1. The Core Objective of Inventory Accounting
Inventory represents goods held for sale in the ordinary course of business, in the process of production, or as materials to be consumed. The primary objective of inventory accounting is to determine the correct asset value to carry on the Balance Sheet and ensure that the cost of inventory sold is matched accurately against current revenues (Matching Principle).
2. Defining “Cost” under Accounting Standards
According to standard accounting rules (like IAS 2), the cost of inventory must include all costs incurred to bring the items to their present location and condition:
- Purchase Price: Net purchase price after deducting trade discounts and rebates.
- Import Duties & Taxes: Non-refundable import tariffs and transport taxes.
- Direct Handling Costs: Freight-in (carriage inwards), insurance during transit, and unloading costs.
- Excluded Costs: Storage costs after delivery, general administrative overheads, and selling expenses must be treated as period costs and expensed immediately.
3. The Lower of Cost and Net Realizable Value (NRV) Rule
To comply with the Prudence concept, inventory must be valued at the lower of cost and Net Realizable Value (NRV). This ensures that inventory assets are not overstated if their market value drops.
Net Realizable Value (NRV) = Estimated Selling Price − Estimated Costs of Completion − Estimated Costs to Make the Sale
Where:
- Estimated Selling Price: The expected price at which the inventory can be sold in the ordinary course of business.
- Estimated Costs of Completion: Any additional costs required to finish the goods (relevant for work-in-progress or unfinished inventory).
- Estimated Costs to Make the Sale: Selling and distribution costs, such as commissions, marketing, and transportation to the customer.
If the calculated NRV falls below the original cost of the inventory, the inventory must be written down to this lower NRV amount, with the difference recognized as an expense in the period it occurs.