At what amount do we value the goods left unsold at the year end?
Value closing inventory at the lower of cost and net realisable value
A simple answer to the N(A)-Level Principles of Accounts outcome on inventory valuation. The lower of cost and net realisable value rule, why prudence requires it, and how the valuation affects profit.
Reviewed by: AI editorial process; not yet individually human-reviewed
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What this dot point is asking
SEAB wants you to value closing inventory at the lower of cost and net realisable value. Because closing inventory feeds directly into cost of sales, this valuation changes the reported profit. The central insight is the prudence concept: a business should never overstate its assets or profit, so when goods are worth less than they cost, the loss is recognised at once.
The answer
The rule
Closing inventory is valued at the lower of cost and net realisable value (NRV):
- Cost is what the business paid to buy or make the goods.
- Net realisable value is the expected selling price less any costs needed to sell or complete the goods.
For each item or line, take whichever is lower.
Why prudence requires it
The prudence concept says do not overstate assets or profit, and recognise likely losses early. If goods can only be sold for less than they cost, holding them at cost would overstate the asset. Valuing at NRV recognises the expected loss now, before the goods are even sold.
Apply it line by line
The rule is applied to each separate line of inventory, not to the total. You cannot let a profit on one line cancel a loss on another; each line is valued at its own lower figure, and the results are added.
The effect on profit
Closing inventory is subtracted in the cost of sales calculation, so:
- A higher closing inventory means a lower cost of sales and a higher profit.
- A lower (prudent) closing inventory means a higher cost of sales and a lower, but more truthful, profit.
Examples in context
Example 1. Goods that have gone out of fashion. A clothes shop has stock that cost \2,000\ after a markdown. The prudence concept requires valuing it at the \1,200\ loss now rather than pretending the stock is still worth its cost. This keeps both the asset and profit honest.
Example 2. Why each line is separate. A shop has one line worth more than cost and another worth less. If it netted them, the gain on the first would hide the loss on the second, overstating profit. Valuing each line at its own lower figure stops this, which is exactly why the rule is applied line by line and not to the total.
Try this
Q1. A line of inventory cost \900\. State the value to use. [1 mark]
- Cue. \750$, the lower of cost and net realisable value.
Q2. State what net realisable value means. [2 marks]
- Cue. The expected selling price of the goods less any costs needed to complete or sell them.
Q3. Explain why valuing inventory above cost would break the prudence concept. [2 marks]
- Cue. It would overstate the asset and recognise profit before the goods are sold, whereas prudence says not to overstate assets or profit and to wait until profit is earned.
Exam-style practice questions
Practice questions written in the style of SEAB exam questions on this dot point, with worked answer explainers. The year tag is the paper they imitate, not the source.
Original6 marksA business has three product lines at the year end. For each, state the value to use: (A) cost \2\,000\; (B) cost \1\,500\; (C) cost \800\. State the total closing inventory.Show worked answer →
The rule is the lower of cost and net realisable value for each line:
- A: lower of \2,000\ is \2,000$.
- B: lower of \1,500\ is \1,200$.
- C: lower of \800\ is \800$.
Total closing inventory = 2\,000 + 1\,200 + 800 = \4,000$.
What markers reward: applying the lower of the two figures to each line separately (not to the total), and the correct total of \4,000$.
Original5 marksExplain why inventory is valued at the lower of cost and net realisable value, and state the effect on profit if it were overvalued.Show worked answer →
Inventory is valued at the lower of cost and net realisable value because of the prudence concept: a business should not overstate its assets or its profit, and should recognise a likely loss as soon as it is expected. If the goods can only be sold for less than they cost, that loss is recognised now by valuing them at net realisable value.
If inventory were overvalued, closing inventory would be too high, which would lower the cost of sales and overstate profit. Assets would also be overstated.
What markers reward: linking the rule to prudence (not overstating assets or profit), and explaining that overvaluing inventory overstates profit and assets.
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