the difficulties of valuing inventory

10.1 Financial Statements – Inventory Valuation

Objective

To understand the difficulties businesses face when valuing inventory for financial statements and to see how inventory valuation links to working‑capital management, financing decisions and overall business performance (Cambridge 9609 10.1).

1. Why Inventory Valuation Matters

• Working‑capital requirement: Inventory ties up cash that could otherwise be used for operating expenses or investment. The amount of stock held directly influences the cash‑conversion cycle.
• Cash vs. profit: A high inventory value reduces cost of goods sold (COGS) and therefore inflates profit, but it may mask cash shortages and increase solvency risk.
• Risk of failure: Over‑stocking or a large write‑down erodes profit margins, may breach loan covenants and increase the chance of business failure.

2. Inventory in the Financial Statements

2.1 Profit & Loss Account (Statement of Income)

Item	Explanation
Sales Revenue	All income from the sale of goods or services.
Opening Inventory	Stock at the start of the period (used to calculate COGS).
Purchases (net of returns)	Cost of stock bought during the period.
Closing Inventory	Stock remaining at period‑end – **valuation method** determines this figure.
Cost of Goods Sold (COGS)	Opening Inv + Purchases – Closing Inv.
Gross Profit	Sales Revenue – COGS.
Operating Expenses (including depreciation of plant)	All expenses incurred to run the business.
Profit before Tax	Gross Profit – Operating Expenses.
Tax	Current tax charge.
Profit after Tax	Bottom‑line profit.

2.2 Statement of Financial Position (Balance Sheet)

Assets	Liabilities & Equity
Non‑current assets (plant, equipment – net of depreciation) Current assets Inventory (valued by the chosen method) Trade receivables Cash & bank	Current liabilities (trade payables, overdraft, short‑term loans) Non‑current liabilities (long‑term loans, bonds) Equity (share capital, retained earnings – affected by profit after tax)

Inventory appears under current assets; its valuation therefore influences the current ratio, working capital and the amount of retained earnings.

2.3 Capital vs. Revenue Expenditure

• Capital expenditure – purchase of non‑current assets (e.g., plant, machinery). Capitalised on the balance sheet and depreciated over useful life.
• Revenue expenditure – costs incurred in the normal running of the business, such as purchases of stock. Charged to the income statement as part of COGS.
• Depreciation of plant is a **revenue expense** that is allocated to the cost of goods manufactured, so it indirectly affects COGS and therefore the profit impact of inventory valuation.

3. Working Capital and the Cash‑Conversion Cycle

Working capital = Current assets – Current liabilities

Component	Relation to Inventory
Inventory	Financing needed to hold stock; excess stock lengthens the cash‑conversion cycle.
Trade receivables	Higher inventory can generate higher sales and thus larger receivable balances.
Trade payables	Delaying payment for purchased stock reduces cash outflow, but may affect supplier terms.

Cash‑Conversion Cycle (CCC) = Days Inventory Outstanding + Days Sales Outstanding – Days Payables Outstanding.

Shortening the CCC improves liquidity and reduces the need for external finance.

4. Sources of Finance and the Influence of Inventory Valuation

Finance Source	Typical Use	Impact of Inventory Level	Key Ratio Considered by Lender
Bank overdraft / short‑term loan	Cover temporary cash shortfalls (e.g., seasonal stock build‑up)	Higher inventory increases current assets → improves current ratio, making overdraft easier to obtain.	Current ratio (≥ 1.5 often required)
Factoring of receivables	Convert sales on credit into immediate cash	Large inventory may generate large receivables; factoring reduces dependence on inventory‑backed borrowing.	Debt‑to‑equity ratio
Equity issue (new shares)	Long‑term funding for expansion or major stock‑take losses	Write‑downs lower retained earnings, potentially diluting existing shareholders; a strong inventory base can offset the effect on equity.	Return on equity, earnings per share
Long‑term loan / debenture	Finance permanent increase in working capital	Lenders look at the stability of inventory values; frequent write‑downs raise perceived risk.	Interest‑coverage ratio

5. Cash‑Flow Forecasting – Effect of an Inventory Write‑down

Assume a company expects the following cash flows for the next month:

Cash Flow Item	Amount ($)
Cash sales	30,000
Collections from receivables (previous month)	20,000
Payments to suppliers (including inventory purchases)	(35,000)
Operating expenses (incl. depreciation)	(15,000)
Tax payment	(5,000)

If the year‑end inventory is written down by $4,000, the accounting profit falls by $4,000, but the cash outflow for the write‑down is **zero** (it is a non‑cash expense). The revised cash‑flow forecast becomes:

• Operating cash outflow reduces to $(15,000 – 4,000) = $(11,000).
• Net cash flow improves by $4,000, showing how a lower inventory value can actually **increase** short‑term cash availability, even though profitability falls.

