Valuation of Inventories

Objective

A primary issue in accounting for inventories is the determination of the value at which inventories
are carried in the financial statements until the related revenues are recognised. This Standard deals
with the determination of such value, including the ascertainment of cost of inventories and any
write-down thereof to net realisable value.

How Do Firms Update Inventory Values?

Total inventory value typically changes more or less continuously, as firms’ stock new items and
either sell or lose existing stock. The market value of individual items in stock also changes over
time, for instance, when inventory items spoil or become obsolete.

In any case, total inventory value must appear on the Balance sheet as it stands at the end of the
reporting period after changes for the period are complete. Firms usually apply this equation:

Ending value = Beginning value + Net purchases – Cost of Goods Sold

Note that cost of goods sold (COGS) sometimes appears as a stand-in for stock used up during an
accounting period (see the inventory turns metric, below, for instance). This value is appropriate
especially when a company turns raw materials into work in progress and then finished goods. "Cost
of goods sold" reflects the direct and indirect labour costs and materials costs used to bring stock
from one stage to the next. As a result, COGS represent the total historical "cost" of these assets.

LIFO and FIFO Conventions: How Do They Differ?

When the historical costs (or COGS) of each specific stock unit is known, the above instructions for
reaching the total current inventory value are sufficient. However, the firm must refer to additional
valuing rules when both of two conditions apply:

 Firstly, units in stock are interchangeable.

One barrel of crude oil as raw materials is probably interchangeable with any other barrel of
the same kind. One sealed can of peas in finished goods may be interchangeable with
thousands of others in stock.

 Secondly, the costs of acquiring units in stock are changing over time.
A firm may purchase oil as raw materials in January at $85 / barrel. In June, the same barrel
may cost $90, and another barrel may cost $98 in December. Similarly, a can of peas may
have a COGS of $1.00 in January, $1.10 in February, and $1.50 in March.

Choose any method when units are interchangeable

Referring to the example above, suppose the firm adds cans of peas to inventory as follows:

Inventory additions:
January, 75 cans added, @ $1.00.
February, 125 cans added, @$1.10.
March, 100 cans added, @$1.50.

Suppose that a total of 60 cans sell from inventory during these three months. The accounting
question in such cases then is this: What was COGS for the 60 units that left stock? Would that be
January's COGS or another month's COGS?
With interchangeable units and changing price conditions, companies can choose any one of three
approaches to value inventory. After selecting a method for the first reporting period, however, tax
authorities do not make it easy to change the plan in subsequent periods.

In any case, three acceptable approaches to valuing under these conditions include:

1. First in, First Out (FIFO)

2. Last in, First Out (LIFO)

3. Average Cost

1. First in First Out (FIFO)

Under FIFO, as items leave inventory, the accountant proceeds as though the single unit in stock for
the longest time goes first. And, the next to move has the value of the item on hand second-longest,
and so on.

Under FIFO, when 60 cans leave inventory, the firm reports them as 60 of the 75 "January" cans. As a
result, COGS become the following:

COGS = 60 x $1.00
= $60.00.

2 Last in First Out (LIFO)

Under LIFO, the accountant precedes as though the first to leave is the item that has been there the
shortest time. And, the next to move has the value of the item on hand for the next longest time,
and so on&mdashin this case, the value of the100 "March" cans. As a result, for a COGS becomes the
following:

COGS = 60 x $1.50
= $90.00

3. Average Cost

Under the average cost method, the accountant computes a weighted average cost of goods sold
per unit. For the peas example:

Weighted Average COGS per Unit

= (75 x $1.00 + 125 x $1.10 + 100 x $1.50) / ( 75 +125 + 100)
= $362.50 / 300
= $1.21 / unit

Under the weighted average COGS approach:

COGS = 60 x $1.21
= $72.60

Choosing a Costing Approach

Which costing approach should a company choose? Remember that once a firm chooses a costing
method, tax authorities do not make it easy to change.

 When costs are rising, LIFO maximizes COGS and therefore minimizes the total value of the
remaining items. A higher COGS under LIFO leads to lower reported income and lower taxes.
  When costs are rising, FIFO minimizes COGS and thus maximizes the total value of remaining
items. A lower COGS under FIFO leads to higher reported income and higher taxes.

Note that International Financial Reporting Standards (IFRS) do not allow the use of LIFO in many
countries.

Regardless of which accounting convention is in use, FIFO, in fact, describes the actual flow of
inventory in most companies. Few companies sell newer items before selling older stock they are
holding. Many companies choose the Average cost method instead of either LIFO or FIFO, believing
the average provides a more accurate measure of true stock costs during the period.

* Rio wooden plank supplies the following wooden planks relating to stores
transactions during an October, 2019
OCTOBER 1 Opening Balance of wooden planks 300 units@150 per sq. feet

OCTOBER 5 issues 200

OCTOBER 9 receipts from laxman wooden planks lmt 150 units@130 per sq. feet

OCTOBER 15 issues 50 units

OCTOBER 21 return to laxman wooden planks lmt 50 units

OCTOBER 24 issues 50 units

OCTOBER27 receipts from royal wooden plank lmt 100 units @140 per sq. feet

OCTOBER 30 issues 100 units

Stock ledger of Rio wooden planks lmt (LIFO)
Stock ledger of Rio wooden planks Lmt (FIFO)
Stock ledger of Rio wooden planks Lmt (average cost method)