understand the basis of the valuation of inventory at the lower of cost and net realisable value
4.5 Valuation of Inventory – Lower of Cost and Net Realisable Value (NRV)
1. Context within the Accounting Cycle
Where does inventory valuation fit?
After purchases are recorded in the books of prime entry and posted to the ledger, the trial balance is prepared.
Before the Statement of Financial Position is drawn up, all inventory balances must be valued.
The “lower of cost and NRV” rule is the final adjustment in the accounting procedures of Section 4.5.
Once the inventory is valued, the adjusted trial balance is used to prepare the income statement, statement of financial position and cash‑flow statement (see Section 5 – Preparation of Financial Statements).
Income statement, statement of financial position, cash‑flow statement for sole traders, partnerships and limited companies.
Manufacturing & Costing
Raw materials, work‑in‑progress, finished goods, production overheads, cost of goods sold.
Incomplete Records & Analysis
Reconstruction of accounts, ratio analysis, interpretation of results.
Accounting Policies & Ethical Issues
Selection of policies, impact on financial statements, professional ethics.
3. Learning Objectives
Explain why inventory is valued at the lower of cost and NRV.
Calculate NRV for raw materials, work‑in‑progress and finished goods.
Record the write‑down (and any permissible reversal) in the journal.
Identify the impact on the profit‑and‑loss account and the statement of financial position.
Link the valuation rule to the accounting principles of prudence and matching (syllabus 7.1‑7.2).
4. Key Concepts
Term
Definition (Cambridge)
Cost of inventory
All costs incurred to bring the inventory to its present location and condition (purchase price, import duties, transport, handling, conversion costs and any other directly attributable costs).
Net Realisable Value (NRV)
Estimated selling price in the ordinary course of business less the estimated costs of completion and disposal.
Lower of Cost and NRV rule
At each reporting date, inventory must be recorded at the lower of its historical cost or its NRV (Cambridge requirement).
5. Why Apply the Lower‑of‑Cost‑and‑NRV Rule?
Prudence (conservatism) principle: Prevents the over‑statement of assets and unrealised profit.
Matching principle: The expense of a write‑down is recognised in the same period that the loss in value occurs.
Provides a realistic estimate of the cash that can be recovered from the inventory.
6. Calculating Net Realisable Value
NRV formula (as stated in the syllabus)
NRV = Estimated selling price – Estimated costs of completion – Estimated costs of disposal
7. Step‑by‑Step Procedure (Section 4.5)
Identify each class of inventory (raw materials, work‑in‑progress, finished goods).
Determine the cost per unit for each class (including all acquisition and conversion costs).
Estimate the selling price per unit at the reporting date.
Estimate any additional costs required to make the item saleable (completion, transport, commissions, disposal).
Calculate NRV per unit using the formula above.
Compare cost and NRV:
If Cost ≤ NRV → retain the inventory at cost (no entry).
If Cost > NRV → write the inventory down to NRV.
Record the write‑down as an expense in the profit‑and‑loss account.
At the next reporting date, re‑assess NRV. A reversal is allowed only up to the amount of the original write‑down (no profit is recognised).
8. Common Pitfalls (AO3 – Evaluation)
Do not record a gain when NRV rises above the original cost after a write‑down – only a reversal up to the amount written down is permitted.
If NRV is higher than cost, no journal entry is required.
The rule applies to *all* inventory categories; forgetting work‑in‑progress is a frequent error.
Do not include future expected price increases that are not yet realised in the NRV calculation.
9. Journal Entries
Situation
Journal Entry
Write‑down (Cost > NRV)
Dr Loss on inventory write‑down xxx
Cr Inventory (balance‑sheet) xxx
Permissible reversal (NRV rises but not above original cost)
Dr Inventory yyy
Cr Gain on reversal of inventory write‑down yyy
Note: yyy ≤ original write‑down amount.
10. Illustrative Example (Section 4.5)
Company XYZ – inventory at 31 December
Item
Cost per unit (£)
Units on hand
Estimated selling price per unit (£)
Completion cost per unit (£)
Disposal cost per unit (£)
Finished goods A
12.00
500
15.00
0.50
0.30
Work‑in‑progress B
8.00
300
9.00
0.80
0.20
Raw material C
5.00
400
4.50
0.00
0.10
NRV Calculations
Finished goods A: 15.00 – 0.50 – 0.30 = £14.20 per unit
Work‑in‑progress B: 9.00 – 0.80 – 0.20 = £8.00 per unit
Raw material C: 4.50 – 0.00 – 0.10 = £4.40 per unit
Decision & Write‑down
Finished goods A: Cost £12.00 < NRV £14.20 → keep at cost (no entry).
Work‑in‑progress B: Cost £8.00 = NRV £8.00 → keep at cost (no entry).
Raw material C: Cost £5.00 > NRV £4.40 → write‑down required.
Assume at 31 December of the following year the NRV of raw material C rises to £5.00 per unit.
Maximum reversal allowed = original write‑down (£240).
Reversal needed = (5.00 – 4.40) × 400 = £240.
Dr Inventory £240
Cr Gain on reversal of inventory write‑down £240
If NRV had risen only to £4.70, the permissible reversal would be £120 (half of the original write‑down).
11. Effect on the Financial Statements
Statement of Financial Position: Inventory is shown at the lower of cost or NRV.
Profit‑and‑Loss Account: The write‑down appears as an expense, reducing profit for the period. Any permissible reversal is recorded as other income.
The adjustment follows the same prudence approach used for depreciation, provisions and doubtful debts (see Sections 4.2‑4.4).
12. AO2‑Style Question (Analysis)
Given the trial balance below, identify which inventory items require a write‑down, calculate the total write‑down amount, and state the effect on gross profit.
Item
Cost per unit (£)
Units
Estimated selling price (£)
Completion cost (£)
Disposal cost (£)
Finished goods X
20
150
22
0.5
0.2
Raw material Y
6
300
5.5
0
0.1
Answer outline: calculate NRV for each, compare with cost, write‑down only for Raw material Y (NRV = 5.5‑0.1 = £5.40 < cost £6). Write‑down = (6‑5.40)×300 = £180. Gross profit falls by £180.
13. Quick‑Check Questions (AO3 – Evaluation)
Explain why a company cannot record a profit if the NRV of inventory rises above the original cost after a write‑down.
Company Q recorded a £500 write‑down on raw materials in Year 1. In Year 2 the NRV increases, allowing a £300 reversal. Show the journal entry and explain why the reversal is limited to £300.
14. Key Points to Remember
Assess NRV at each reporting date – it is a forward‑looking estimate.
Write‑downs are recognised immediately; reversals are allowed only up to the amount of the original write‑down (no new profit).
The rule applies to all inventory categories – raw materials, work‑in‑progress, finished goods.
It embodies the prudence and matching principles (Section 7.1‑7.2).
After valuation, adjust the trial balance before preparing the income statement and balance sheet (see Sections 5.1‑5.2).
Suggested diagram: Flowchart illustrating the decision process for applying the lower‑of‑cost‑and‑NRV rule (from cost determination → NRV calculation → comparison → journal entry → impact on financial statements).