While inventory is perceived by most people as just a list of items being held at a storage facility, its accounting can significantly influence the figures in a company’s financial reports. The valuation of inventory will determine the cost of goods sold, gross profit, income tax payable, as well as the book value of the current assets of a company. This explains why one should learn about Inventory Accounting Methods.
When a company buys the same kind of goods at different prices, it has to choose a way of deciding how much of the expenses will be attributed to goods that have been sold, and how much will be left in ending inventory. There are three inventory accounting methods usually mentioned in accounting; these include FIFO, LIFO, and weighted average. These three use different cost flow assumptions while using the same amount of items purchased or sold.
Why Inventory Accounting Matters
Inventory is normally considered a current asset, consisting of raw materials, Work in Process, and Finished Goods. With the sale of the products, its cost is transferred from Inventory on the Balance Sheet to Cost of Goods Sold (COGS) in the Income Statement. This link makes Inventory valuation an integral component of financial reporting.
Take an example of a company that is purchasing the same product a number of times throughout the year. The first purchase would be at a cost of ₹100, and the next one after some time will be at a cost of ₹110, due to an increase in prices. But which cost of the product should be considered as the cost of units sold? It depends on the choice of Inventory Valuation Method.
Here comes the application of Accounting for Inventory, going beyond the simple accounting for purchases and sales of Inventory. Depending on the method chosen by the company, COGS and remaining inventory would differ.
FIFO: First-In, First-Out
First-in, First-out is an acronym for FIFO. Simply put, FIFO refers to the assumption that the goods acquired or manufactured first will be the ones that will be sold first. This way, the remaining inventory would be associated with the latest purchase price. IAS 2 allows FIFO for interchangeable inventories under IFRS.
For example, let us assume a retail store buys 100 units for ₹50 each and then buys another 100 units for ₹60 each. In case there is a sale of 120 units, FIFO will assume that the initial 100 units will be from the ₹50 purchase and the final 20 units will be from the ₹60 purchase. Therefore, COGS will be ₹5,000 + ₹1,200 = ₹6,200.
It is often easy to use FIFO as it mirrors the physical flow of inventory. For instance, companies dealing with goods that become obsolete, expire, or go bad with time, such as food products, medicines, cosmetics, among others, will actually physically sell off the older items first regardless of what the cost flow assumption would be.
When prices of purchases are rising, the FIFO method tends to yield older, cheaper units in the COGS account, while the more recent and expensive units will be in the ending inventory. In this case, gross profit yielded by FIFO will be higher than gross profit yielded by LIFO.
But accountants must take note that FIFO is merely an assumption on cost flow and does not necessarily mean that companies sell the oldest unit first.
LIFO: Last-In, First-Out
First-in, First-out is an acronym for FIFO. Simply put, FIFO refers to the assumption that the goods acquired or manufactured first will be the ones that will be sold first. This way, the remaining inventory would be associated with the latest purchase price. IAS 2 allows FIFO for interchangeable inventories under IFRS.
For example, let us assume a retail store buys 100 units for ₹50 each and then buys another 100 units for ₹60 each. In case there is a sale of 120 units, FIFO will assume that the initial 100 units will be from the ₹50 purchase and the final 20 units will be from the ₹60 purchase. Therefore, COGS will be ₹5,000 + ₹1,200 = ₹6,200.
It is often easy to use FIFO as it mirrors the physical flow of inventory. For instance, companies dealing with goods that become obsolete, expire, or go bad with time, such as food products, medicines, cosmetics, among others, will actually physically sell off the older items first regardless of what the cost flow assumption would be.
When prices of purchases are rising, the FIFO method tends to yield older, cheaper units in the COGS account, while the more recent and expensive units will be in the ending inventory. In this case, gross profit yielded by FIFO will be higher than gross profit yielded by LIFO.
But accountants must take note that FIFO is merely an assumption on cost flow and does not necessarily mean that companies sell the oldest unit first.
