6. Inventory Valuations (indistinguishable goods)

Question 1

What is FIFO?

Answer 1

First In, First Out (FIFO) is a method for determining inventory valuation and cost-of-sales for indistinguishable goods, in which:
- Cost of sales is based on the cost of the oldest stock bought.
- Inventory valuation is based on most recently bought stock (so closer reflects market value/replacement cost).

Question 2

What is average cost valuation?

Answer 2

Average cost (AVCO) is a method for determining inventory valuation and cost-of-sales for indistinguishable goods, in which:
- Cost of sales and inventory valuation are both based on the average cost of inventory bought.

Question 3

What is LIFO?

Answer 3

Last In, First Out (LIFO) is a method for determining inventory valuation and cost-of-sales for indistinguishable goods, in which:
- Cost of sales is based on the cost of the newest stock bought.
- Inventory valuation is based on the costs of the first (oldest) stock bought.

Question 4

How does the choice of inventory valuation method impact the financial statements?

Answer 4

Revenue is unaffected by how we account for inventory sold. However, profit depends on how cost of sales is calculated and this in turn depends on how the inventory is valued.
AVCO always gives cost of sales and profit values between FIFO and LIFO.
If prices are rising:
FIFO gives the lowest cost of sales and highest profit.
LIFO gives the highest cost of sales and lowest profit.
(vice versa if prices falling)

Question 5

What is net realisable value (NRV) and inventory impairment?

Answer 5

Inventory impairment is a permanent reduction in the fair/market value of stock (inventory).

Net realisable value (NRV) = Expected selling price - Costs of selling the asset

The NRV is applied if the fair/market value of the inventory is below its value in the balance sheet. When this happens (e.g., due to damage or change in demand), management should reduce the book value to that of the net realisable value - this loss will be taken through the SoPL as a higher cost of sales.
If the inventory’s book value is already lower than NRV, its value is left unchanged.

Question 6

What is the difference between US GAAP and IFRS in inventory valuation?

Answer 6

The use of LIFO is permitted under US GAAP whereas IFRS prohibits it.

Question 7

What are some arguments (principled accounting reasons) AGAINST applying LIFO on accounting grounds?

Answer 7

• It does not reflect the common business practise of firms selling their oldest inventory first.
• Part of its inventory is ‘never’ sold.
• Understated inventory valuations and book values.
• Investment comparison is harder with companies that follow IFRS (as IFRS prohibits the use of LIFO).
• Incentivises inefficient inventory management. Incentive for firms to increase the amount of their stocks held above that needed on operational grounds to increase their LIFO reserve.
• Unfair due to avoidance of taxes on profits.

Question 8

What is inventory?

Answer 8

Current assets:
- Held for sale in the ordinary course of business (finished goods)
- In the process of production for such sale (work in progress)
- In the form of materials or supplies to be consumed in the production process or in rendering services (raw materials)