Value inventory at the lower of cost and net realisable value and explain the effect on profit and the statement of financial position

What this dot point is asking

SEAB wants you to value inventory at the lower of cost and net realisable value (NRV) and to explain how the valuation affects profit and the statement of financial position. Inventory sits at the junction of the income statement (through cost of sales) and the balance sheet (as a current asset), so its valuation directly moves both. The central insight is that prudence forbids carrying inventory above what it will realise, so any expected loss is recognised at once, while any expected profit waits until the sale.

The answer

The rule

Inventory is valued at the lower of:

• Cost - the purchase cost plus the costs of bringing it to its present location and condition (for example carriage in and, for manufacturers, direct production costs).
• Net realisable value (NRV) - the estimated selling price less any costs still to be incurred to complete and sell it.

The comparison is normally made line by line (or by group of similar items), not on the inventory as a whole, so a write-down on one line is not offset by a gain on another.

Why the lower of the two

This is prudence in action: an asset must not be overstated, and a foreseeable loss must be recognised early. If NRV has fallen below cost (because of damage, obsolescence or a price fall), the inventory is written down to NRV and the loss hits this year's profit. If NRV exceeds cost, inventory stays at cost; the profit is not anticipated until the goods are actually sold, consistent with realisation.

Effect on profit

Closing inventory is deducted in computing cost of sales, so it feeds straight into profit:

Overstating closing inventory understates cost of sales and overstates profit (and current assets); understating it does the reverse. Because closing inventory becomes next year's opening inventory, an error reverses in the following period.

Examples in context

Example 1. Obsolete stock. A phone retailer holds last year's models costing \40,000$that can now be sold for only$\$25\,000$ after a \2,000$clearance promotion. NRV is$25,000 - 2,000 = \$23\,000$, well below cost, so the stock is written down to \23,000$and the$\$17\,000$ loss recognised now. Prudence ensures the balance sheet does not carry obsolete stock at an unrealistic value.

Example 2. The closing-inventory error in an exam. A candidate values closing inventory at \60,000$when a damaged batch should reduce it to$\$55\,000$. The \5,000$overstatement understates cost of sales, overstating profit and inventory by$\$5\,000$. Examiners deliberately plant such write-downs to test whether students apply the lower of cost and NRV before slotting the figure into cost of sales.

Try this

Q1. Stock cost \10,000$and can be sold for$\$12\,000$ after \1,000$ of selling costs. State its value. [2 marks]

• Cue. NRV = 12\,000 - 1\,000 = \11,000$; lower of cost ($\$10\,000$) and NRV (\11,000$) is$\$10\,000$ (cost).

Q2. Closing inventory is understated by \3,000$. State the effect on this year's profit. [2 marks]

• Cue. Cost of sales is overstated by \3,000$, so profit is understated by$\$3\,000$ this year (and overstated next year through opening inventory).

Q3. Explain why inventory is not valued above cost even when it can be sold for more. [3 marks]

• Cue. Prudence and realisation prevent anticipating profit; the gain is only recognised when the goods are sold, so inventory is capped at cost unless NRV is lower.