Inventory
Inventory is typically the largest single asset on a trading entity’s balance sheet. Getting the valuation wrong has a ripple effect — it distorts cost of sales, gross profit, net profit, total assets and equity, and carries forward into the next year as the opening inventory.
1. What inventory includes
Inventory is any of the following goods held by an entity:
2. Why correct valuation matters
An incorrect inventory figure at year-end has a compounding effect that spans two financial years. The closing inventory of year 1 becomes the opening inventory of year 2, so an error is never confined to a single period.
| If closing inventory is understated | Effect in Year 1 | Effect in Year 2 |
|---|---|---|
| Cost of sales | Overstated ↑ | Understated ↓ |
| Gross profit | Understated ↓ | Overstated ↑ |
| Net profit | Understated ↓ | Overstated ↑ |
| Total assets (SFP) | Understated ↓ | Correct (error cancels) |
| Equity (Capital) | Understated ↓ | Correct (error cancels) |
What to include in closing inventory
- All goods physically on the premises that belong to the entity
- Goods in transit that have been shipped FOB (Free on Board) from the seller — ownership has passed
- Do NOT include goods received on consignment (they belong to the supplier)
- Do NOT include goods already sold and dispatched to the buyer (even if still physically present)
3. Valuation at historical cost
In FAC1502, inventory is valued at historical cost — the actual cost paid to acquire it. This is the default basis required by IAS 2 (Inventories).
4. Net realisable value (NRV)
NRV is the estimated selling price in the normal course of business, less any estimated costs necessary to make the sale (e.g. selling costs, completion costs). When NRV falls below cost — due to damage, obsolescence or falling market prices — inventory must be written down to NRV.
If cost < NRV → value at cost
If NRV < cost → value at NRV (write down to the lower figure)
5. What is included in the cost of inventory
The historical cost of inventory is more than just the invoice price. All costs incurred to bring the inventory to its present location and condition are included:
▸ Carriage outwards (delivery costs to customers) — this is a selling expense
▸ Packaging material used — this is a selling expense
▸ Abnormal wastage — this is charged to profit or loss, not inventorised
▸ Trade discount — deducted from the invoice price; not separately recorded
Bombay Traders worked example
6. The gross profit method
When inventory cannot be physically counted — for example after a fire, flood or theft — the gross profit method is used to estimate the inventory value. The method works backwards from known sales and the historical gross profit percentage to calculate an estimated cost of sales, and from that, the estimated closing inventory.
To find Cost of sales from Sales:
Cost = Sales × (100 ÷ (100 + GP%))
Example: GP% on cost = 50%
Cost = Sales × 100/150
To find Cost of sales from Sales:
Cost = Sales × (100 − GP%) ÷ 100
Example: GP% on sales = 33⅓%
Cost = Sales × 66.67/100
Gross profit method — M Dry example (fire destroyed inventory)
From prior year: Revenue R114 000, Cost of sales R76 000, Gross profit R38 000.
Current year: Sales R120 000, Purchases R96 000. Fire occurred before year-end count.
7. Consistency
Whichever basis of inventory valuation is chosen — historical cost, FIFO, weighted average — it must be applied consistently from year to year. If the basis changes, the change and its effect must be disclosed in the notes to the financial statements. This is the consistency principle.
8. Disclosure on the SFP
Inventory is a current asset. All different types of inventory are sub-classified under Inventories on the SFP. The accounting policy used for valuation must be disclosed in the notes.
▸ The accounting policy for measuring inventory (historical cost, lower of cost and NRV)
▸ The cost formula used (FIFO, weighted average, etc.)
▸ Any write-down of inventory to NRV and the reversal thereof
9. Inventory & gross profit calculator
Calculate cost of goods purchased, cost of sales, gross profit, and estimate inventory using the gross profit method.
10. Worked exercises
Inventory questions in the FAC1502 exam style.
11. Quick quiz
Twelve questions covering the full study unit.