Inventory Valuation
Inventory-Stock of Goods: these are those products which are brought or manufactured for resale yet unsold.
In accounting, we do not prepare the ledger account for inventory; instead of inventory is counted or valued.
As per prudence concept inventory is valued at lower of cost and net realizable value.
Cost = Purchase Price + all cost associated with Purchases |
NRV= Net realizable Value= Selling Price – all costs associated with Sales. |
There are three cash flow assumptions of valuing inventory and two methods of doing so. The three cash flow assumptions are:
1. FIFO (First in First Out)
2. LIFO (Last in First Out)
3. AVCO (Average Cost of Inventory)
As per the O’level syllabus outline, their calculations are not a part of the syllabus.
If an inventory is not valued at the end of the period, it is practically not possible to prepare the financial statements. Therefore, if inventory is valued before the accounting year ended or after the accounting year ended, we have to adjust those inventory figures to ensure that we obtain the valuation of inventory on the last day of the accounting period.
Inventory Valuation Forwards |
Q: What are goods sent on sale or return basis?
Answer:
If the business sends goods to its customers on sale or return basis, it is an indication that sale is not yet made because the person who has received the goods have not yet confirmed whatever he has brought them or not. When inventory is counted, such goods are automatically not there in inventory, but they should be part of inventory since they are not yet sold and hence must be added to inventory at cost price. Similarly, goods acquired on the purchase or return basis are not part of the company’s inventory because the business has not yet confirmed that they have bought them, and hence although when doing inventory valuation, they exist in business and are counted in inventory, they should be deducted from inventory.
How to Convert Selling Price into Cost Price
Selling Price is $480 markup is 20%
Markup =20%
Cost = 100% - ?
S.P= 120% → 480
Selling Price is $500 margin is 10%
Margin =10%
Sales = 100% →500
Cost= 90% →?
(90/100) * 500=$450
Sales Returns are %220, markup is 10%
Markup =10%
Cost = 100% -?
S.P= 110% →220
(100/110) * 220=$200
Sales Returns are %40, Margin is 30%
Margin =30%
Sales = 100% →40
Cost= 70% →?
(70/100) * 40=$28
If an incorrect value is placed on the inventory, it will affect the gross profit and the net profit for both the current financial year and the following financial year incorrect values will also be shown for both current assets and capital in the balance sheet. Inventory is always valued at the lower of cost on net realizable value. This is an application of the principle of prudence as over-valuing the inventory causes both the profit and the assets to be overvalued. The cost of the inventory is the actual purchase price plus any additional cost (such as carriage, freight) incurred in bringing the inventory to its present position and condition. The net realizable value is the estimated receipts from the sale of inventory, less any cost of completing the goods, or the cost of selling the goods. Usually, the cost of the inventory will be lower than the net realizable value. It may happen that the goods are damaged, or there is no demand for such type of goods because of change in taste or fashion. In this situation, the net realizable value will be lower than the cost.
Example:
Sara traders sell two different types of goods, type A and B. They provide the following information on 31 Dec 2007. You must calculate the value of the closing inventory of Sara traders on 31 Dec 2007.
SOLUTION:
• Type A has been valued at net realizable value, as this is below the cost price.
• Type B has been valued at cost price as this is below the net realizable value.