Alright everyone, today we’re going to talk about inventory valuation and why it’s such an important part of financial statements. Now, inventory simply means the goods a business holds, either to sell to customers or to use in production. It might be finished goods on a shop shelf, or raw materials waiting to be used in a factory.
Getting the value of inventory right is really important because it affects two key financial statements: the statement of profit or loss and the statement of financial position. If we overvalue or undervalue inventory, it can make profits and assets look very different from reality, which could mislead investors, lenders, and managers.
Inventory is classed as a current asset, and it’s a big part of a company’s working capital. The value of closing inventory helps calculate cost of sales, which then affects gross profit and net profit. For example, if a shop reports more inventory than it actually has, it looks like it spent less on goods sold, so profits appear higher. But if it undervalues inventory, profits look lower than they really are.
Now, let’s look at some of the difficulties businesses face when trying to value inventory. First, some items become obsolete or damaged. Think about a clothing store with unsold winter coats when summer starts. Those coats probably can’t be sold for the same price next year, so their value has dropped. Similarly, food that has passed its expiry date or technology that’s been replaced by newer models loses value quickly.
The second challenge is fluctuating market prices. For instance, if a company makes products using oil or wheat, and the prices of those materials change sharply, it affects the value of the goods made from them.
The third issue is predicting future selling prices. For some industries, especially tech, prices can fall fast. Imagine a phone company that produces a model for three hundred dollars, but then a newer version hits the market and the old one can only be sold for less. That’s where the method of Net Realisable Value, or NRV, becomes important.
Let’s understand the NRV method clearly. The Net Realisable Value is the estimated selling price of the inventory minus any extra costs needed to make the sale, like advertising, packaging, or delivery. According to accounting standards, inventory should always be valued at the lower of cost or NRV. This means if the item’s market value has dropped below its original cost, we record the lower amount to stay realistic.
Here’s an example. Suppose a tablet costs a business three hundred dollars to make. But because of new competition, it can now only be sold for two hundred and eighty dollars. On top of that, it costs ten dollars to sell each tablet. That means the NRV is two hundred and seventy dollars. Since this is lower than the cost of three hundred, the tablet should be valued at two hundred and seventy dollars. This prevents the business from overstating the value of its assets.
Let’s see how this affects the financial statements. In the statement of profit or loss, if inventory is overvalued, cost of sales will appear too low and profit will look too high. If inventory is undervalued, cost of sales will look too high and profit too low. In the statement of financial position, overvalued inventory makes current assets and total assets look higher than they really are, while undervaluing it makes the company appear weaker than it is.
So, in simple terms, accurate inventory valuation keeps financial statements honest. It gives a fair view of the company’s profitability and financial strength. Using the NRV method ensures that businesses don’t overstate their assets and provides a true picture for managers, investors, and other stakeholders.
By the end of this lesson, you should be able to explain what inventory is, understand why accurate valuation is important, describe the challenges businesses face when valuing inventory, apply the NRV method, and see how inventory valuation affects profits and assets.
