Chapter 7 Summary - Inventory

Inventory (Stock) Valuation and Accounting Adjustments

Valuation of Inventory

• Inventory, also known as stock, is a crucial asset in financial statements.
• Valuation is done at the lower of cost and net realizable value (NRV) due to the principle of prudence.
  • Prudence dictates anticipating potential losses.

Cost

• Cost includes:
  • Cost of Purchase: The direct cost of buying the stock.
  • Cost of Conversion: Costs to convert raw materials into a sellable product.
    • Includes labor costs.
    • Includes overhead costs.
  • Other Costs: Costs incurred to bring the inventory to its present location and condition.
    • Example: Delivery costs.
• Cost is generally an auditable figure, often supported by invoices.

Methods of Estimating Costs

• First-In, First-Out (FIFO)
  • The first stock purchased is assumed to be the first stock sold.
  • This leaves the newest stock in inventory at the end of the period.
• Average Cost (AVCO)
  • Calculates a weighted average cost based on all stock purchased during the year.
  • The average is recalculated each time new stock is bought or sold.

Net Realizable Value (NRV)

• NRV is the estimated selling price less any costs to complete and sell the inventory.
  • Estimated Selling Price: What you think you can sell the item for.
  • Costs to Complete: Additional costs required to finish the product (alterations, modifications).
  • Selling and Distribution Costs: Expenses incurred to sell and deliver the product to the customer.

Cost vs. NRV: Exam Considerations

• In exam scenarios, you may be given multiple pieces of information.

• You will need to identify which figures are relevant for calculating cost and NRV.

  • Costs to complete: Relevant for NRV
  • Selling and distribution costs: Relevant for NRV
  • Cost of acquiring goods: Relevant for Cost

Effect on Profit and Assets (Rising Prices)

• In times of rising prices (inflation):
  • FIFO: Produces a higher closing inventory figure, a lower cost of sales, and a higher profit figure compared to AVCO.
    • Higher Closing Inventory: Because the newest, more expensive items are still in stock.
    • Lower Cost of Sales: Because the older, less expensive items are assumed to be sold first.
    • Higher Profit: Resulting from the lower cost of sales.

Accounting Adjustments

• Opening Inventory: Debit Opening Inventory, Credit Inventory
• Closing Inventory: Debit Inventory, Credit Closing Inventory