In this session we will look at what inventories are and how they should be valued and recorded in the financial statements.
Inventories
Inventories are assets:
- Held for sale in the ordinary course of business (i.e. finished goods)
- In the process of production for such sale (i.e. work-in-progress)
- In the form of materials or supplies to be consumed in the production process or in the rendering of services (i.e. raw materials)
Valuation of inventories
Inventories shall be measured at the lower of cost and net realisable value.
Cost
“The cost of inventories shall comprise all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition” IAS 2
Purchase costs will include
- Purchase price (after trade and similar discounts)
- Import duties
- Transport and handling costs
Conversion costs will include
- Direct labour
- A share of fixed and variable production overheads (calculated using the absorption method or a similar method)
Costs that should not be included in the cost of inventory
- Abnormal amounts of wasted materials, labour or other production costs
- Storage costs (unless those costs are necessary in the production process)
- Administrative overheads
- Selling costs
Question
A company has identified the following costs that are associated in some way to one of the products it makes:
Cost of materials used in making 1 unit: £16
Import duties payable on 1 unit: £4
Cost of direct labour used in making 1 unit: £7
Average cost of delivering 1 unit to a customer: £1
Production overheads absorbed into 1 unit: £12
Commission payable to Sales Representatives for 1 unit: £2
Calculate the cost of 750 units
Click here to reveal the answer
The cost of 1 unit is £39. We would not include the costs of delivery to the customer or the commission payable on sale.
The cost of 750 units is therefore £29,250 (i.e. 750 x £39).
Calculating the cost of identical items
If the company purchases identical items of inventory it may use the following methods to value them:
FIFO (“First-in, First-out”) where the company assumes that it uses or sells its oldest items of inventory first
AVCO (“Weighted average cost”) where the company assumes that it uses or sells its inventory in no particular order
[Note that a company may not use LIFO or Last-in, Last-out to value its inventories]
Illustration
Two companies both made the following purchases and sales of a particular product over the course of the last year.
- 100 units were purchased at a price of £9 per unit; then
- 50 units were purchased at a price of £12 per unit; then
- 120 units were sold
One company values its year-end inventories using FIFO whilst the other uses AVCO.
Valuation of inventory using FIFO
The company will hold 30 units at the year end. Under FIFO we assume that the oldest inventory would be sold first which means that the 30 units would come from the 50 units purchased at a price of £12 per unit.
The inventory would therefore have a cost of £360 (i.e. 30 units at £12 each)
Valuation of inventory using AVCO
150 units had been purchased prior to the sale of 120 units. These 150 units cost £1,500 (i.e. 100 units at £9 each plus 50 units at £12 each).
The average cost per unit would therefore be £10 (i.e. £1,500/150 units) and the 30 units in inventory would have a cost of £300 (i.e. 30 units at £10 each).
Question
Last year, a company undertook the following transactions in respect of a product. The transactions are shown in the order in which they occurred.
1. Purchase of 100 units at £30 each
2. Purchase of 200 units at £24 each
3. Sale of 250 units
Calculate the quantity and value of the inventory held at the end of the year using:
a) FIFO
b) AVCO
Click here to reveal the answer
a) The company holds 50 units in inventory at the year end. If they are valued using FIFO they will be recorded at a value of £1,200 (each will be valued at £24 each)
b) The company holds 50 units in inventory at the year end. If they are valued using AVCO they will be recorded at a value of £1,300 (the total cost of 300 units is £7,800 so 50 will have a cost of 50/300 x £7,800, or £1,300)
Net Realisable Value (“NRV”)
“Net realisable value refers to the net amount that an entity expects to realise from the sale of inventory in the ordinary course of business” IAS 2
NRV is therefore the amount by which the company expects to benefit from the inventory’s sale or use. Unlike cost, NRV looks at what we expect to happen in the future.
Calculating NRV
Start with the item of inventory’s expected selling price and then deduct:
- The expected selling and delivery costs
- The expected costs to be incurred in bring the item to a saleable condition
[Note. It is often the case that valuation of inventories takes place some time after the end of the financial period. This can mean that the company is able to identify the actual NRV rather than use estimated amounts.]
Identifying when a company might need to calculate NRV
Accountants should watch out for any of the following situations which can indicate that an item of inventory might have to be valued at its net realisable value rather than its cost.