Students should be able to explain this distinction in exam questions.

6. Key Difficulties in Valuing Inventory

• Choosing the valuation method – FIFO, LIFO, weighted‑average, specific identification each give different COGS and closing‑stock values.
• Lower of cost or net realisable value (NRV) – Requires judgment about future selling prices and disposal costs.
• Obsolescence and spoilage – Estimating the amount and timing of write‑offs.
• Price volatility – Rapid changes in purchase prices can make historical‑cost figures misleading.
• Multiple locations and formats – Consolidating stock in warehouses, retail outlets and consignment arrangements.
• Periodic vs. perpetual systems – Periodic counts increase error risk; perpetual systems need sophisticated tracking.
• Allocation of overheads – Deciding which indirect costs (storage, handling, insurance) are includable in inventory cost.
• Returns and allowances – Estimating the impact of future customer returns on current inventory value.
• Foreign‑currency purchases – Converting costs at the correct exchange rate adds complexity.

7. Lower of Cost or Net Realisable Value (NRV)

IAS 2 requires inventory to be recorded at the lower of its cost or NRV.

NRV = Estimated selling price – Estimated costs of completion and disposal

Worked example

• Cost of a batch of finished goods: $12 000
• Estimated selling price: $11 000
• Estimated costs of disposal: $500

NRV = $11 000 – $500 = $10 500

Since NRV ($10 500) < cost ($12 000), the inventory must be written down to $10 500, giving a write‑down expense of $1 500.

8. Comparison of Common Valuation Methods

Method	Principle	Effect on COGS (rising prices)	Effect on Closing Inventory	Typical Use & Exam Relevance
FIFO (First‑In, First‑Out)	Oldest units sold first; remaining stock consists of most recent purchases.	Lower COGS → higher gross profit.	Higher closing‑stock value.	Common in retail & perishable goods; fully examined.
LIFO (Last‑In, First‑Out)	Newest units sold first; remaining stock consists of earliest purchases.	Higher COGS → lower gross profit.	Lower closing‑stock value.	Allowed under US GAAP but prohibited under IFRS (IAS 2); rarely examined in Cambridge papers.
Weighted Average Cost	Average cost per unit = Total cost of goods available ÷ Total units available.	COGS reflects a blend of old and new costs.	Closing inventory valued at the same average cost.	Suitable for large volumes of indistinguishable items; fully examined.
Specific Identification	Each item is tracked individually and its actual cost is assigned.	COGS matches the exact cost of each sold item.	Closing inventory shows the exact cost of remaining items.	Used for high‑value, low‑volume items (e.g., cars, jewellery); examined in case‑study questions.

9. Illustrative Calculation – FIFO vs. Weighted Average

Assume a company purchases 1,000 units at $5 each, then 1,000 units at $7 each. At period‑end it has 800 units on hand.

FIFO

$$\text{Closing Inventory}_{\text{FIFO}} = (200 \times \$5) + (600 \times \$7) = \$1,000 + \$4,200 = \$5,200$$

Weighted Average Cost

$$\text{Average Cost} = \frac{(1,000 \times \$5) + (1,000 \times \$7)}{2,000} = \frac{\$12,000}{2,000} = \$6$$ $$\text{Closing Inventory}_{\text{Avg}} = 800 \times \$6 = \$4,800$$

10. Depreciation (Fixed Assets) – Interaction with Inventory

Although depreciation relates to non‑current assets, it influences inventory valuation for manufacturers because a portion of depreciation is allocated to the cost of goods manufactured.

• Straight‑line depreciation = (Cost – Residual value) ÷ Useful life.
• The annual depreciation charge is added to production costs, appears in COGS and therefore affects gross profit and the profitability of inventory.

11. Practical Tips for the Exam

1. Read IAS 2 (or the Cambridge “Accounting standards” summary) before attempting any calculation.
2. State clearly which inventory valuation method you are using and justify the choice (e.g., nature of product, price trends).
3. Always apply the “lower of cost or NRV” test after the initial valuation; include a brief NRV calculation if the question asks.
4. Remember the impact on key ratios:
   • Higher closing inventory → higher current ratio but may reduce gross profit if a high‑cost method (e.g., LIFO) is used.
   • Write‑downs reduce profit but improve operating cash flow.
5. For foreign‑currency purchases, convert at the spot rate on the date of purchase (or the average rate if the syllabus permits).
6. Practice a simple cash‑conversion‑cycle calculation and a short cash‑flow forecast to see how changes in inventory affect financing needs.
7. When dealing with multiple locations, remember to consolidate stock values before applying the chosen valuation method.

12. Suggested Diagram