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 Unit Amoun Quanti Unit Amoun Quantit Unit Amount
ty Cost t ty Cost t y Cost

Jan-09 40 $3 $120 - - - 40 $3 $120

Mar- 40 @ $3
50 $5 $250 - - - 90 $370
12 50 @ $5
Mar- 40 @ $5
- - - 80 $320 10 $5 $50
15 40 @ $3
10 @ $5
Jun-07 100 $7 $700 - - - 110 100 @ $750
$7
Aug- 10 @ $5
- - - 105 $715 5 $7 $35
05 95 @ $7
5 @ $7
Oct-
140 $9 $1260 - - - 145 140 @ $1295
02
$9
5 @ $7
140 @
Nov-
200 $12 $2400 - - - 345 $9 $3695
03
200 @
$12
5 @ $7
140 @
- - - 320 $9 $3395 25 $12 $300
Dec-
175 @
30
$12
TOTAL - - - - - $4430 - - $300

Cost of Good Balance Sheet as

Sold an (ending)
b. LAST-IN-FIRST OUT METHOD (LIFO): 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. ()

The example given above, when solved using LIFO will give a different result.
Receipts Issues Balance
Quanti Unit Amou Quant Unit Amou Quant Unit Amou
Date
ty Cost nt ity Cost nt ity Cost nt
Jan-
40 $3 $120 - - - 40 $3 $120
09
40 @
Mar- $3
50 $5 $250 - - - 90 $370
12 50 @
$5
50 @
Mar- $5
- - - 80 $340 10 $3 $30
15 30 @
$3
10 @
Jun- $3
100 $7 $700 - - - 110 $730
07 100 @
$7
100 @
Aug- $7
- - - 105 $715 5 $3 $15
05 5@
$3
5@3
Oct-
140 $9 $1260 - - - 145 140 @ $1275
02
$9
5 @ $3
140 @
Nov-
200 $12 $2400 - - - 345 $9 $3675
03
200 @
$12
200 @
Dec- 12 5@3
- - - 320 $3480 25
30 120 @ 20 @ 9 $195
$9
T
$453
OTA - - - - - - - $ 195
5
L
 Cost of Good Balance Sheet as
Sold an (ending)
c. AVERAGE COST METHOD (AVCO)
inventory
Under the average cost method, the costs of goods are equally divided,
or averaged, among the units of inventory. It is also called the weighted
average method. When this method is used, costs are matched against
revenue according to an average of the unit of cost of goods sold. The same
weighted average unit costs are used in determining the cost of the
merchandise inventory at the end of the period. For businesses in which
merchandise sales may be made up of various purchases of identical units,
the average method approximates the physical flow of goods.

This method is determined by dividing the total cost of the units of

each item available for sale during the period by the related number of units
of that item. ()
Receipts Issues Balance
Quantit Unit Quantit Unit Quantit Unit Amoun
Date Amount Amount
y Cost y Cost y Cost t
Jan-09 40 $3 $120 - - - 40 $3 $120
Mar-
50 $5 $250 - - - 90 $4.1 $369
12
Mar-
- - - 80 $4.1 $328 10 $4.1 $41
15
Jun-07 100 $7 $700 - - - 110 $6.73 $740
Aug-
- - - 105 $6.73 $707 5 $6.73 $34
05
Oct-02 140 $9 $1260 - - - 145 $8.92 $1293
Nov-
200 $12 $2400 - - - 345 $10.7 $3692
03
Dec-
- - - 320 $10.7 $3424 25 $10.7 $268
30
TOTAL - - - - - $4459 - - $ 268

Cost of Good Balance Sheet as

Sold (ending) inventory
COMPARISON BETWEEN THE METHODS OF INVENTORY
VALUATION
a. FIFO – Advantages and Disadvantages

ADVANTAGES DISADVANTAGE
Confirms to the actual flow of inventory Fails to match current costs against
items current revenues on income statement
Simple assumption for valuation of Company charges the oldest costs
inventory against the more current revenue,
distorting gross profit and net income
Comparatively inexpensive to use Higher revenues leads to higher tax
payments
Less subject to management The matching of old, comparatively low
manipulation acquisition costs against higher sales
revenue can give an inflated net income
Reports somewhat higher profits by It ignores the cost of replacing inventory
assigning lower (older) costs to cost of at higher prices (during rising prices),
goods sold in case of rising prices
Assets in balance sheet closely it leads to misleading figures probably
approximate its current replacement for investors, giving figures of inventory
costs the company doesn’t have
A company cannot pick a certain cost
item to charge to expense
Ending inventory is close to current costs
Inventory consistent with most recent
purchases.
(Kieso, Weygandt, & Warfield, 2004);

