Chapter 29 The valuation of inventory

Learning objectives After you have studied this chapter, you should be able to: Calculate the value of inventory using three different methods Explain why using the most appropriate method to value inventory is important Explain what effect changing prices has on inventory valuation under each of three different methods

Learning objectives (Continued) Explain why net realisable value is sometimes used instead of cost for inventory valuation Adjust inventory valuations, where necessary, by a reduction to net realisable value Explain how subjective factors influence the choice of inventory valuation method Explain why goods purchased on ‘sale or return’ are not included in the buyer’s inventory

Inventory Inventory is the name given to goods held for resale, work-in-progress and raw materials. There are several different ways to value inventory FIFO (first in, first out) LIFO (last in, first out) AVCO (average cost)

Activity Using the following transactions, we will look at the FIFO, LIFO and AVCO methods of valuation.

FIFO valuation

LIFO valuation

AVCO valuation * 10x30=300 + inventory received (10 x 34) =340 = total 640. then 640/20 = 32 * *12x32=384 + inventory received (20 x 40) =800 = total 1184. there are 32 units in inventory, 1184/32 = 37

The calculation of profits The choice of valuation method used has an effect on profit.

Net realisable value Once a valuation method has been chosen and used, you need to consider whether that value is realistic. If the inventory is not worth its value at the end of the period, an adjustment must be made. This adjustment is in accordance with the prudence concept.

Reduction to net realisable value Net realisable value is calculated as: If the net realisable value of inventory is less than the cost of the inventory, then the net realisable value is used in the financial statements.

What factors affect the choice of inventory valuation? Ignorance of other methods. Convenience, because it’s the easiest method. Custom, because it’s the usual method in the industry. Taxation – lower profits delay taxation payments. Making the business look attractive with a high stock valuation.

What factors affect the choice of inventory valuation? (Continued) Remuneration purposes, if someone is paid according to profits earned. Lack of information, because proper records haven’t been kept. Advice of the auditors, who prefer a particular method.

Goods on sale or return Sometimes goods are supplied on a sale or return basis. This means that payment is not due until the buyer has sold the goods on. In this situation, the buyer cannot recognise the existence of the goods in either the stock valuation or the purchases figure.

Learning outcomes You should have now learnt: That methods of valuing inventory, such as FIFO, LIFO and AVCO, are only that – methods of valuing inventory. It does not mean that goods are actually sold on a FIFO or LIFO basis That because different methods of valuing inventory result in different closing inventory valuations, the amount of profit reported for a particular accounting period is affected by the method of inventory valuation adopted

Learning outcomes (Continued) That using net realisable when this is lower than cost, so that profits are not overstated, is an example of the application of the prudence concept in accounting That many subjective factors may affect the choice of inventory valuation method adopted That without inventory records of quantities of items, it would be very difficult to track down theft or losses or to detect wastage of goods

Learning outcomes (Continued) That without proper inventory records, it is unlikely that AVCO or LIFO can be applied in the way described That goods sold on sale or return should be included in the inventory of the seller until the buyer has sold them That stocktaking is usually done over a period of time around the end of the accounting period

Learning outcomes (Continued) That the inventory levels identified at a stocktake need to be adjusted to the level they would have been at, had the stocktake taken place on the date of the statement of financial position