Inventory Valuation at Kestrel Sports
Kestrel Sports prepares accounts to 31 March. The inventory ledger shows £84,000 at 31 March 20X6. The following have not been adjusted: (i) 200 running shoes cost £60 each and normally sell for £110 each; they are damaged and can be sold for £35 each after repair costs of £10 each; (ii) 300 units of a discontinued line cost £40 each and can be sold for £45 each, but selling costs are £8 each; (iii) goods held on sale or return from a supplier cost £9,000 and are included in the £84,000; (iv) goods costing £4,000 were sold for £6,000 on 30 March; the sale was correctly recorded, but the goods were still counted in closing inventory because the customer collected them on 2 April. The owner argues that inventory should be kept at cost because the shoes and discontinued line will eventually sell, and that the sale-or-return goods are 'in our warehouse so they are ours'.
1. Calculate the correct inventory at 31 March 20X6, justifying each adjustment.
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Shoes: cost 200 × £60 = £12,000. NRV = 200 × (£35 − £10) = £5,000. Lower of cost and NRV = £5,000, so write down £7,000.
Discontinued line: cost 300 × £40 = £12,000. NRV = 300 × (£45 − £8) = £11,100. Write down £900.
Sale-or-return goods: the supplier retains the risks and rewards of ownership, so the goods are not Kestrel's asset. Exclude £9,000.
Goods sold on 30 March: the sale was correctly recorded; control passed under the unconditional contract, so the cost of £4,000 must be removed from inventory.
Correct inventory = £84,000 − £7,000 − £900 − £9,000 − £4,000 = £63,100.
2. Explain the effect on gross profit and the current ratio if the owner's view is followed and no adjustments are made.
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If no adjustments are made, closing inventory is £84,000 instead of £63,100 - overstated by £20,900. Closing inventory is deducted from cost of sales, so the overstatement understates cost of sales and overstates gross profit and profit by £20,900. Current assets are overstated by the same amount, so the current ratio is overstated; the statement looks more liquid than it is.
The sale-or-return goods are particularly misleading: including £9,000 of supplier-owned goods inflates inventory without any corresponding liability, overstating net assets. The damaged shoes and discontinued line will still be held at cost even though they cannot realise that amount. The owner's view confuses physical possession with ownership and ignores the need to compare cost with net realisable value.
3. Justify the treatment of the sale-or-return goods and the damaged shoes using relevant accounting principles.
Read the worked answer
The sale-or-return goods are not owned by Kestrel: the supplier retains the risks and rewards, so control has not passed. Including them would recognise an asset the business does not control. The damaged shoes must be carried at the lower of cost and net realisable value, not at cost. NRV is the estimated selling price less costs to complete and sell: £35 − £10 = £25 per shoe, below the £60 cost.
Prudence does not mean deliberately understating assets; it means not overstating them when the evidence shows the economic benefit has fallen. The same logic applies to the discontinued line, where NRV is £37 per unit against £40 cost. The 30 March sale is different: control passed, so the related cost is no longer an asset.