Accounting for IGCSE - Video 29 - Inventory Valuation
Summary
TLDRThis video delves into the critical aspect of inventory valuation in accounting, explaining its necessity for accurate financial reporting. It covers the principles behind valuing inventory at the lower of cost or net realizable value (NRV), influenced by historical cost and prudence concepts. The script provides an example calculation to illustrate the process and discusses the impact of incorrect inventory valuations on financial statements, including effects on cost of sales, gross profit, net profit, and current assets.
Takeaways
- đ The primary reason for inventory valuation is to calculate gross and net profit accurately, which involves determining the cost of goods sold and opening inventory for the next financial period.
- đŒ Inventory is also a crucial asset to be presented in the balance sheet, which is part of a company's financial statements.
- đ Physical inventory checks are conducted to cross-verify computerized records and to prevent fraud and theft.
- đ The basic inventory valuation principle is to value inventory at the lower of cost or net realizable value (NRV).
- đ The cost of inventory includes the purchase price and any additional expenses incurred to get the goods to the point of sale.
- đĄ NRV is the estimated selling price of inventory after deducting any necessary expenses to complete and sell the inventory items.
- đ The historical cost concept dictates that assets should be recorded and valued at the cost at which they were acquired.
- đ« The prudence concept in accounting advises against overstating assets or profits, emphasizing the recording of potential losses in advance.
- đ These principles guide the inventory valuation principle, which ensures that inventory is not overvalued, potentially inflating profits.
- đ The script provides an example calculation of inventory value, demonstrating how to determine the value based on cost and NRV.
- đš Incorrect inventory valuation can have repercussions on financial statements, affecting cost of sales, gross profit, net profit, and the balance of current assets.
Q & A
Why is inventory valuation necessary for a company?
-Inventory valuation is necessary for calculating gross and net profits on the income statement, determining the cost of goods sold. It also helps in presenting current assets accurately on the balance sheet, which includes inventory as one of the assets.
What is the basic inventory evaluation principle?
-The basic inventory evaluation principle is to value inventory at the lower of cost or net realizable value (NRV).
What are the two main accounting principles that underlie the inventory valuation principle?
-The two main accounting principles are the historical cost concept and the prudence concept. Historical cost principle values assets at the price at which they were bought or acquired, while the prudence concept prevents overstatement of assets or profits.
What is meant by 'cost' in the context of inventory valuation?
-'Cost' refers to the purchase price of the goods plus any additional expenses incurred to get the inventory items to the location of sale, including carriage inward, duties, or any other expenses paid before the inventory reaches its current location.
What is 'net realizable value' (NRV) and how is it calculated?
-Net realizable value (NRV) is the estimated selling price of the inventory after deducting any necessary expenses to complete and sell the inventory item, such as additional costs to finish work in progress or selling expenses like carriage outward and commissions on sales.
Why is it important to physically check and value inventory despite having computerized records?
-Physically checking and valuing inventory helps prevent fraud and theft, as inventory is susceptible to these issues if not properly controlled. It allows for cross-checking of inventory records and ensures accuracy.
How does overstating inventory values affect financial statements?
-Overstating inventory values will understate the cost of sales in the current year, leading to overstated gross and net profits. It will also overstate current assets on the balance sheet but will not affect the next year's balance sheet.
What is the impact of understating inventory values on financial statements?
-Understating inventory values will overstate the cost of sales in the current year, leading to understated gross and net profits. It will also understate current assets on the balance sheet but will not affect the next year's balance sheet.
Can you provide an example of how to calculate the inventory value using the provided script?
-Yes, for item AB12 with a purchase cost of $24 and an estimated selling price of $28, if there's an additional selling cost of $5 per unit, the NRV would be $23 per unit. Since this is lower than the cost, the inventory value is taken as $23 per unit for the 100 units in stock, totaling $2300.
What is the effect of incorrect inventory valuation on the cost of sales and gross profit for the next year?
-If inventory is overstated, the cost of sales for the next year will be overstated because the closing inventory (which becomes the opening inventory for the next year) is too high. This will result in understated gross profit for the next year. Conversely, if inventory is understated, the cost of sales for the next year will be understated, leading to overstated gross profit.
How does the script suggest enhancing the understanding of inventory valuation?
-The script suggests practicing more questions and accessing detailed notes on the topic, possibly through a paid course, to deepen the understanding of inventory valuation.
