Study tips: how to prepare closing inventory for financial statements

Accounts preparation is tricky, because to do it successfully we have to understand what we’re doing, as well and why we’re doing it. 

In this article we’re going to focus in-depth on closing inventory.

What is it?  Closing inventory is the amount of stock that an organisation has at the end of an accounting period.

It is a combination of raw materials, work in progress (WIP) and finished goods.  For a manufacturing business that is what’s left in the stock room, on the factory floor and in the warehouse.  However, for a retailer it is more likely to be a stockroom full of goods bought for resale and for a service business, like an accountants, it might partially complete contracts.

Why is it important to value it?  It is included in the financial statements and has an impact on both an organisation’s profits and the value of its assets.

Monitoring and controlling inventory levels and costs throughout the year is generally seen as a management accounting function.  However, year-end financial accounting standards require a value to be placed on the closing inventory for inclusion in the financial statements.  It forms part of the ‘cost of goods sold’ (COGS) calculation on the Statement of profit or loss (SoPL) due to the accruals concept.  It is also a current asset on the Statement of financial position (SoFP) as it is owned by the organisation but its value will change within a 12 month period.

How is it valued?  At the lower of cost or net realisable value (NRV) in accordance with IAS2.

A physical stock take is required to ascertain the levels of each stock line and reconcile them to the accounting records.  Each type of inventory and each inventory line within each type, must be valued separately by comparing its cost to its NRV and choosing the lower value.  For example, 5mm nails and 5mm screws are both raw materials but are different lines.

Definition of cost:

The purchase price plus the cost of getting the inventory into its current position, for example, a supplier’s delivery charges.

Definition of NRV:

The expected selling price of the inventory, less any further costs to be incurred such as selling or distribution costs or repairs.

Worked example:

Inventory line GM47 costs £9 plus £1 delivery per unit and sells for £13 per unit.  The packaging of 100 items has become damaged and needs to be repackaged at a cost of £2.50 per unit.  They will then sell for £12 per unit.

Calculate the total cost and total net realisable value of the inventory and state the correct value to be used in the financial statements.

Total cost is £1,000

£9 cost plus £1 delivery is £10 per unit.  100 units x £10 per unit = £1,000

Total net realisable value is £950

£12 selling price less £2.50 additional costs is £9.50 per unit.  100 units x £9.50 per unit = £950

The inventory should be valued at £950 in the financial statements as the NRV is lower than the cost.

How do we calculate the inventory value if we are only given the selling price?  If we know the selling price is greater than cost, then because of IAS2, we know to value the closing inventory at cost as it will be the lower of cost and NRV.

Worked example:

GM Manufacturing’s selling price is calculated by marking up the cost by 27% and the sales price of the closing inventory is £265,457.

Calculate the total cost and total net realisable value of the inventory and state the correct value to be used in the financial statements, rounded to the nearest whole £.

Total net realisable value is £265,457

The cost value equals 100%

As the NRV is 27% higher than the cost, £265,457 represents 127%

Therefore the total cost is calculated as £265,457 ÷ 127 x 100 = £209,021.25

How is the year-end adjustment made?  By debiting closing inventory on the SoFP and crediting closing inventory on the SoPL.

This is usually done by using a journal or in the adjustment columns of an extended trial balance.

Why is the accounting treatment of inventory an application of the accruals concept?  Because it matches the cost of the inventory to the financial period in which it will generate income.

Accounting for inventory is a cycle. The cost of goods sold calculation on the SoPL starts with opening inventory, which was last year’s closing inventory.  We then add this year’s purchases as that is how much we have spent on inventory during the year.  The opening inventory and most of the purchases will have been sold to generate this year’s sales figure, but there will be some left unsold and that’s the closing inventory.  Therefore, in order to calculate the true cost of the goods sold, we need to deduct the value of the closing inventory.  This will become next year’s opening inventory and the cycle will continue.

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Gill Myers is a self-employed accounts consultant. She has taught AAT qualifications since 2005 and written numerous articles and e-learning resources.