Inventories are unsold ready goods. Inventories might also be in the form of raw materials and components that have not yet been made into completed units. Also, some goods are in the process of being made and these are referred to as work in progress.
So, most companies hold inventories in the following four forms:
- Raw materials.
- Components.
- Work in progress.
- Ready goods.
Valuation of Inventories
How should these raw materials, components, work in progress and ready goods be valued in Balance Sheet under Current Assets?
Inventories should be recorded at their historical cost or at their Net Realizable Value, whichever is the lower. Historical cost is the purchase price of inventories in the past. Net Realizable Value is the amount for which an inventory can be sold minus the cost of selling it. It is only used in Balance Sheet when estimated to be below historical cost.
Example 1: Valuing raw materials using Net Realizable Value. A hamburger restaurant bought ten big bottles of oil to fry hamburger meat for USD$10 per bottle, so USD$100 in total. At the end of the financial year, it has three bottles of oil remaining unused. But, the oil is nearing the expiry date and the hamburger restaurant will not be able to use all the oil before the expiry date. So, the restaurant manager is thinking of selling redundant amount of oil bottles to other restaurants at a reduced price of USD$8 per bottle. This is below the price he originally paid for them which was USD$10. Therefore, the Net Realizable Value of those three bottles of oil is only USD$24. It is this value, and not USD$30 which is the historical cost, that should appear in Balance Sheet. As the conservatism principle states that losses should be recorded as soon as they are believed to occur.
The concept of Net Realizable Value can also be used to value other inventory such as ready goods in Balance Sheet. The following example also follows the conservatism principle in order to avoid unnecessary over inflation of inventory.
Example 2: Valuing ready goods using Net Realizable Value. A furniture store has some unsold wardrobes that has been in stock for 12 months. They were bought from the manufacturer for USD$900. Some of the wardrobes have been damaged in the shop and need a quick repair costing $100. The store manager believes that after the repair the wardrobes could be sold for USD$1,000. They should not be valued in Balance Sheet at USD$1,000 as this assumes that a profit will be made and this is against the conservatism principle. The wardrobes should not be valued at USD$900 either as this ignores the fact that they have been damaged. The most accurate Net Realizable Value is USD$900-USD$100 = USD$800, which is less than the historical cost of USD$900. So, USD$800 becomes the inventory value in Balance Sheet.
