Inventories are a type of current asset. They are goods, materials and consumables held by a business for use in making products or are for sale to the business’ customers. Financial accountants typically split inventories into three broad categories:
- Raw materials – items that will be used in the manufacture of products.
- Work in progress – partially completed products
- Finishes goods or goods for sale – finished goods that will be sold in due course
Businesses that hold any type of inventory will periodically conduct an inventory count (also known as a stock-take) and one of these will usually coincide with the business’ accounting year-end. The purpose of the inventory count is to identify the type and quantity of different types of stock held and to establish their condition and, in the case of work in progress, their level of completion.
Once a business knows type and quantity of inventory is held it can then be valued.
The rules regarding inventory are provided in IAS 2 Inventories which tell us what inventories are, how they should be valued and how they should be presented in a business’ accounts.
IAS 2 tells us that each item of inventory should be valued at the lower of its:
- COST; and
- NET REALISABLE VALUE (“NRV”)
This approach is an application of the Prudence Concept as it forces accountants to make sure that a business’ inventories are not overvalued.
The cost of an item of inventory includes all costs incurred in getting the item to its current condition and location. It includes:
Purchase costs; i.e. purchase price (net of discounts), plus import duties and any delivery costs
Conversion costs; i.e. the direct labour costs of employees who have worked on the item, plus any direct expenses incurred in making the product and a fair share of indirect production costs (e.g. a share of the cost of the machinery used in its manufacture).
Net realisable value (or “NRV”)
NRV is the amount by which the business expects to gain from the sale of item of inventory. This valuation method ignores the costs that have been incurred on the item and instead focuses on the future.
NRV is calculated by taking the expected selling price of the item (net of VAT) and then deducting any costs required to complete the item for sale as well as the costs of selling the item.
A business holds an item of inventory/stock which cost £1,500 to buy plus a fee of £35 for it to be delivered to the business’ warehouse. Unfortunately, the item has been damaged and will require £200 of repairs before it can be sold for an estimated £1,650
|Cost||Net realisable value|
|The item’s cost is £1,535 being the purchase price plus the delivery fees||NRV is £1,450 being the selling price less the costs to be incurred before the item can be sold|
The item will be valued at the lower of cost and NRV, in this example it will be valued at its NRV; i.e. £1,450.
Why would NRV be used in practice?
In practice, most inventories are valued at their cost – which makes sense as businesses will fail if they regularly sell items for less than it cost to make or buy them. Valuations using NRV tend to be seen when one or more of the following circumstances exist:
- The inventory has been damaged
- Inventory has deteriorated in condition
- Technology in the inventory is now outdated
- Inventory is now unfashionable
- There have been significant changes to the market or economy
Posting inventory journals
After inventory has been valued it can then be posted to the General Ledger using the following journal:
The credit part of the journal will end up being moved out of the Inventory account and into the Statement of Financial Position (“SOFP”) whilst the debit will be carried down to the start of the next period.
At the end of her first year of trading a car dealer had three cars in her inventory and she has calculated both their cost and NRV.
The value of the cars that will be included in the business’ General Ledger and accounts is shown below:
The journal to record the inventory is therefore:
The Inventory Account
The inventory account is where we will record the values of opening and closing inventory (i.e. the balances at the start and end of the accounting period).
At the start of an accounting period, a business held £10,000 of inventory. By the end of the accounting period, it held £15,000 of inventory.
At the start of the year, the inventory account will record a balance brought down on the debit side of £10,000 (being the value of its opening inventory).
At the start of the year, a journal will move the above balance to the Profit & Loss account.
Then at the year end, a journal will record the value of the closing inventory
The credit of £15,000 will then be posted to the Profit & Loss.
Finally, the account can be closed down and the balance brought down to the start of the next accounting period.