Inventory valuation methods assign costs to inventory and determine Cost of Goods Sold (COGS). For IFRS (IAS 2) the lower of cost and net realizable value is used to measure inventories, while cost can be assigned using specific identification for non-interchangeable items and FIFO or weighted average for interchangeable items. LIFO is specifically prohibited under IFRS and is not an option; thus either FIFO or average cost are available under IFRS.
By comparison, US GAAP (ASC 330) allows for the use of FIFO, LIFO or weighted average cost methods and specific identification as appropriate. With respect to inventory measurement, US GAAP uses the lower of cost or market for LIFO and the lower of cost or net realizable value for FIFO/average method. In order to be in compliance with the consistency principle each type of inventory should be valued using the same cost method.
First-In, First-Out (FIFO)
Under the FIFO method, the value of oldest inventory will be the first to be recorded as cost-of-goods-sold when sold. The accounting standard for FIFO under IFRS (International Financial Reporting Standards) identifies FIFO as: “Cost of items purchased or manufactured before (i.e., first) are recognised as costs of inventory matter in the current period and thus, in that period, the ending balance of the inventory will consist of the most recently purchased or manufactured costs.” In practice, FIFO will result in a lower COGS amount and a higher ending balance of the inventory when prices are rising, thus resulting in a higher gross profit and, therefore, a higher amount of taxable income than would LIFO (last in, first out).
For example, under an illustrative transaction set (based on ten (10) units of inventory at $10.00 each for a beginning balance, with subsequent purchases of inventory at $12.00, $15.00, and $18.00, with a total of forty (40) units sold), using FIFO for costing will produce a total COGS of $505.00 and a total ending inventory value of $345.00, compared to LIFO, which will produce a total COGS greater than that using FIFO and total ending inventory value less than that of FIFO (this is discussed in more detail later).
The methodology used for recording FIFO transactions in a perpetual inventory system is a straightforward manner: inventory is debited when a purchase is made and accounts payable (or cash) is credited; when purchased inventory is sold (i.e., in the period the inventory is sold), COGS is debited and inventory is credited. For example, if an entity purchases $1,000 of inventory, the entity records the transaction as Debit Inventory $1,000; a Credit Accounts Payable $1,000; if the entity sells the inventory sold at the purchase price, the entity records the transaction as Debit COGS $1,000; a Credit Inventory $1,000. This allows the same apply regardless of the costing method, the difference is in the computation of COGS and the ending inventory, respectively.
The advantages of using FIFO (First in First Out) are that it gives businesses reliable inventory data as well as reporting profits accurately in a time of rising prices. The recent cost of an item is matched against the amount at which a business sold that item, creating a more accurate measure of profitability for businesses. FIFО is also simply understood by many and can integrate with current accounting practices. Finally, FIFO will tend to produce the highest reported profits during periods of inflation, thereby purchasing the amount at which a firm shows on the balance sheet.
The disadvantages of FIFO include 1: The business will generally incur a higher income tax liability due to higher profits being reported therefore higher taxable income will be due to the business at the time of income tax. 2: FIFO may lead to exaggerated amounts being reported as profit on the income statement due solely to the inflationary period. 3: FIFO may result in great differences between the carrying amount of an inventory and the reported amount; this is generally due to the fact that IFRS states that FIFO should not be used for inventory charged to the income statement. 4: Many companies will violate the IFRS’s requirement of using the same method for similar inventory throughout the entire period of the business’ existence; they will also violate the IFRS’ requirement of therefore their results using arbitrary methods beyond their ability to create best practice accounting methods.
Last-In, First-Out (LIFO)
LIFO describes that the more recent inventory costs are sold before the inventory costs of older inventory items. As such, ending inventory under LIFO would be based on older inventory costs. While US GAAP does allow for companies to use LIFO (ASC 330), IFRS does not. Because COGS under LIFO reflects the cost of using recently purchased, expensive inventory, COGS will be greater than COGS under FIFO in inflationary environments. This results in lower gross profit, net income, and taxes when using LIFO compared to FIFO.
The journal entries for LIFO follow the same format for inventory purchases and sales. However, the calculation of COGS and ending inventory will differ for LIFO and FIFO. Under inflationary conditions, the value of either COGS will be higher and the value of both ending inventories will be less. This reduces the value of the ending inventory reported on the balance sheet.
Benefits of using LIFO, where allowed, include improved correlation between recent cost and present revenue along with substantial income tax savings for businesses in an inflationary environment. LIFO reports newer (higher) costs as Cost of Goods Sold (COGS) allowing LIFO to better portray true earnings and to minimize taxes during times of increasing costs. In effect, LIFO functions as a hedge against inflation because recently incurred higher costs flow directly into the income statement protecting profit margins. Additionally, LIFO may reflect certain types of physical flows (e.g., stacked pallets using the newest stock first) in some organizations.
