understand the basis of the valuation of inventory at the lower of cost and net realisable value

4.5 Valuation of Inventory 📦

What is Inventory Valuation?

Inventory valuation is the method used to determine the monetary value of goods that a company keeps for sale. It tells us how much those goods are worth on the balance sheet and how they affect profit when sold.

Lower of Cost and Net Realisable Value (LCNRV) Principle

The LCNRV rule says that inventory should be recorded at the lower of:

1. Cost – the amount paid to acquire or produce the item.
2. Net Realisable Value (NRV) – the selling price minus any selling costs.

Cost of Inventory

• Purchase price of goods.
• Freight, handling, and insurance costs.
• Customs duties and taxes.
• Any costs directly attributable to bringing the inventory to its present location and condition.

Net Realisable Value (NRV)

• Estimated selling price in the ordinary course of business.
• Subtract expected costs to complete and sell (e.g., shipping, commissions).
• Result is the amount that can realistically be realised from the inventory.

Applying the LCNRV Rule

1. Calculate the Cost of each inventory item.
2. Estimate its NRV.
3. Choose the lower of the two figures.
4. Record that amount as the inventory value on the balance sheet.
5. Any difference (Cost – NRV) is recognised as a loss in the profit and loss account.

Example: Toy Store Inventory

Analogy: The “Cheapest Gift” Rule 🎁

Imagine you bought a gift for a friend. You could either keep the original price you paid or offer it to your friend at a discount. The LCNRV rule is like saying: “Give your friend the cheaper option.” If the gift’s resale value is lower than what you paid, you should record it at the lower resale value to avoid over‑valuing your gift book. This keeps your books honest and realistic.

Exam Tips 📚

• Remember the formula: $LCNRV = \min(\text{Cost}, \text{NRV})$
• Check the wording: “lower of cost and net realisable value” – it’s not “higher of” or “average”.
• Show your calculations: Write out Cost, NRV, and the chosen lower figure.
• Explain the impact: If NRV < Cost, record a loss; if Cost < NRV, record the cost.
• Use examples: Practice with different scenarios (e.g., damaged goods, obsolete stock).
• Time management: Spend a few minutes on each item; don’t get stuck on one calculation.