LOS B requires us to:
describe different inventory valuation methods (cost formulas).
The value of closing, as well as beginning inventory, can be calculated using the equations given in the introduction section of this chapter. As per these equations, the value of inventory at the beginning and purchases equals the value of closing inventory and the cost of goods sold (COGS). And, for the purpose of valuation, the cost of all units must be allocated between the value of COGS and ending inventory.
1. Cost Flow Formulas / Cost Flow Assumptions
If the cost of the inputs remains the same over a period of time, it becomes easier to compute the COGS and the value of ending inventory. It simply would be the number of units multiplied by the cost per unit.
However, in most cases, the cost per unit does change over a period of time. In such cases, the firms need to use the cost flow assumption or the formulas to compute the cost.
Under IFRS, the following methods are permissible for the calculation of the value of inventory:
1.1. Specific Identification Method
a. As per this method the specific cost of each unit of the goods sold as well as the ending inventory are identified and allocated to such unit.
b. Both the COGS and ending inventory reflects the actual cost of producing the same.
c. This method is most appropriate and typically used for the valuation of non-interchangeable goods and firms with a smaller number of costly inventory. This method is also useful for the special orders received outside the normal course of business of the firm.
d. This method matches the physical flow of the goods with the actual cost of it.
1.2. First In First Out (FIFO)
a. As per this method, the oldest items purchased are assumed to be the first item sold.
b. According to this method, the oldest items go to the cost of goods sold and the newest items form a part of the ending inventory.
1.3. Weighted Average Cost
a. As per this method, the costs are allocated evenly across all the units for sale.
b. Both the cost of goods sold and ending inventories are valued at the average prices, as per this method.
c. The average cost per unit of inventory is computed by dividing the total cost of goods available for sale (i.e. beginning inventory plus the purchases) by the total quantity available for sale.
d. Thus, the value of inventory at the end and that sold can be calculated by multiplying the average cost with the respective quantities.
U.S. GAAP allows the use of one more method apart from the above three mentioned, i.e. LIFO method.
1.4. Last In First Out (LIFO)
a. Under this method, it is assumed that the goods purchased last are the first ones sold.
b. Thus, under this method, the newest units purchased are a part of the COGS and the oldest units form a part of ending inventory.
c. Thus, in the situation of rising prices, the value of the cost of goods sold is higher and that of the cost of ending inventory is lower.
2. Periodic Vs. Perpetual Inventory Valuation
A periodic inventory valuation system is one where the physical count and valuation of inventory takes place at a specified interval of time. This specified time may vary according to what is most appropriate for the firm’s needs, and it may vary from a day to a week, or a month, quarter, or year also.
A perpetual inventory valuation system is one where the inventory is valued or/and counted every time there is an inflow or outflow. Therefore, the count, as well as the value as seen in the books of accounts, is always the updated value of inventory.
The perpetual inventory valuation method is the more generally used method. This method is especially useful when there is a large inventory and a very frequent inflow and outflow as this method helps in keeping track of the value and reduces the chances of misappropriations and errors. The periodic valuation method is less commonly used and is only desirable if the inventory consists of identical items and less frequently moving.