LIFO: Last-In, First-Out
LIFO stands for Last-In, First-Out. This method assumes that the last purchased or manufactured inventories are the ones that are being sold. Thus, the latest cost flows into COGS, and the older costs stay in ending inventory.
For instance, consider a situation where a company purchases 100 units at ₹50 per unit and then another 100 units at ₹60 per unit. It then sells 120 units, which results in the 100 units purchased at ₹60 and another 20 units purchased at ₹50 being assigned to COGS, resulting in ₹6,000 + ₹1,000 = ₹7,000.
This difference becomes especially significant if the prices change. In times of increasing prices, LIFO will result in a higher COGS and lower ending inventory compared to FIFO, provided the transactions and inventories are identical.
It is also necessary to understand LIFO since its acceptability depends on the reporting standard adopted by a company. LIFO is acceptable under US GAAP but not allowed under IFRS. IAS 2 requires FIFO or weighted average cost for ordinary inventories rather than LIFO.
The relevance of this differentiation becomes even more pronounced for accounting professionals in India dealing with companies that have foreign operations or need to report under foreign jurisdictions or on the basis of foreign accounting standards. The Indian Accounting Standards (Ind AS), which are highly harmonised with IFRS, apply in India, but IFRS itself does not.
Weighted Average Cost Method
The weighted average method takes a different approach. Instead of assigning the oldest or newest purchase costs to goods sold, it calculates an average cost for units available for sale. The average is based on the total cost of goods available divided by the total number of units available.
Suppose a company has 100 units costing ₹50 each and purchases another 100 units at ₹60 each. The total cost is ₹11,000 for 200 units, giving a weighted average cost of ₹55 per unit. If the company sells 120 units, the COGS based on this average would be ₹6,600, while the remaining 80 units would be valued at ₹4,400.
The weighted average approach can be useful when a business holds large quantities of similar or interchangeable products and tracking the exact cost of every individual unit would be unnecessarily complicated. IAS 2 allows weighted average cost for ordinarily interchangeable inventories, and the average can be calculated periodically or as additional shipments are received, depending on the circumstances.
An additional benefit of this technique is that it helps to reduce the volatility in impact created by a single purchase price change. By not having the cost of a sale be influenced by a single purchase price, this technique can even out the costs.
Understanding the Difference Between FIFO, LIFO and Weighted Average
One of the differences between these techniques lies in the approach used for allocating the cost between the cost of goods sold and the ending inventory. Under FIFO, early costs will be allocated to goods sold, while under LIFO, later costs will be allocated to the goods sold. Under the weighted average, the allocation is done using the average cost per unit.
It is easier to see the effects of these different techniques on accounting when there is an increasing purchase cost. FIFO will tend to have lower cost of goods sold and higher ending inventory since early costs,s which are lower, will be assigned to the goods sold. On the other hand, LIFO will have higher cost of goods sold and lower ending inventory.
It is equally important to note that these approaches do not necessarily account for the physical flow of goods. This is simply an assumption made in accounting when it comes to the allocation of costs. A firm can opt to sell new products before older ones physically while still adopting FIFO.
Inventory Methods and Financial Statements
The selection of the costing method impacts many aspects of financial reporting. Because inventory is stated as an asset and the cost of goods sold is expensed when associated revenues are recognised, any changes in the cost of inventory impact gross profit and other financial ratios.
For instance, when a business reports reduced cost of goods sold, gross profit increases if the level of sales revenue stays the same. The increase in ending inventory results in higher balances in the inventory account. This is why inventory valuation cannot be considered an individual bookkeeping matter.
Furthermore, inventory valuation is significant for analysts who make comparisons between various companies. Analysts should consider the inventory accounting policy that a particular business follows when COGS and inventory balances are different despite similar levels of purchases and sales.
Finally, inventory valuation is critical in the case of impairment. According to IAS 2, inventories are stated at the lower of cost or net realisable value. When the inventory is damaged, deteriorated, or is otherwise impaired and cannot be sold at recorded cost, a write-down may be needed.