Outlines
đ Introduction to Inventory Valuation
This paragraph introduces the topic of inventory valuation in accounting, emphasizing its importance in calculating gross and net profits as well as presenting current assets in a company's balance sheet. It outlines the structure of the video, which includes the reasons for valuing inventory, the principles behind inventory valuation, key terms, and the effects of incorrect inventory valuation on financial statements. The video also promotes a paid course for further study.
đ Understanding Inventory Valuation Principles
The paragraph delves into the inventory valuation principle, which states that inventory should be valued at the lower of cost or net realizable value (NRV). It explains the concepts of cost, including purchase price and additional expenses incurred to get the goods to the sale location, and NRV, which is the estimated selling price minus any necessary expenses to complete and sell the inventory. The paragraph also discusses two underlying accounting principles: the historical cost concept and the prudence concept, which together form the basis for the inventory valuation principle.
đ Inventory Valuation Examples and Financial Impact
This paragraph provides an example of how to calculate inventory value using the provided cost and selling price data, taking into account additional costs like carriage and selling expenses. It illustrates the process for two inventory items, showing how to determine the inventory value by comparing cost and NRV. The paragraph also explains the financial implications of incorrect inventory valuation, such as the effects on cost of sales, gross profit, net profit, and current assets in the balance sheet, both in the current and subsequent years.
Mindmap
Keywords
đĄInventory Valuation
đĄCost of Goods Sold
đĄGross Profit
đĄBalance Sheet
đĄNet Realizable Value (NRV)
đĄHistorical Cost Concept
đĄPrudence Concept
đĄCarriage Inward
đĄCarriage Outward
đĄFinancial Statements
đĄCurrent Assets
Highlights
Introduction to the importance of inventory valuation in accounting for IGCSE students.
Explanation of why companies need to value inventory for income statement and balance sheet purposes.
The necessity of correct inventory values for calculating the cost of goods sold and gross profit.
Inventory as an asset on the balance sheet and its importance in financial reporting.
The role of physical inventory checks in preventing fraud and theft.
Introduction to the inventory valuation principle: valuing at the lower of cost or net realizable value (NRV).
Definition and calculation of 'cost' in inventory valuation, including additional expenses.
Definition and calculation of 'net realizable value' (NRV), considering estimated selling price and necessary expenses.
The impact of the historical cost concept on the inventory valuation principle.
The role of the prudence concept in inventory valuation to avoid overstating assets or profits.
Two scenarios illustrating the application of the inventory valuation principle based on cost and NRV.
An example calculation of inventory value for two items, considering additional costs and selling prices.
The effect of incorrect inventory valuation on financial statements, including income statement and balance sheet.
How overstating inventory affects cost of sales, gross profit, and current assets in financial statements.
How understating inventory impacts cost of sales, gross profit, and current assets in financial statements.
The importance of accurate inventory valuation for maintaining the integrity of financial reporting.
Invitation to join a paid course for more practice and detailed notes on inventory valuation.
Transcripts
hey welcome to this channel and
today's video which is on inventory
valuation so we've already uploaded a
lot of videos for
igcse accounting i hope you've checked
them out if you're new to this channel
make sure you subscribe and hit the bell
icon so what are we going to study here
today
first we see why do we need to value our
inventory this chapter is about
inventory valuation we need to
understand why
by evaluating inventory then we
understand the
inventory evaluation principle then some
important
terms that are used in the principle
then the accounting principles that form
a basis or the core of
this inventory evaluation principle
finally we see one example on
calculation of inventory value
and finally see the effect of incorrect
inventory values
on the financial statement if you want
to practice more questions if you want
to have access to detailed notes
on this chapter you can consider joining
our paid course which is just for 99
that gives you access until june 2021
so why would one want to invent value
inventory why would companies value
inventory
first of all companies prepare income
statement to calculate gross profit and
net profit
to calculate gross profit you need the
cost of goods sold
now to arrive at the cost of goods sold
correctly you need the correct closing
inventory values
and obviously this closing inventory
value will be the opening inventory in
the next year so you need the inventory
values
to arrive at the cost of goods sold
secondly
balance sheet is a part of financial
statements balance sheet presents all
the assets
and liabilities that the company holds
on a particular date now
inventory is one of the assets of the
company so that also has to be presented
under the current assets of the
balance sheet so second purpose is to
present
the present the current assets properly
in the balance sheet
then obviously every company would
maintain computerized
inventory records but in spite of that
many of these companies would still do a
physical check of their inventory
value the inventory manually why so that
they can cross check their inventory
records
inventory is subject to lot of fraud and
theft
if not kept under control and hence when
we value
inventory physically we help the company
keep a check
on the theft and fraud also
so what is the inventory valuation
principle the basic inventory evaluation
principle you must have heard about it
is the is that the inventory should be
valued at lower of cost
or net realizable value also known as
nrv
let's understand the meaning of cost and
nrv first now
cost is the co price at which the
company has purchased these goods from
the supplier so the purchase price
