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By the end of these notes, you should be able to:
Inventory simply means the stock of goods that a business holds and intends to sell. At the end of every accounting period, the business needs to put a money value on that stock — this is called inventory valuation.
You might think: "Why not just use the selling price?" The answer lies in a very important accounting rule called the Prudence Concept.
The Prudence Concept (also called the prudence principle) is an accounting rule that says:
Never overstate assets or income, and never understate liabilities or expenses.
In plain English: if in doubt, go with the lower, more cautious number. A business should not make itself look more profitable or more valuable than it really is.
When it comes to inventory, this means the business must not record inventory at a value that is too high. Overstating inventory would inflate profits and make the business look wealthier than it actually is — which would be misleading.
To follow the Prudence Concept, accountants compare two values for each item of inventory and then choose the lower one. The two values are:
Cost is the total amount the business paid to obtain the goods and bring them to their current location and condition. It includes:
Formula:
Cost = Purchase Price + Carriage Inwards
Example: A business buys goods for USD 50 and pays USD 5 delivery to bring them in. Cost = USD 50 + USD 5 = USD 55
Net Realisable Value (NRV) is the amount the business actually expects to receive from selling the goods, after deducting any costs it must pay to get them ready for sale or to complete the sale.
In plain English: it is the selling price minus any selling-related costs.
Formula:
NRV = Expected Selling Price − Selling Costs (e.g. repair costs, selling expenses)
Example: A business expects to sell goods for USD 60, but must spend USD 8 to repair them before they can be sold. NRV = USD 60 − USD 8 = USD 52
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