Inventory

Inventories are assets:

(a) held for sale in the ordinary course of business;
(b) in the process of production for such sale; or
(c) in the form of materials or supplies to be consumed in the production process or in the rendering of
services.
Inventory must be recorded at the lower of cost or net realizable value.
Cost. Includes the purchase cost and any other costs necessary in bring the inventories to their present
location and condition. These may include costs incurred directly in the production of inventory such as
direct labor and production overheads (i.e. conversion costs) and other expenses such as transportation
and handling charges, taxes and duties that may not be recoverable from tax authorities. However, costs
do not include general and administrative costs which cannot reasonable attributed to the cost of
inventory. Similarly, selling and distribution expenses, storage costs and excessive expenditure resulting
from abnormal wastage shall not be included in the cost of inventory.
Net realisable value is the estimated selling price in the ordinary course of business less the estimated
costs of completion and the estimated costs necessary to make the sale(IAS 2).
This is simply the expected revenue from the sale of inventory after deducting any further costs that are
necessary in order to sell the inventory. For example if a company has raw material costing $50, which
will be sold as finished products for $80 after additional $10 of labor costs are incurred for completion,
its NRV will be $70 ($80 - $10). The need to value the inventory at the lower of cost and NRV stems
from the concept of prudence which requires that the assets of the entity, which in this case is inventory,
must not be stated above the amount expected to be earned from its use or sale. For example, if an
inventory costs $100 but its NRV is only $70, the inventory is recorded at the year end at $70. Recording
inventory at a lower amount has the effect of reducing profit because a decrease in closing inventory
increases the cost of sales (expense).

Why accounting for inventory separate from purchase and sales accounting?
Every time a sale or purchase occurs, they are recorded in their respective ledger accounts. However, as
we shall see in following sections, inventory is accounted for separately from purchases and sales through
a single adjustment at the year end. Theoretically, the cost of inventory sold could be determined in two
ways. One is the standard way in which purchases during the period are adjusted for movements in
inventory. The second way could be to adjust purchases and sales of inventory in the inventory ledger
itself. The problem with this method is the need to measure value of sales every time a sale takes place
(e.g. using FIFO, LIFO or AVCO methods). If accounting for sales and purchase is kept separate from
accounting for inventory, the measurement of inventory need only be calculated once at the period end.
This is a more practical and efficient approach to the accounting for inventory which is why it is the most
common approach adopted.
Methods of calculating inventory cost As inventory is usually purchased at different rates (or
manufactured at different costs) over an accounting period, there is a need to determine what cost needs
to be assigned to inventory. For instance, if a company purchased inventory three times in a year at $50,
$60 and $70, what cost must be attributed to inventory at the year end? Inventory cost at the end of an
accounting period may be determined in the following ways:
First In First Out (FIFO)
Last In First Out (LIFO)
Average Cost Method (AVCO)
Actual Unit Cost
First In First Out (FIFO) This method assumes that inventory purchased first is sold first. Therefore,
inventory cost under FIFO method will be the cost of latest purchases. Consider the following example:
Example Bike LTD purchased 10 bikes during January and sold 6 bikes, details of which are as follows:
January 1 Purchased 5 bikes @ $50 each January 5 Sold 2 bikes January 10 Sold 1 bike January 15
Purchased 5 bikes @ 70 each January 25 Sold 3 bikes
The value of 4 bikes held as inventory at the end of January may be calculated as follows: The sales
made on January 5 and 10 were clearly made from purchases on 1st January. Of the sales made on
January 25, it will be assumed that 2 bikes relate to purchases on January 1 whereas the remaining one
bike has been issued from the purchases on 15th January. Therefore, the value of inventory under FIFO
is as follows:
Date Purchase Issues Inventory

Units $/Units $ Total Units $/Units $ Total Units $/Units $ Total
Jan 1 5 50 250

5 50 250
Jan 5

2 50 100 3 50 150
Jan 10

1 50 50 2 50 100
Jan 15 5 70 350

5 70 350
Jan 15

7

450
Jan 25

2 50 100


1 70 70 4 70 280
As can be seen from above, the inventory cost under FIFO method relates to the cost of the latest
purchases, i.e. $70

Last In First Out (LIFO)
This method assumes that inventory purchased last is sold first. Therefore, inventory cost under LIFO
method will be the cost of earliest purchases. Consider the following example:
Example
Bike LTD purchased 10 bikes during January and sold 6 bikes, details of which are as follows:
January 1 Purchased 5 bikes @ $50 each
January 5 Sold 2 bikes January 10 Sold 1 bike
January 15 Purchased 5 bikes @ 70 each
January 25 Sold 3 bikes
The value of 4 bikes held as inventory at the end of January may be calculated as follows: The sales
made on January 5 and 10 were clearly made from purchases on 1st January. However, all sales made
on January 25 will be assumed to have been made from the purchases on January 15. Therefore, the
value of inventory under LIFO is as follows:
Date Purchase Issues Inventory

