Role of Accounting Concepts in Inventory Valuation

Historical cost concept of accounting states that assets including inventory should be recorded at their original cost until they are sold. In other words, no profit should be recognized until the profit is realized, which is when the sale takes place.

However, if we consider that we will not be able to sell the inventory at a profit. The valuation of inventory in such a case should be based on prudence concept of accounting. This concept forces us to recognize a loss immediately, we are aware of it, and therefore if the net realizable value of inventory is lower than its original cost, then it should be valued at its net realizable value. On the contrary, inventory should be shown at cost price. This means inventory should be valued at lower of cost or net realizable value.

Net realizable value is the sales price of the inventory less any future cost to put it into sale able condition and less any anticipated selling expenses.

The valuation of inventory at lower of cost or marker (NRV) is also in accordance to the matching concept of accounting. Any reduction in the value of inventory will be reflected in the income statement of the year in which the loss occurred and recognized rather than in the year in which the goods are sold.

In addition to prudence concept the going concern concept of accounting allows valuation at lower cost or market on the assumption that the inventory will be sold in the normal course of business, unless there is evidence that the business may soon cease trading. If the business is not a going concern, inventory may have to be sold off at a forced sale price and this may result in a much lower net realizable value.

On the other hand the application of “lower of cost or market” violates consistency principle of accounting because inventories may be valued one way at one time and another way to another time. Moreover it recognizes losses in inventory value before inventory is sold but does not recognize increase in inventories market value until goods are sold. However, when inventory is consistently applied on “lower of cost or net realizable value” the consistency concept does apply.