Inventory Valuation: Concepts, Methods, and Applications (IAS 2)

Study Guide - Smart Notes

Tailored notes based on your materials, expanded with key definitions, examples, and context.

Inventory Valuation

The Nature of Inventory

Inventory represents goods held by a business for the purpose of resale or for use in production. The classification of inventory depends on the nature of the business and can be divided into three main categories:

Finished goods: Products ready for sale to customers.
Work in progress (WIP): Goods that are partially completed in the production process.
Raw materials: Basic materials and components awaiting use in production.

For example, a retailer typically holds only finished goods, while a manufacturer may hold all three types. Service businesses may have no inventory at all.

The Importance of Correct Inventory Valuation

The value assigned to closing inventory at year-end directly affects the calculation of gross profit and the financial statements. The formula for gross profit is:

Gross Profit = Sales – Cost of Goods Sold (COGS)
COGS is calculated as:

Overstating closing inventory reduces COGS and increases profit, while understating it has the opposite effect. Therefore, accurate inventory valuation is essential for fair financial reporting.

IAS 2 Inventories: Key Rules

IAS 2, issued by the International Accounting Standards Board (IASB), governs inventory valuation. The standard requires:

Inventory must be valued at the lower of cost and net realisable value (NRV).
Clear guidance on how to determine both cost and NRV.

Valuing Inventory: Lower of Cost and Net Realisable Value (NRV)

Historical cost is the usual basis for inventory valuation. However, if inventory is damaged, obsolete, or expected to sell for less than cost, it must be valued at NRV to avoid overstating assets, in line with the prudence concept.

Net Realisable Value (NRV) is calculated as:
Costs to sell may include repairs, packaging, and delivery.

Example: If 100 units cost £27 each, but require £5 repair per unit and can be sold for £30 each, NRV per unit is £25. Inventory should be valued at £2,500 (100 × £25).

Comparing Cost and NRV: Item-by-Item Basis

IAS 2 requires comparison of cost and NRV on as detailed a basis as possible, ideally for each item. This prevents overstatement of inventory value for items expected to be sold at a loss.

Item	Cost (£)	NRV (£)	Lower of Cost & NRV (£)
A	100	150	100
B	120	90	90
C	180	250	180
D	150	130	130
E	90	140	90

Total inventory value = £590 (sum of the lowest values for each item).

Inventory Write-Downs and Write-Offs

If NRV falls below cost, inventory is written down to NRV. If NRV is zero, it is written off completely. The write-down is reflected in the closing inventory figure, which automatically adjusts COGS and gross profit. No separate journal entries are required.

Example: If closing inventory at cost is £7,300, but includes £1,900 of items with NRV £700, the write-down is £1,200. Closing inventory in the financial statements is £6,100.

Determining the Cost of Inventory

The cost of inventory includes all costs incurred to bring inventory to its present location and condition:

Purchase price
Carriage inwards (delivery to business)
Import taxes and duties
Conversion costs (for manufacturers: direct labor and factory overheads)

Costs such as carriage outwards (delivery to customers) and storage of finished goods are not included in inventory cost.

Costing Methods for Large Volumes of Identical Inventory

When individual item costs cannot be identified, businesses must use an assumption about the flow of inventory. The main methods are:

FIFO (First In, First Out)
LIFO (Last In, First Out) (not permitted under IAS 2)
AVCO (Average Cost)

FIFO (First In, First Out)

Assumes the oldest inventory is sold first. Closing inventory consists of the most recently purchased items.

Example: If 24 units remain, and the last purchase was 20 units at £41 each, and the previous was 4 units at £34 each, closing inventory is (20 × £41) + (4 × £34) = £956.

LIFO (Last In, First Out)

Assumes the most recently purchased inventory is sold first. Closing inventory consists of the oldest items. LIFO is not allowed under IAS 2 due to its potential to distort inventory values and profits.

Example: Using the same data, closing inventory under LIFO is valued at £808.

AVCO (Average Cost)

Values inventory at a weighted average cost per unit, recalculated each time new inventory is purchased.

Example: If after purchases and sales, 24 units remain and the latest average cost is £37 per unit, closing inventory is 24 × £37 = £888.

Impact of Inventory Valuation Methods on Profit

The choice of inventory valuation method affects COGS and gross profit:

Method	Closing Inventory (£)	Gross Profit (£)
FIFO	956	1,040
LIFO	808	892
AVCO	888	972

When purchase prices rise, FIFO gives the highest closing inventory and profit. Over the business's life, total profit is unaffected by the method, but annual profits can vary.

Other Inventory Costing Techniques Allowed by IAS 2

Standard Cost: Used by manufacturers, inventory is valued at a predetermined standard cost. Variances between actual and standard costs are recorded separately.
Retail Method: Used by retailers, inventory is valued at selling price less the normal profit margin. Care must be taken to distinguish between margin (percentage of selling price) and mark-up (percentage of cost).

Example: If selling price is £140 and margin is 25%, cost is £105. If mark-up is 25%, cost is £112.

Stocktaking and Year-End Adjustments

Physical counting of inventory (stocktaking) is often required at year-end. If the count occurs after the balance sheet date, adjustments must be made for purchases and sales between the count and year-end.

Example: If inventory counted on 7 January is £28,850, with purchases of £2,370 and sales of £3,800 (at selling price, with a 25% mark-up) between 31 December and 7 January, the closing inventory at 31 December is:

Inventory counted: £28,850
Add: Cost of goods sold after 31 Dec: £3,800 × 100/125 = £3,040
Less: Purchases after 31 Dec: £2,370
Less: Returns inwards after 31 Dec: £350 × 100/125 = £280
Adjusted inventory at 31 Dec: £29,240

Inventory Held on a 'Sale or Return' Basis

Goods sent to customers on a sale or return basis remain the property of the sender until accepted or sold by the recipient. At year-end, such goods must be included in the sender's inventory and excluded from the recipient's. They are valued at the lower of cost and NRV.

Summary Table: Key Inventory Valuation Methods

Method	Assumption	IAS 2 Status	Effect on Profit (Rising Prices)
FIFO	Oldest items sold first	Allowed	Highest profit
LIFO	Newest items sold first	Not allowed	Lowest profit
AVCO	Average cost per unit	Allowed	Middle
Standard Cost	Predetermined cost	Allowed	Varies
Retail Method	Selling price less margin	Allowed (retailers)	Varies

Key Learning Points

Inventory includes finished goods, WIP, and raw materials.
Inventory must be valued at the lower of cost and NRV, item by item where possible.
Cost includes all expenses to bring inventory to its current state.
FIFO and AVCO are the main methods allowed by IAS 2; LIFO is prohibited.
Inventory valuation method affects reported profit and must be applied consistently.
Physical stocktaking and adjustments are necessary for accurate year-end reporting.
Goods on sale or return remain in the sender's inventory until sold or accepted.

Additional info: For more advanced study, management accounting covers detailed allocation of overheads and standard costing variances. The distinction between margin and mark-up is crucial for retail inventory valuation.