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

2. Quick Syllabus Overview (Cambridge IGCSE Accounting 0452 – 2026)

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

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

7. Step‑by‑Step Procedure (Section 4.5)

1. Identify each class of inventory (raw materials, work‑in‑progress, finished goods).
2. Determine the cost per unit for each class (including all acquisition and conversion costs).
3. Estimate the selling price per unit at the reporting date.
4. Estimate any additional costs required to make the item saleable (completion, transport, commissions, disposal).
5. Calculate NRV per unit using the formula above.
6. Compare cost and NRV:
   • If Cost ≤ NRV → retain the inventory at cost (no entry).
   • If Cost > NRV → write the inventory down to NRV.
7. Record the write‑down as an expense in the profit‑and‑loss account.
8. 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

Dr  Loss on inventory write‑down          xxx
    Cr  Inventory (balance‑sheet)               xxx

Dr  Inventory                               yyy
    Cr  Gain on reversal of inventory write‑down   yyy

10. Illustrative Example (Section 4.5)

Company XYZ – inventory at 31 December

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.

Write‑down amount = (Cost – NRV) × Units = (5.00 – 4.40) × 400 = £240

Journal Entry (31 Dec)

Dr  Loss on inventory write‑down   £240
    Cr  Inventory                     £240

Reversal Example (Next Year)

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.

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)

1. Explain why a company **cannot** record a profit if the NRV of inventory rises above the original cost after a write‑down.
2. 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).