IGCSE Accounting 0452 - 4.5 Valuation of Inventory

Objective: Prepare simple inventory valuation statements

Introduction

Inventory is a crucial asset for businesses, particularly those involved in trading or manufacturing. Accurately valuing inventory is essential for preparing the financial statements, specifically the Balance Sheet and the Profit & Loss Account. This section will cover the methods used to value inventory and how to prepare simple inventory valuation statements.

Methods of Inventory Valuation

There are two main methods for valuing inventory: First-In, First-Out (FIFO) and Last-In, First-Out (LIFO). The choice of method can significantly impact a company's reported profit and taxable income.

1. First-In, First-Out (FIFO)

FIFO assumes that the first items purchased are the first ones sold. This means the inventory on the Balance Sheet reflects the most recent purchases. It's generally considered a more realistic valuation method, especially for perishable goods.

Example: A company buys 10 items for $10 each on January 1st and 15 items for $12 each on March 1st. If 12 items are sold on April 1st, using FIFO, the cost of goods sold (COGS) would be $100 (10 items * $10) and the remaining inventory on hand would be 8 items valued at $12 each ($96).

2. Last-In, First-Out (LIFO)

LIFO assumes that the last items purchased are the first ones sold. This means the inventory on the Balance Sheet reflects the oldest purchases. LIFO is less commonly used now due to accounting standards, but it can be advantageous in periods of rising prices as it results in a lower COGS and higher profit.

Example: Using the same scenario as above, with the same purchase dates and quantities, if 12 items are sold on April 1st using LIFO, the COGS would be $150 (15 items * $12) and the remaining inventory on hand would be 10 items valued at $10 each ($100).

3. Weighted Average Cost

This method calculates a weighted average cost for all inventory items and uses that average cost to value both COGS and ending inventory. It's a simpler method than FIFO and LIFO.

Calculation:

Weighted Average Cost = (Total Cost of Goods Available for Sale) / (Total Number of Units Available for Sale)

Example: A company has 100 units available for sale with a total cost of $500. The weighted average cost is $5. If 40 units are sold, the COGS is 40 units * $5 = $200, and the ending inventory is 60 units * $5 = $300.

Inventory Valuation Statement

An inventory valuation statement summarizes the cost of inventory at a specific point in time. It's typically prepared at the end of an accounting period (e.g., at the end of the financial year).

Example Inventory Valuation Statement

Description	Amount ($)
Opening Inventory (Beginning Inventory)	$5,000
Purchases during the period	$20,000
Goods available for sale	$25,000
Cost of Goods Sold (COGS)	$18,000
Ending Inventory (at cost)	$7,000

Calculating Ending Inventory (at cost)

Ending Inventory = Goods Available for Sale - Cost of Goods Sold

In the example above: $25,000 - $18,000 = $7,000

Impact on Financial Statements

The valuation of inventory directly affects the Balance Sheet and the Profit & Loss Account:

• Balance Sheet: Inventory is shown as an asset. The value of inventory on the Balance Sheet is determined by the chosen valuation method.
• Profit & Loss Account: The Cost of Goods Sold (COGS) is an expense. The COGS is calculated using the chosen inventory valuation method.

Practice Questions

1. A company has an opening inventory of $2,000. Purchases during the year total $10,000. Sales during the year are $15,000. Using FIFO, what is the value of the ending inventory?
2. A company uses the weighted average cost method. The cost of goods available for sale is $10,000 and the number of units available for sale is 100. Sales are 60 units. What is the cost of goods sold?