6. Valuing Inventories

Question 1

How is inventory typically valued?

Answer 1

Inventory is normally valued at its historical cost (the cost at which the inventory was originally bought).

The only time when (historical) cost is not used is when cost needs to be reduced to net realisable value (the expected selling price, less any costs still to be incurred in getting the inventory ready for sale and in making the sale). In accordance with IAS 2, inventory should be valued at the lower of cost and net realisable value.

Question 2

If the business has multiple different items of inventory to value, how should it do so?

Answer 2

If a business has many inventory items on hand, the comparison of cost and NRV should be carried out for each item separately. It is not sufficient to compare the total cost of all inventory items with their total NRV, unless the items are interchangeable such as nuts and bolts.

Question 3

Why is the valuation of inventory particularly vulnerable to manipulation?

Answer 3

The valuation of inventory is an area in which there is potentially scope for manipulation of the financial statements.

Inventory impacts on the carrying amount of assets and on gross and net profit. If a business is under pressure to increase its asset value or report strong profits, perhaps to secure bank funding or to achieve targets, it will want to avoid writing inventory down below its cost.

Professional accountants must ensure that the NRV has been correctly determined and that the lower of cost and NRV principle is adhered to.

Question 4

Define cost of inventories.

Answer 4

Cost of inventories comprises all costs of purchase, of conversion (e.g. labour) and of other costs incurred in bringing the items to their present location and condition.

Question 5

Define cost of purchase.

Answer 5

Cost of purchase comprises the purchase price, import duties and other non-recoverable taxes, transport, handling and other costs directly attributable to the acquisition of finished goods and materials.

Question 6

What is included in the total cost of an item of inventory? (4)

Answer 6

The total cost of an item of inventory includes all costs incurred in bringing the item to its present location and condition. This consists of:
1. The purchase cost of raw materials
2. Delivery inwards
3. Import taxes and duties
4. Conversion costs

Question 7

Define conversion costs.

Answer 7

Conversion costs includes any costs involved in converting raw materials into final product, including labour, expenses directly related to the product and an appropriate share of production overheads (but not sales, administrative or general overheads).

Question 8

What techniques are used to attribute cost to interchangeable inventory items? (3)

Answer 8

1. FIFO (First in, first out): Items are assumed to be used in the order in which they are received from suppliers, so oldest items are issued first. Inventory remaining is therefore the newer items and cost is measured as such.
2. LIFO (last in, first out): Items issued are assumed to be part of the most recent delivery, while oldest consignments are assumed to remain in the stores. LIFO is not allowed under the IFRS Accounting Standards and it is not considered further in Accounting.
3. AVCO (average cost): As purchase prices can change with each new consignment received, the average value of an items is constantly changing. Each item at any moment is assumed to have been purchased at the average price of all the items together, so inventory remaining is therefore valued at the most recent average price.

In the exam you may be asked to use the FIFO or AVCO method to determine the cost of inventory in the statement of financial position and the statement of profit or loss.