Accounting for IGCSE - Video 29 - Inventory Valuation

Summary

This 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

• 📈 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.
• 💼 Inventory is also a crucial asset to be presented in the balance sheet, which is part of a company's financial statements.
• 🔍 Physical inventory checks are conducted to cross-verify computerized records and to prevent fraud and theft.
• 📝 The basic inventory valuation principle is to value inventory at the lower of cost or net realizable value (NRV).
• 🛒 The cost of inventory includes the purchase price and any additional expenses incurred to get the goods to the point of sale.
• 💡 NRV is the estimated selling price of inventory after deducting any necessary expenses to complete and sell the inventory items.
• 📉 The historical cost concept dictates that assets should be recorded and valued at the cost at which they were acquired.
• 🚫 The prudence concept in accounting advises against overstating assets or profits, emphasizing the recording of potential losses in advance.
• 🔄 These principles guide the inventory valuation principle, which ensures that inventory is not overvalued, potentially inflating profits.
• 📚 The script provides an example calculation of inventory value, demonstrating how to determine the value based on cost and NRV.
• 🚨 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

00:00

📚 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.

05:02

🔍 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.

10:03

📘 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.

Keywords

💡Inventory Valuation

Inventory valuation is the process of determining the value of goods held in stock by a company. It is crucial for financial reporting as it affects the calculation of cost of goods sold and gross profit. In the video script, inventory valuation is the central theme, with the speaker discussing its importance in financial statements and the principles guiding its calculation.

💡Cost of Goods Sold

Cost of Goods Sold (COGS) refers to the direct costs attributable to the production of the goods sold in a company. It includes the cost of the inventory and any direct costs of production. In the script, COGS is mentioned as a key figure that needs to be accurately determined through correct inventory valuation to reflect the company's profitability accurately.

💡Gross Profit

Gross profit is the profit a company makes after deducting the costs associated with making and selling its products, or the costs of providing its services. It is calculated as sales revenue minus the cost of goods sold. The script emphasizes the importance of inventory valuation in accurately calculating gross profit, which is a key indicator of a company's financial health.

💡Balance Sheet

A balance sheet is a financial statement that provides a snapshot of a company's financial position at a specific point in time, listing what the company owns (assets) and owes (liabilities). The script mentions that inventory is one of the current assets that must be accurately presented on the balance sheet, which is why proper inventory valuation is essential.

💡Net Realizable Value (NRV)

Net Realizable Value is the estimated selling price of inventory items after deducting the costs to complete the sale, such as any additional expenses required to prepare the items for sale and selling costs. The script explains that inventory should be valued at the lower of cost or NRV, using the concept of NRV to illustrate how inventory valuation can impact financial reporting.

💡Historical Cost Concept

The historical cost concept is an accounting principle that requires assets to be recorded at their original purchase price. In the script, this principle is used to justify valuing inventory at cost, as it reflects the original transaction value and is consistent with the historical cost principle.

💡Prudence Concept

The prudence concept is an accounting principle that advises against overstating assets or profits and encourages the anticipation of losses. The script explains how the prudence concept supports the inventory valuation principle by advocating for inventory to be valued at the lower of cost or NRV to avoid overestimating profits.

💡Carriage Inward

Carriage inward refers to the transportation costs incurred to bring goods to the company's location or warehouse. In the script, carriage inward is mentioned as an example of an additional cost that must be included in the total cost of inventory, highlighting the comprehensive nature of inventory valuation.

💡Carriage Outward

Carriage outward is the cost of transporting goods from the company to the customer. The script uses carriage outward as an example of a selling expense that must be deducted from the estimated selling price to determine the net realizable value of inventory.

💡Financial Statements

Financial statements are formal records of a company's financial activities, including the balance sheet, income statement, and cash flow statement. The script discusses how incorrect inventory valuation can impact financial statements, affecting the accuracy of reported profits, assets, and overall financial health.

💡Current Assets

Current assets are a company's assets that are expected to be converted into cash or used up within one year. The script mentions current assets in the context of the balance sheet, explaining how the valuation of inventory as a current asset can influence the total value of current assets reported.

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

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