- Inventories are damaged
- Inventories are wholly or partially obsolete
- Selling prices have declined
- Estimated costs of completing work-in-progress have increased
Question
It is the end of summer and a department store holds the following items of inventory. Which items might have to be valued using their net realisable value?
a) Women’s beachwear
b) A set of plates, one of which is cracked
c) Men’s overcoats
d) Older versions of current mobile phones
Click here to reveal the answers
The items that might have to be valued at their net realisable value are:
a) As the demand for beachwear will fall at the end of summer, the store might have to discount these items in order to sell them
b) The fact that one of the plates is cracked means that it cannot be sold for the normal price
d) As the phones have been updated they may have to be discounted in order to sell them
Valuing inventory: illustration 1
Calliope Ltd is a company that restores and sell antiques. Its accountant is valuing its year-end inventory and an extract from its list of inventory is shown below.
For each item of inventory, the accountant will identify the lower of cost and net realisable value.
The value at which these three items will be included in the company’s year end inventory is therefore £2,666 (i.e. £760 + £516 + £1,390)
Valuing inventory: illustration 2
A housebuilder has incurred the following costs in building a property that was held in stock at its year-end.
- Cost of purchasing the land £310,000
- Cost of building materials £205,000 (this includes £8,000 incurred in replacing materials destroyed in a fire)
- Costs of builders, plumbers, electricians and other direct labour £175,000
- Professional fees incurred (i.e. architects, project manager and solicitor) £45,000
- Estate agent’s fee for advertising the property for sale £2,000
The value of the above inventory at the year-end is:
Notes: Materials cost should exclude the £8,000 cost of replacing materials destroyed in a fire as these would be classed as an abnormal cost. In addition, the estate agent’s fees of £2,000 would be excluded as these are selling costs.
Valuing inventory: illustration 3
Aeneas plc is a company that makes clocks. At its year-end it has a part-completed clock in its inventories. The clock was being made to order but unfortunately the buyer had died and Aeneas plc believed that it would be unable to to find a new buyer without reducing the selling price from £2,750 to £1,500.
The costs that had incurred in bringing the clock to its current condition were as follows:
- Materials £408
- Direct labour £662
- Overheads £243
In order to sell the clock, the company believed it would have to incur the following costs
- Additional direct labour costs £90
- Delivery costs £175
In order to calculate the value at which the clock should included in the company’s year-end inventory we would have to calculate both its cost and its net realisable value.
The value used when valuing this clock for inclusion in the business’ inventories will be the lower of cost and NRV, that is £1,235.
Question
At its financial year-end, a company has an item of inventory that has been damaged. The item’s materials cost £268 and direct labour and production overheads costing £94 were incurred in bringing the item to its current location and condition. The damage to the item means that it cannot be sold at its normal price of £645. Instead the company estimates that it could be sold for £350 if repairs costing £50 were undertaken.
a) What is the item’s cost
b) What is the item’s net realisable value?
c) At what value will the item be included at in the company’s year-end financial statements?
Click here to reveal the answer
a) The cost is £362 (i.e. £268 plus £94)
b) The net realisable value is £300 (i.e. £350 less £50)
c) The item will be included at the lower of its cost and net realisable value; that is £300
Question
It is May 20X1 and a company is preparing its financial statements for the year ended 31 December 20X0. The Managing Director has told the company’s accountant to value its year-end inventory at their selling price on the grounds they were worth that amount of money and this has been proved by the fact that they were all sold at their full price in the months following the year-end.
Explain why the Managing Director is wrong to ask for this to be done.
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The Managing Director is wrong to ask for the company’s inventories to be recorded at their selling price as this is not the treatment specified in IAS 2 Inventories.
IAS 2 tells us that the company should value its inventories at the lower of cost and net realisable value. The fact that the items were sold for a higher value after the year-end does not affect the way it should be valued.
Recognition of inventories as an expense
“When inventories are sold, the carrying amount of those inventories shall be recognised as an expense in the period in which the related revenue is recognised” IAS 2
In practice, this is achieved by calculating the company’s Cost of Sales by starting with the value of its opening inventory, adding the purchase costs and conversion costs incurred in a period and then deducting the value of its closing inventory. An illustration is given below.
