INVENTORY VALUATION METHODS

Q: Discuss the types of inventory valuation methods – First-in-First-out (FIFO), Last-in-First-out (LIFO), and

Average Cost Method (AVCO), analyze them and explain their impact on the records of the financial

statements?

INTRODUCTION:
By definition, inventory is the term used to describe the assets of a

company that are intended for sale in the ordinary course of business, are in

the process of being produced for sale, or are to be used currently in

producing goods to be sold.()

Inventory in a business is a list of goods or products that is held in

stock. It takes a lot of time to keep inventory, but failure to do so could result

in major financial disasters. Depending on the size of your business, there

are people whose sole job is to keep track of inventory. In a small business,

this would not have to be their only task.

• Treatment in Financial Statement:

Inventory is converted into cash within the company’s operating cycle

and, therefore, is regarded as a current asset. In the balance sheet,

inventory is listed immediately after Accounts Receivable,because it is just

one step farther removed from conversion into cash than customer

receivables. Being an asset, it is shown in the balance sheet at its cost. As

items are sold from this inventory, their costs are transferred into cost of

goods sold, which is offset against sales revenue in the income statement. ()
 Having no inventory or having wrong inventory can lead to many

problems. Because inventory is reflected in the company’s books, a business

owner may make decisions based on the inventory numbers he sees in the

books. If the number is wrong, he just made a wrong decision that could be

costly. In order to prevent this from happening in your business, there are

ways to keep proper inventory that any sized business can use. ()

Classifying Inventories :
Inventories can be classified according to type of business:
1.Merchandise Inventory: merchandise available of hand and
available for sale to customers. For e.g.: canned foods, meats, dairy
products etc. Items in the merchandise inventory have two common
characteristics:
a: they are owned by the company
b: they are in the form ready for sale to customers in the ordinary
course of business.
Inventory sold becomes the cost of merchandise sold. It is the ready-to-sell
inventory of merchandising firms.
2.Manufacturing Inventory: merchandise that needs to be produced

in order to sell is called manufacturing inventory. Although products may differ, manufacturers normally have

three inventory accounts, each of which is associated with a stage of the production process:raw

materials inventory, work-in-process inventory, finished goods

inventory.
a.Raw Materials Inventory: It consists of goods and materials

that ultimately will become part of the manufactured product but have not yet entered the production process.

For example, the raw materials of an automobile manufacturer generally include sheet metal, nuts, bolts, and

paint.

b.Work-In- Process Inventory: It consists of units in the

production process that require additional work or processing
before becoming finished goods.
c.Finished Goods Inventory: It consists of units that have been
completed and are available for sale at the end of the accounting
period. ()
INVENTORY VALUATION:
Goods sold (or used) during ac accounting period seldom correspond
exactly to the goods bought (or produced) during that period. As a result,
inventories either increase or decrease during the period. Companies must then allocate the cost of all the

goods available for sale (or used) between the goods that were sold or used and those that are still on hand. The

cost of goods available for sale or use is a sum of

1. The cost of goods on hand at the beginning of the period.

2. The cost of goods acquired of produced during the period.

The cost of goods sold is the difference between the cost of goods available for sale during the period and

the cost of goods on hand at the end of the period.

Valuing inventories can be complex. It requires determining the

following:
1. The physical goods to include in inventory (who owns the goods –
goods in the transit, consign goods, special sales agreements).
2. The cost to include in inventory (product vs. period cost)
3.The cost flow assumptions to adopt (specific identification, average
cost, FIFO, LIFO, retail, etc.). ()
INVERTORY VALUATION METHODS:
There are three methods of valuation of inventories under the accounting
systems based on the type and nature of products.

1. First-In-First Out (FIFO)

2. Last-In-First Out (LIFO)

3. Average Cost Method (AVCO)

a. FIRST-IN-FIRST OUT METHOD (FIFO):

The FIFO method assumes that a company uses the goods in the order in which it purchases them. In

other words, the FIFO method assumes that the first goods purchased are the first used (manufacturing

concern), or the
first sold (in a merchandising concern). The inventory remaining must
therefore represent the most recent purchases. ()

FIFO often parallels the actual physical flow of merchandise because it generally is good business

practice to sell the oldest units first. That is, under FIFO, companies obtain the cost of ending inventory by

taking the unit cost of the most recent purchase and working backwards until all units of inventory have been

costed. () This is true whether a company computes cost of goods sold as it sells goods throughout the

accounting period (perpetual system) or as a residual at the end of the accounting period (periodic system).

The example below illustrates this approach.

Receipts
Issues
Balance
Date
Quanti
ty
Unit
Cost
Amoun
t
Quanti
ty
Unit
Cost
Amoun
t
Quantit
y
Unit
Cost
Amount
Jan-09
40
$3
$120
-
-
-
40
$3
$120
Mar-
12
50
$5
$250
-
-
-
90
40 @ $3
50 @ $5
$370
Mar-
15
-
-
-
80
40 @ $5
40 @ $3
$320
10
$5
$50
Jun-07
100
$7
$700
-
-
-
110

10 @ $5
100 @
$7

$750
Aug-
05
-
-
-
105
10 @ $5
95 @ $7
$715
5
$7
$35
Oct-
02
140
$9
$1260
-
-
-
145

5 @ $7
140 @
$9

$1295
Nov-
03
200
$12
$2400
-
-
-
345

5 @ $7
140 @
$9
200 @
$12

$3695
Dec-
30
-
-
-
320

5 @ $7
140 @
$9
175 @
$12

$3395
25
$12
$300
TOTAL
-
-
-
-
-
$4430
-
-
$300
b.LAST-IN-FIRST OUT METHOD (LIFO):
Cost of Good
Sold
Balance Sheet as
an (ending)
inventory

The LIFO method assumes the cost of the total quantity sold or issued during the month comes from

the most recent purchases. That is, the latest goods purchased are the first to be sold. LIFO coincides with the

actual physical flow of inventory. The method matches the cost of the last goods purchased against revenue.
Under the LIFO method, the costs of the latest goods purchased are the first to be recognized in determining

the cost of goods sold. The ending inventory is based on the prices of the oldest units purchased.

Companies obtain the cost of the ending inventory by taking the unit cost of the earliest goods

available for sale and working forward until all units of inventory have been costed. ()