening inventory} + \text{Purchases} - \text{Closing inventory}$

If closing inventory is HIGHER (FIFO in rising prices) → Cost of sales is LOWER → Gross profit is HIGHER. If closing inventory is LOWER (AVCO in rising prices) → Cost of sales is HIGHER → Gross profit is LOWER.

Summary table:

Condition	FIFO closing inventory	AVCO closing inventory	FIFO profit vs AVCO profit
Rising prices	Higher	Lower	FIFO profit HIGHER
Falling prices	Lower	Higher	FIFO profit LOWER
Stable prices	Same	Same	Same

Consistency principle: A business should use the SAME inventory valuation method from one year to the next. Changing the method changes reported profit without any real change in economic activity — this can mislead users of financial statements.

Cambridge examiner note: When asked to compare methods, always state:

1. Which method gives higher/lower closing inventory.
2. Which method gives higher/lower gross profit.
3. Why this is (link to price trend — rising or falling prices).

Inventory count (stocktake): A physical count of all inventory held at the year-end (or at another date). The counted quantities are then valued using the chosen method (FIFO or AVCO) to determine the closing inventory figure for the financial statements.

Discrepancies between records and count: If the physical count differs from the book records (perpetual inventory system), possible causes include:

• Wastage or damage (goods spoiled and discarded)
• Theft or pilferage
• Recording errors (items received or issued incorrectly entered)
• Goods received but not yet recorded

Effect of inventory errors on profit: Since closing inventory appears in the cost-of-sales calculation, an error in closing inventory directly distorts gross profit:

• Closing inventory OVERSTATED (counted too high):

  • Cost of sales understated → Gross profit OVERSTATED
  • Next year: opening inventory overstated → cost of sales overstated next year → next year's profit UNDERSTATED

• Closing inventory UNDERSTATED (counted too low):

  • Cost of sales overstated → Gross profit UNDERSTATED
  • Next year's profit OVERSTATED (counterbalancing effect)

Key principle: Inventory errors have a SELF-CORRECTING effect over two periods — the overstatement in one year is reversed in the next. However, each individual year's profit is still misstated.