The definition of inventories

Inventories represent the stock of goods that a business holds but has not yet sold. They form an essential part of a company's assets and are recorded on the statement of financial position.

Types of inventories

• Unsold goods - Finished products ready for sale to customers.
• Raw materials - Basic items used in the production process.
• Components - Parts that will be assembled into final products.
• Work-in-progress - Items that are partially completed in the manufacturing process.

How inventories are valued

Inventories must be valued accurately to reflect their true worth on the statement of financial position. They are recorded at the lower of two possible values to ensure the financial statements present a realistic picture.

The basis for valuing inventories

• Historical cost - The original purchase price of the inventories.
• Net realisable value (NRV) - An estimate used when the expected selling price, minus any costs to sell, is lower than the historical cost.
• Inventories are always valued at whichever of these two is lower to avoid overstating assets.

Calculating net realisable value

Net realisable value (NRV) is an estimate of the amount that inventories can realistically generate after accounting for selling expenses. It is applied when this value falls below the historical cost, preventing the overvaluation of assets.

$\text{Net realisable value}=\text{estimated selling price}-\text{cost of selling}$

Where:

• Estimated selling price = The price at which the inventory is expected to be sold (£)
• Cost of selling = Expenses involved in making the sale, such as repairs or marketing (£)

NRV is only used on the statement of financial position if it is lower than the historical cost.

The principle of conservatism in inventory valuation

The principle of conservatism is a key accounting guideline that promotes caution in financial reporting. It ensures that potential losses are recognised early, while gains are only recorded when they are certain.

Application to inventories

• Losses on inventories, such as a drop in value due to obsolescence or damage, should be recorded as soon as they are reasonably expected.
• This principle supports using the lower of historical cost or NRV, preventing the overstatement of asset values and providing a more prudent view of the business's financial position.

Worked example - Valuing outdated inventory using NRV

A bookshop buys 30 paperback books from a supplier at £10 each. At the year-end, 8 copies are unsold and have become outdated due to a new edition being released. The manager estimates they can be sold at a reduced price of £7 each. Calculate the NRV for these books and determine the value to record on the statement of financial position.

Step 1: Identify the values

• Historical cost per book = £10
• Number of unsold books = 8
• Estimated selling price per book = £7
• Total historical cost = 8 × £10 = £80
• No additional selling costs mentioned

Step 2: Apply the NRV formula

$\text{Net realisable value}=\pounds 7-\pounds 0=\pounds 7\text{ per book}$ Total NRV = 8 × £7 = £56

Step 3: Compare with historical cost

NRV (£56) is lower than historical cost (£80), so record £56 on the statement of financial position.

Worked example - Valuing defective inventory using NRV

An electronics retailer holds a wireless headphone set in inventory, purchased for £60. It has a small fault requiring a repair costing £15. The manager estimates that after repair, it can be sold for £70. Calculate the NRV and determine the value to record on the statement of financial position.

Step 1: Identify the values

• Historical cost = £60
• Estimated selling price = £70
• Cost of selling (repair) = £15

Step 2: Apply the NRV formula

$\text{Net realisable value}=\pounds 70-\pounds 15=\pounds 55$

Step 3: Compare with historical cost

NRV (£55) is lower than historical cost (£60), so record £55 on the statement of financial position.