Inventories and Cost of Sales
What you must know
Inventories are measured at the lower of cost and net realisable value (NRV = estimated selling price less costs to complete and costs to sell). Cost comprises purchase cost, conversion cost and other costs to bring inventory to its present location and condition. Know cost formulas: specific identification for items not ordinarily interchangeable; FIFO or weighted average for others. LIFO is not permitted. Understand the effect of inventory errors on profit or loss and on the statement of financial position across two periods. Know when to write down and when to reverse a write-down (limited to the original write-down). Apply the retail and standard cost methods only as approximations, and understand disclosure requirements.
Traps candidates fall into
- Using replacement cost or fair value less costs to sell as the measurement basis; NRV is entity-specific.
- Forgetting that abnormal waste, storage costs (unless necessary in the production process) and selling costs are excluded from cost.
- Failing to reverse a prior write-down when NRV recovers, capped at the original write-down.
- Confusing the effect of an overstatement of closing inventory: it overstates profit in the current year and understates it next year.
- Applying the lower-of-cost-and-NRV rule to a whole category when it should be applied item by item.
Rule of thumb
Compute cost and NRV for each item; take the lower. If NRV recovers, reverse up to the original write-down. Remember the two-period symmetry of inventory errors.
Worked example
Item A costs 40,000; NRV is 34,000. Item B costs 25,000; NRV is 30,000. Apply item by item: A is written down to 34,000 (loss 6,000) and B stays at 25,000. Total inventory 59,000, not 65,000 (which would result from category-level application).