Acca f3 Financial Accounting (int) Study Text

Part D  Recording transactions and events

  8:  Inventory

135

(d) 

Inventories might be valued at the amount it would cost to replace them. This amount is referred to 

as the current replacement cost of inventories. 

Current replacement costs are not used in the type of accounts dealt with in this syllabus.

The use of selling prices in inventory valuation is ruled out because this would create a profit for the 

business before the inventory has been sold. 

A simple example might help to explain this. A trader buys two items of inventory, each costing $100. He 

can sell them for $140 each, but in the accounting period we shall consider, he has only sold one of them. 

The other is closing inventory in hand. 

Since only one item has been sold, you might think it is common sense that profit ought to be $40. But if 

closing inventory is valued at selling price, profit would be $80, ie profit would be taken on the closing 

inventory as well. 

This would contradict the accounting concept of 

prudence, ie to claim a profit before the item has actually 

been sold.

The same objection 

usually applies to the use of NRV in inventory valuation. The item purchased for $100 

requires $5 of further expenditure in getting it ready for sale and then selling it (eg $5 of processing costs 

and distribution costs). If its expected selling price is $140, its NRV is $(140 – 5) = $135. To value it at 

$135 in the statement of financial position would still be to anticipate a $35 profit. 

We are left with 

historical cost as the normal basis of inventory valuation. The only time when historical cost 

is not used is in the exceptional cases where the prudence concept requires a lower value to be used. 

Staying with the example above, suppose that the market in this kind of product suddenly slumps and the 

item's expected selling price is only $90. The item's NRV is then $(90 – 5) = $85 and the business has in 

effect made a loss of $15 ($100 – $85). The prudence concept requires that losses should be recognised 

as soon as they are foreseen. This can be achieved by valuing the inventory item in the statement of 

financial position at its NRV of $85. 

The argument developed above suggests that the rule to follow is that inventories should be valued at 

cost, or if lower, net realisable value. The accounting treatment of inventory is governed by an accounting 

standard, IAS 2 Inventories. IAS 2 states that 

inventory should be valued at the lower of cost and net 

realisable value as we will see below. This is an important rule and one which you should learn by heart.

Inventory should be valued at the lower of cost and net realisable value. 

4.2 Applying the basic valuation rule 

If a business has many inventory items on hand the comparison of cost and NRV should theoretically be 

carried out for each item separately. It is not sufficient to compare the total cost of all inventory items with 

their total NRV. An example will show why. 

Suppose a company has four items of inventory on hand at the end of its accounting period. Their cost 

and NRVs are as follows. 

$

$

Sales

140

Opening inventory

–

Purchases (2 × $100)

200

200

Less closing inventory (at selling price)

140

Cost of sale 

 

  60

Profit

 80

Rule to learn 

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136

8: Inventory   Part D  Recording transactions and events 

 Inventory item 

Cost

NRV

Lower of cost/NRV

$

$

$

1

27

32

27

2

14

8

8

3

43

55

43

4

 

 

29

  40

  29

113

135

107

It would be incorrect to compare total costs ($113) with total NRV ($135) and to state inventories at $113 

in the statement of financial position. The company can foresee a loss of $6 on item 2 and this should be 

recognised. If the four items are taken together in total the loss on item 2 is masked by the anticipated 

profits on the other items. By performing the cost/NRV comparison for each item separately the prudent 

valuation of $107 can be derived. This is the value which should appear in the statement of financial 

position.

However, for a company with large amounts of inventory this procedure may be impracticable. In this case 

it is acceptable to group similar items into categories and perform the comparison of cost and NRV 

category by category, rather than item by item. 

Question

Valuation

The following figures relate to inventory held at the year end. 

A  

B  

C  

$  

$  

$  

Cost 20 

9

12

Selling price 

30 

12 

22 

Modification cost to enable sale 

–

2

8

Marketing costs 

7

2

2

Units 

held 

200 150 300 

Required

Calculate the value of inventory held. 

Answer

 Item 

Cost

NRV

Valuation

Quantity

Total value

$

$

$

Units

$

A

20

23

20

200

4,000

B

9

8

8

150

1,200

C

12

12

12

300

3,600

 

 

 

 

8,800

So have we now solved the problem of how a business should value its inventories? It seems that all the 

business has to do is to choose the lower of cost and net realisable value. This is true as far as it goes, but 

there is one further problem, perhaps not so easy to foresee: for a given item of inventory, 

what was the 

cost?

4.3 Determining the purchase cost 

Inventories may be 

raw materials or components bought from suppliers, finished goods which have been 

made by the business but not yet sold, or work in the process of production, but only part-completed (this 

type of inventory is called 

work in progress or WIP). It will simplify matters, however, if we think about 

the historical cost of purchased raw materials and components, which ought to be their purchase price. 

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