Chapter 2 Inventory valuation Flashcards
2.1 Inventory valuation
Inventory valuation is important for financial reporting and costing. Businesses value inventory using either FIFO, LIFO, or averaging basis.
FIFO: assumes materials are issued out of inventory in the order in which they were delivered into inventory. This is easily understood, inventory values are up-to-date, and this is acceptable to HMRC and per IAS2. The disadvantages are that in times of rising prices reported profits are high due to lagging issue prices and high closing inventory valuations.
LIFO assumes that materials are issued out of inventory in the reverse order to which they were delivered. This is only appropriate for a few businesses. This means issue prices are up to date, in times of rising prices reported profits are reduced as closing inventory is lower and it makes managers aware of recent costs. The disadvantages are it rarely reflects physical use of inventory, not acceptable as per IAS2 or HMRC, the inventory values become out of date and cost comparisons between jobs are difficult.
Cumulative weighted average values all issues and inventory at an average price, the average price is recalculated after each receipt. This average price is the running total of costs divided by the running total of units. This method is appropriate for businesses where deliveries are fully mixed in with existing inventory. This is acceptable to HMRC and per IAS2, logical because all units have the same value and fluctuations are smoothed out. The disadvantages are that issue prices and inventory values may not be an actual purchase price and inventory values and issue prices may lag behind current values.
Periodic weighted average values each issue at the same average price which is based on all purchases for the period. The calculation is total costs for the period / total units for the period.
The difference in profit calculated under each method is due to the difference in closing inventory valuations. Which differ due to the values that the inventory will be recorded at, under the different methods. The profit differences are only temporary.