but not only that it also includes
whatever expenses or whatever amounts
have been paid to get the goods or the
inventory items
to the location of its sale to the
present location of sale
okay for giving an example if the
company is purchased an inventory item
for let's say twenty dollars from a
supplier
but the supplier has not arranged
delivery to our location or a warehouse
and the companies have to incur carriage
inward of let's say dollars one per unit
so what will be the total cost of the
inventory not dollars twenty but twenty
plus one
twenty one dollars per unit apart from
carriage invert any other expenses like
duties
or anything else that is paid before we
get the inventory to our current
location and then naturalizable value is
nothing but estimated selling price of
the inventory
but after deducting any necessary
expenses
to complete and sell the inventory item
what do you mean by
expenses to complete so let's say
inventory items are not in completed
stage
they are in work in progress so you need
to you might have to incur additional
expenses to complete them
so to convert them into finished
products so that and
at times business may have to incur some
selling expenses before they can sell
the inventory
like carriage outward commission on
sales etc now these expenses have to be
deducted from
estimated selling price to arrive at the
net realizable value
now once you've understood these terms
now the inventory valuation principle
would make
more sense the inventory is to be valued
at lower of the
cost or an rv why is this principle used
let's have a look at it at the next
slide there are certain accounting
principles
that form a basis for many of the
accounting treatments you've already
studied in the course
in the same way there are two important
accounting principles that form a base
or the core
for the inventory evaluation principle
the first one is the
historical cost concept historical cost
principle now this
principle tells you that all
transactions all assets in the business
or in the accounting recalls have to be
recorded and valued at their historical
cost
historical cost is the cost at which
they were bought or acquired for
so that makes us understand why was the
first part of inventory valuation
principle to value inventory at cost
so that cost comes from the historical
cost principle
now there's another counting principle
that explains the
inventory valuation principle which is
the prudence concept prudence principle
prudence states that you should not
overstate your assets
or profits in any manner you can
understate them you can
you can record your estimated losses in
advance but you can never record your
estimated profits
in advance now let's see how are these
two principles leading us to the
eventual
inventory valuation principle for that
we'll take up two situations in the
first situation let's say the cost of
the inventory is
ten thousand dollars and the net
realizable value estimated selling
prices
fifteen thousand dollars now as per the
inventory valuation principle
inventory shall be valued at ten
thousand dollars why
see you have to understand the effect of
inventory
on the cost of sales and the gross
profit so if your cost of the inventory
is ten thousand
but the estimated selling price of nrd
is fifteen thousand
so instead of valuing inventory at ten
thousand if you value it at fifteen
thousand what are you trying to do
you're trying to reduce your cost of
sales by five thousand
and increase your gross profit by five
thousand but is this correct
this five thousand profit on this
inventory is not yet realized
we are estimating that we will sell it
in the next year
or next financial period so can we
record this 5000 profit in advance no we
cannot because prudence does not allow
us
so hence here we have to value our
inventory at cost
second situation where the cost of the
inventory is ten thousand but the
business expects to sell it for seven
thousand
nrv seven thousand now here there is an
estimated loss
that we might incur on the inventory of
three thousand dollars so ten thousand
minus seven thousand
so if you value your inventory at 10 000
here
you are not trying to record your
potential losses in advance which is
against the prudence
prudence requires you to estimate your
losses and record them in advance for
example we've done that in the
provision for doubtful debts also so
since there's a potential loss here you
need to record that in the current year
itself
how can you do that you you do that by
valuing your inventory at
7 000 instead of the cost of 10 000 when
you do this
you increase your cost of sales by three
thousand
and hence reduce your gross profit by
three thousand
so when you're following the inventory
valuation principle you're making sure
that you're not recording your potential
profits
but you're recording your potential
losses in advance
now let's have a look at the example on
inventory valuation this is the kind of
questions you might expect in exam
so here we have two inventory items av12
and kg5
quantity is given purchase cost is given
selling price is given
apart from that additional information
is given the first one is related to
ab12 where they tell you that the cost
of dollars five
is to be incurred on the inventory item
of ab12
before it can be sold so basically a
selling cost is involved
and the second information is about kg5
and they tell you that carriage of 10
per unit is to be paid and to be added
on kg5 it's not yet included in the
purchase cost
so using this information can i say okay
let's do ab12 first
so my av 12 cost per unit is
24 my nrv is
28 estimated selling price but i have to
reduce my selling cost
estimated selling cost which in the
additional information number
one is given as dollars five so i'll
reduce five
so i get my nrv as 23 dollars per unit
if you compare your cost and nre your
nrv is lower and hence the value of
inventory is to be taken at 23 dollars
per unit but we have 100 units in stock
so our total inventory value will be
2300
same way for kg5 let's calculate the
cost of kg5 first
now the cost given as the purchase cost
given is dollars 80
but they tell you that a carriage of
dollars 10 per unit is to be paid but
not yet
included i told you all expenses
necessary to get the
inventory to the location of sale has to
be included and hence i'll add
10 to the purchase cost to get a final
cost of dollars 90.