Drawbacks of the use of LIFO include (a) LIFO cannot be used under IFRS, therefore LIFO is not permissible in most countries other than the U.S; (b) inventory is generally understated on financial statements, old lower cost units remain in ending inventory; (c) lower net income reported on financial statements during inflationary periods can lead to concern among investors; and (d) if a company discontinues LIFO or sells excessively large amounts of older LIFO layers, it may incur significant tax liability. Because of the fact that many nations and the majority of investors prefer FIFO or average, which are more representative of both physical flows and current value, LIFO use has declined.
Weighted Average Cost
The Weighted Average Cost Method uses a single cost per unit for all inventory that will be sold, based on the total cost of the inventory divided by the total units. Periodic and perpetual calculations can be used in this method (i.e., calculating an average cost at the end of each month or after each purchase). Both IFRS and US GAAP allow for the use of weighted average for interchangeable inventory.
Take the above transaction examples as an example, the weighted average cost per unit is determined by (100 + 180 + 300 + 270) / 60 = $14.17 per unit; with selling 40 units the Cost of Goods Sold is $566.80 and the total value of ending inventory 20 units x $14.17 = $283.40. The weighted average cost falls in between the FIFO and LIFO methods (FIFO Cost of Goods Sold $505 and LIFO Cost of Goods Sold is $605). The Weighted Average Cost Method smooths out price fluctuations; each Sold unit’s cost of goods sold is based on an average cost between beginning and ending product costs (as opposed to older or newer).
In the case of weighted average journal entries, the only difference between periodic and perpetual methods of calculating the average cost of inventory is the method used for calculating the average cost of inventory. The same double entry will be used for both types of journal entries (an increase to inventory when purchased and an increase to COGS when sold). The benefits associated with using weighted average include its simplicity when applying weighted average accounting; it provides a stable basis for accounting; it will require less detail to track each different price layer; simplified calculations and moderate fluctuations in profit. When using weighted average it will automatically blend cost increases & decreases so that sudden price jumps or drops will have little impact on COGS. It will also eliminate the wide range of potential profits experienced with FIFO and LIFO.
The disadvantages of using weighted average include: it will not generally track the actual physical flow of goods unless that physical flow is completely random and it can lag behind changes in price. In periods of rapidly rising prices, average cost will understate COGS when compared to LIFO, but overstate it when compared to FIFO. Consequently, average cost may misrepresent profit margins. In a rapidly increasing cost environment; average cost will generally be lower than LIFO cost and higher than FIFO cost. The use of weighted average does require some calculations, which can be done very easily using accounting software. While both IFRS and GAAP consider weighted average acceptable, analysts need to be aware of the fact that “weighted average tends to cover up the impact of any recent changes in costs” and therefore will reduce sensitivity of inventory valuation to price fluctuations.
Specific Identification
The specific identification method identifies unique costs to distinct items in inventory. It’s used when items being tracked are unique or are easy to track through specific tracking mechanisms (for example, an automobile can be tracked through its vehicle identification number (VIN), custom machines, or artwork). Specific identification also applies to ‘projects’ that are not interchangeable and for which production materials have been specifically produced (i.e., non-inventory items). Every time an item is sold from inventory, the actual cost of the item sold will be moved to ‘Cost of Goods Sold’ (COGS) and the same amount will be removed from the inventory account.
As an example, a car dealership that sells a variety of different types of cars that are unlike any other cars will use the actual invoice amount associated with each vehicle sold to track its COGS. When the vehicle is sold, the COGS account will be increased by the invoice amount, and the inventory account will be decreased by the same amount. The journal entry to record the sale will still be Debit COGS (for the entire invoice amount), Credit Inventory (for the entire invoice amount), but will be specifically ‘itemized’ as the same amount associated with that specific item being sold.
Advantages of this method: Highly accurate! There is NO average/estimates with this method!! So, profit on each sale is based on the actual cost of that product/item! This can work great for high-value items or one-of-a-kind items.
Disadvantages of this method: Using this specific identification method isn’t practical if you have many like items in your inventory – like 500 pairs of shoes, etc. Who can keep track of everything by using that level of detail? It requires very good record keeping (like keeping track of serial numbers or lot numbers). The IFRS mentions that “it is inappropriate to use specific identification for inventory items that are typically interchangeable and will have a lot of like items in them.” If you have more than one like item, you will find it is easier to use FIFO or average. Because the costs involved with using specific identification are based on actual costs, you cannot manipulate your profits when using a method of specific identification.
Conclusion
The way businesses value their inventory can impact their bottom line since it will determine how they value their inventory, determine COGS, and determine how much profit they will show to their investors. There are various ways to assign cost to inventory including FIFO, LIFO, weighted average cost and specific identification. Each method has pros and cons depending on the type of business, the volatility of prices, and general accounting rules. For example, FIFO typically shows the flow of goods most accurately, shows higher profits during periods of inflation, whereas LIFO would allow a business to lower its taxes by matching its most recent higher collected cost against its sales revenue. Similarly, weighted average makes it easier to calculate cost and makes it easier for businesses to smooth out the price volatility in their inventory, while specific identification will give businesses the most accurate means of assigning cost for unique or high-value items. Thus, properly selecting an inventory valuation method is critical to having accurate financial statements, managing your inventory effectively and making sound decisions about your business.
Bibliography
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