How to value closing inventory

Step by step

1. Find the cost of each line. Cost is what the business paid to buy or make the goods, including bringing them in.
2. Estimate net realisable value. Net realisable value is the expected selling price less any costs still needed to complete and sell the goods.
3. Compare the two for each line. Take the lower of cost and net realisable value for each separate line of inventory, not for the total.
4. Add up the chosen figures. Total the lower figures to get the closing inventory value.
5. Enter it in both statements. Deduct it in the cost of sales calculation and show it as a current asset.

Worked example

Goods cost RM1,000 but can now sell for only RM750 net. Value them at RM750, the lower figure.

Understanding the method

Accounting is cautious about overstating assets and profit. This is the prudence concept. So inventory is never shown at more than the business can expect to recover.

Cost is what was paid to bring the goods to their present place and condition, including carriage inwards. Net realisable value (NRV) is the expected selling price less any costs still needed to finish and sell them. The lower of the two is the value.

The valuation affects profit directly. Closing inventory is deducted when working out cost of sales, so a higher closing inventory means a lower cost of sales and a higher gross profit.

Apply the rule line by line, or to groups of similar items. If you compared total cost with total NRV, a profitable line could hide a loss-making one. Going line by line records every expected loss and never anticipates a profit.

Example 1. A line costs RM4,000, but a newer model has arrived. It will now sell for RM3,600, and RM200 of repackaging is needed.

NRV is 3,600 − 200 = RM3,400. This is below cost, so the goods are valued at RM3,400 and the RM600 loss is recognised now.

Example 2. A line costs RM2,500 and will sell for RM4,000.

NRV is higher than cost, so it stays at RM2,500. Profit is only recognised when goods are sold.

Example 3, for a kitchenware shop. Pots cost RM6,000 (NRV RM7,200). A discontinued range of pans costs RM3,000 (NRV RM2,100 after a clearance discount and delivery).

Utensils cost RM1,500 (NRV RM1,700). The lower figures are 6,000 + 2,100 + 1,500 = RM9,600. Using total cost of RM10,500 would overstate gross profit and the asset by RM900.

Check each line: is the figure you chose the lower of the two? Also read the question for goods to add, such as inventory held by an agent for the business. Look for goods to remove too, such as goods the business does not own at the year end.

Common mistakes include using selling price instead of NRV and ignoring repair or delivery costs. Another is including carriage outwards in cost. Only carriage inwards counts, because carriage outwards is a selling expense. Others are applying the rule to the grand total, and treating goods on sale or return as sold when they are still the business's inventory. Inventory is never valued above cost, even if prices recover.

If you are unsure how to value each line, we can help. One of our teachers can work through inventory valuation questions with you and show how the figure feeds into cost of sales. Book a trial class

Related skills

• How to prepare an income statement for a sole trader
• How to calculate cost of sales
• How to prepare a statement of financial position

The methods here are standard accounting practice, with original figures. For your exam board's exact requirements, see exam boards and Sources.