an rv for this is 100 they have not
mentioned anything about selling
expenses completing expenses so i assume
that
the selling price given is the nrv which
is 100.
if you compare cost in nrv cost is lower
dollars
90 per unit and hence my value of kg5
inventory will be dollars 90 multiplied
by the number of units in stock forty
thirty six hundred now so is my total
inventory value
twenty three hundred for ab12 and thirty
six hundred for
kg five total inventory value will be
fifty nine hundred
i hope the calculation is clear so this
is the kind of question you might expect
an exam either in form of a multiple
choice question
or in form of a big question
now see sometimes businesses do have
incorrect values placed on the inventory
so the
this incorrect value does affect your
financial statements
financial statements means your income
statement and your balance sheet
so we need to analyze what in what way
has the financial statement been
impacted
when we place an incorrect value on our
inventory so first situation what we're
going to see is
when our inventory is overstated
whatever is the value of inventory we've
stated at a higher value higher amount
so what happens to the cost of sales of
the current year
now to calculate cost of sales if you
remember you need to deduct your closing
inventory
so when closing inventory is overstated
obviously your cost of sales will be
understated and the cost of sales of
next year
will be overstated because this closing
inventory becomes opening inventory in
the next year
when opening inventory is overstated
cost of sales will be overstated i hope
you
remember that cost of sales is opening
stock plus purchases
minus closing stock obviously plus
carriage inward minus purchase returns
fine
but basic opening stock plus purchases
minus closing stock
so when opening stock in the next year
is overstated obviously cost of sales
will be overstated
let's see our effect on gross profit if
the cost of sales of current year is
understated if cost is understated
obviously the profit will be overstated
and what happens to the gross profit of
next year next year's cost of sales is
overstated
so obviously the gross profit will be
understated gross profit is nothing but
sales minus cost of sales
so what happens to net profit if gross
profit is overstated in the current year
net profit will also be overstated and
if gross profit is understated in the
next year net profit will also be
understated
effect on current assets if i value
current year inventory incorrectly
obviously it will affect my balance
sheet also so if the inventory is
overstated
my overall current assets will also be
overstated
but will it affect the inventory or the
current assets
in the balance sheet of the next year no
it will not have any effect on the
balance sheet of the next year
now when we go to inventory is
understated obviously it will be
completely opposite so let's have a
quick look on that also
so when my inventory is understated my
cost of sales will be overstated because
closing stock is subtracted right
so if stock is understated obviously
your
cost of sales will be overstated and my
next year's cost of sales will be
understated effect on gross profit will
be opposite to what was there in the
cost of sales
so if cost of sales is overstated for
current year gross profit will be
understated and next year's gross profit
will be
overstated effect on net profit will be
similar to what was there in gross
profit
gross profit understated net profit also
understated
and next year's gross profit was
overstated
next year's net profit will also be
overstated because
net profit comes from the gross profit
effect on current assets if my current
assets
if my inventory is understated obviously
the current assets in my balance sheet
will also be understated because this
inventory is a part of the current
assets in the balance sheet
and no effect in the inventory or the
current assets in the balance sheet of
the
next year i hope the lecture was
clear it was very useful for you if
you've enjoyed it if you think it was
useful please like the video share it
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and i'll see you in the next video
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