Periodic and Perpetual Inventory Systems’
The techniques used in the valuing of inventories can also be employed within various inventory systems. The periodic inventory system will value the inventory and calculate the cost of goods sold at specific time periods, while the perpetual inventory system maintains continuous updating of the inventory accounts.
In the perpetual inventory system, all purchases and sales will update the inventory accounts, making it easy for organisations to keep track of their inventories throughout the year. This process can now be automated using today’s modern accounting systems.
The main thing that needs to be learned by accountants is the distinction between the inventory valuation technique and the inventory system. FIFO or Weighted Average refers to the way costs are allocated, while Periodic and Perpetual relate to the inventory system.
Why Practical Knowledge Matters for Accountants?
The concept of inventory accounting becomes clearer once learners go past the definitions and deal with practical transactional accounting.
In fact, an accountant might have to record transactions such as purchases, sales, purchase returns, inventory adjustments, COGS, closing inventories and valuation changes, ensuring consistency in the process.
This is why practical accounting training in Bangalore can be helpful for learners trying to apply accounting knowledge to the practical context. The experience of practical accounting can allow learners to learn how transaction accounting is done in accounting software, how it affects financial statements and how different cost assumptions impact the reported results.
Instead of remembering that FIFO stands for first-in, first-out and LIFO stands for last-in, first-out, learners can try solving practical purchase and sales transactions and find out how the same transaction may result in different accounting treatment depending on the chosen approach.
For people starting their careers in accounting, the practical knowledge can prove to be quite helpful. It is relevant for any bookkeeping, accounts payable, accounts receivable, inventory, financial reporting and business analysis role.
Choosing an Appropriate Inventory Method
There is no universal approach to inventory valuation that works equally well in all organisations or environments where reports must be prepared. This approach may differ based on inventory characteristics, accounting rules, and requirements of financial reporting.
An organisation that works with inventory that is interchangeable has to use an approach that can be implemented consistently. According to IAS 2, FIFO and weighted average are allowed cost formulas for ordinarily interchangeable inventory; however, LIFO is not allowed.
Accounting policies of an organisation should be disclosed. According to IAS 2, the accounting policies of an organisation in relation to the measurement of inventories, including the cost formula adopted, have to be disclosed in the financial statements.
The idea is not just to choose a way that will help to achieve specific results. Such an approach should be chosen according to relevant accounting standards.
Final Thoughts
Learning the principles of inventory valuation is a crucial step towards being a competent accountant. In turn, FIFO, LIFO, and weighted average are three different techniques of valuing inventory, which means that the use of one method rather than another will have a certain effect on COGS, ending inventory, gross profit, and other aspects of financial analysis.
The main take-home message is that it is better to learn the rationale behind all three techniques rather than memorising the definitions. As soon as accountants get the idea of how purchase costs are transferred from inventory to COGS, understanding the consequences for the financial statements will become much easier.
For accounting students and professionals who develop their skills, inventory valuation is an excellent example of the importance of practical knowledge in this discipline.
FAQs
Which are the different inventory valuation methods?
These include the FIFO, LIFO, weighted average cost, and specific identification methods. The availability of an inventory valuation method will depend on the type of accounting principles used by the entity.
Is the LIFO method allowed under IFRS?
No. Under IAS 2, the LIFO method is not permitted in the case of inventories that are interchangeable. The FIFO and weighted average cost are allowed cost formulas under IAS 2.
Which inventory valuation method will give higher profits during a period of price increases?
During periods of increasing prices, FIFO will give lower cost of goods sold and hence higher gross profits compared to the LIFO method.
What is meant by weighted average inventory valuation?
The weighted average inventory valuation takes the total cost of goods available for sale and divides it by the number of units available for sale.
What significance does inventory valuation hold?
Inventory valuation determines how much inventory is shown in the balance sheet and the cost of goods sold in the income statement, which can affect reporting of profitability and financial analysis.
Is inventory valuation practical for accounting students?
Absolutely. Solving purchase, sales, stock adjustment, cost of goods sold, and closing inventory problems can help grasp inventory accounting.