Units $/Units $ Total Units $/Units $ Total Units $/Units $ Total
Jan 1 5 50 250

5 50 250
Jan 5

2 50 100 3 50 150
Jan 10

1 50 50 2 50 100
Jan 15 5 70 350

5 70 350
Jan 15

7

450
Jan 25

3 70 210 2 50 100

2 70 140

4

240
As can be seen from above, LIFO method allocates cost on the basis of earliest purchases first and only
after inventory from earlier purchases are issued completely is cost from subsequent purchases
allocated. Therefore value of inventory using LIFO will be based on outdated prices. This is the reason
the use of LIFO method is not allowed for under IAS 2.
Average Cost Method (AVCO)
This method values inventory at the weighted average cost of all purchases. Average cost is calculated
each time inventory is issued. Consider the following example:
Example
Bike LTD purchased 10 bikes during January and sold 6 bikes, details of which are as follows:
January 1 Purchased 5 bikes @ $50 each
January 5 Sold 2 bikes
January 10 Sold 1 bike
January 15 Purchased 5 bikes @ 70 each
January 25 Sold 3 bikes
The value of 4 bikes held as inventory at the end of January may be calculated as follows: All issues of
inventory will be assumed to carry the average cost of all purchases up to the date of the issue. Average
cost will be calculated by dividing total units of inventory by the total cost.

Date Purchase Issues Inventory

Units $/Units $ Total Units $/Units $ Total Units $/Units $ Total
Jan 1 5 50 250

5 50 250
Jan 5

2 50 100 3 50 150
Jan 10

1 50 50 2 50 100
Jan 15 5 70 350

5 70 350

Average Cost of Inventory 7 64.286 450
Jan 25

3 64.286 192.858 4 64.286 257.144

As can be seen from above, AVCO method allocates cost on the average cost of purchases during the
period. Average cost of inventory changes every time a purchase is made at a different price. Therefore
the average cost of inventory changed from $50 to $64.286 after the purchase on January 15.

Actual Unit Cost Method

It may be appropriate to record inventory of very high value at their actual unit costs. This method is
only practical where the number of inventory items is very small and distinguishable such as in the
property business.ABC LTD is a construction company. It buys raw materials such as sand and clay in bulk
and stores it in a central warehouse from
FIFO and LIFO accounting methods are used for determining the value of unsold inventory, the cost of
goods sold and other transactions like stock repurchases that need to be reported at the end of the
accounting period. FIFO stands for First In, First Out, which means the goods that are unsold are the
ones that were most recently added to the inventory. Conversely, LIFO is Last In, First Out, which
means goods most recently added to the inventory are sold first so the unsold goods are ones that were
added to the inventory the earliest. LIFO accounting is not permitted by the IFRS standards so it is less
popular. It does, however, allow the inventory valuation to be lower in inflationary times.

FIFO LIFO
Stands for First in, first out Last in, first out
Unsold
inventory
Unsold inventory comprises
goods acquired most
recently.
Unsold inventory comprises
the earliest acquired goods.
Restrictions
There are no GAAP or
IFRS restrictions for using
FIFO; both allow this
accounting method to be
IFRS does not allow using
LIFO for accounting.

FIFO LIFO
used.
Effect of
Inflation
If costs are increasing, the
items acquired first were
cheaper. This decreases the
cost of goods sold (COGS)
under FIFO and increases
profit. The income tax is
larger. Value of unsold
inventory is also higher.
If costs are increasing, then
recently acquired items are
more expensive. This
increases the cost of goods
sold (COGS) under LIFO
and decreases the net profit.
The income tax is smaller.
Value of unsold inventory is
lower.
Effect of
Deflation
Converse to the inflation
scenario, accounting profit
(and therefore tax) is lower
using FIFO in a deflationary
period. Value of unsold
inventory, is lower.
Using LIFO for a
deflationary period results in
both accounting profit and
value of unsold inventory
being higher.
Record
keeping
Since oldest items are sold
first, the number of records
to be maintained decreases.
Since newest items are sold
first, the oldest items may
remain in the inventory for
many years. This increases
the number of records to be
maintained.
Fluctuations
Only the newest items
remain in the inventory and
the cost is more recent.
Hence, there is no unusual
increase or decrease in cost
of goods sold.
Goods from number of years
ago may remain in the
inventory. Selling them may
result in reporting unusual
increase or decrease in cost
of goods.