b. LIFO – Advantages and Disadvantages

ADVANTAGE DISADVANTAGE
Matches most recent inventory costs Lower profits reported during inflationary
against sales revenue times serve for managers as a distinct
disadvantage
Reported income is more likely to May have a distorting affect of
approximate the amount that really is company’s balance sheet, which is
available for distributors or owners usually outdated because oldest costs
remain in inventory, making working
capital position of the company appear
worse than reality
 By giving low net income during rising
prices, it actually defers income taxes
Cost flow often approximates the
physical flow of the goods in and out of
inventory
Matches current revenues to better
measure of current earnings
Future price declines do not affect Net income can be altered by simply
company’s future report earnings
(Chasteen, Flaherty, & O'Connor, 1989)
Does not approximate the physical flow
of the items except in specific situations
It may match old, irrelevant costs
against current revenues, distorting net
income
May cause poor buying habits – purchase
more goods against revenue to avoid
charging the old cost to expense
altering its pattern of purchases

c. Average Cost – Advantages and Disadvantages

ADVANTAGE DISADVANTAGE
Its very practical – easy to apply changes in current replacement costs
are concealed because these costs are
averaged with older costs
Does not lend itself to manipulation neither the valuation of ending inventory
nor the cost of goods sold will quickly
reflect changes in the current
replacement costs of merchandise
identical items have the same
accounting values
not necessary to keep track of inventory
()

EFFECT OF THE VALUATION METHODS ON FINANCIAL

STATEMENT
Since prices keep on changing, the three methods yield different amounts for
(1) the cost of merchandise sold for the period (2) the gross profit (net
income) for the period (3) the ending inventory. There is also a tax effect that
varies with changes in net income among different valuation methods. ()

a. Income Statement:
FIFO: FIFO gives the highest amount of gross profit (hence, net income)
because the lower unit costs of the first units purchased are matched against
revenues, especially in times of inflation. However in times of falling prices,
FIFO will report lowest inventory. It also yields the highest amount of ending
inventory and the lowest cost of goods sold. This will give a false impression
of paper profit.

LIFO: LIFO gives the lowest amount of net income during inflationary times
and the highest net income during price declines. It gives the lowest amount
of ending inventory and the highest cost of goods sold. ()

AVCO: Average Costs approach tends to produce cost of goods sold and
ending inventory results between the results by LIFO and FIFO. ()

To the management, higher net income is an advantage: it causes

external users to view the company more favorably. In addition,
management bonuses, if based on net income, will be higher. Hence during
inflationary times, companies prefer using FIFO. ()

Methods Cost of Goods Sold Ending Inventory Net Income

FIFO Understated Overstated Overstated
LIFO Overstated Understated Understated
AVCO In between FIFO & In between FIFO & In between FIFO &
LIFO LIFO LIFO

b. Balance Sheet:
FIFO: During periods of inflation, the costs allocated to ending inventory will
approximate their current cost. In fact, the balance sheet will report the
ending merchandise inventory at an amount that is about the same as its
current replacement costs. As inventories are overstated in FIFO, this will
affect the total assets and hence the stockholder’s equity, overstating it.

LIFO: In a period of inflation, the costs allocated to ending inventory may be

significantly understated in terms of current costs. This is because more
recent costs are higher than the earlier unit costs. Thus it matches current
costs nearly with current revenues. ()In LIFO, inventories are understated.
This, in turn, affects the stockholder’s equity by understating the actual
figures.
AVCO: Average cost approach for series of purchases will be same,
regardless of direction of price trends. In its effect on the balance sheet,
however, it is more like FIFO than LIFO. ()

Methods Inventory Current Assets Stockholder’s

Equity
FIFO Overstated Overstated Overstated
LIFO Understated Understated Understated
AVCO In between FIFO & In between FIFO & In between FIFO &
LIFO LIFO LIFO

References
(1989). Inventory Valuation: determing costs and using cost flow assumtions. In L. G.
Chasteen, R. E. Flaherty, & M. C. O'Connor, Intermediate Accounting (pp. 398 - 423). Mc-
GRAW-HILL Publishers.

Inventory and its Importance. (2009, March 7). Retrieved March 19, 2008, from Contractor
Blog: http://www.contractorblabblog.com/2009/03/inventory-and-its-importance/

(2004). Valuation of Inventories - A cost-Basis Approach. In D. E. Kieso, J. J. Weygandt, & T. D.

Warfield, Intermediate Accounting (pp. 383 - 410). John Wiley and Sons.

(2007). Reporting and Analyzing Inventory. In P. D. Kimmel, J. J. Weygandt, & D. E. Kieso,

Financial Accounting (pp. 273 - 290). John Wiley and Sons.

(1999). Inventories and the Cost of Goods Sold. In R. F. Meigs, J. R. Williams, S. F. Haka, & M.
S. Bettner, Accounting (pp. 330 - 339). Mc-GRAW-HILL Publishers.

(2004). Inventories. In C. S. Warren, & J. M. Reeve, Finanical Accounting (pp. 372 - 390).
Thomsom.