Inventory valuation
This chapter explains how businesses measure and report inventories under International Accounting Standard (IAS) 2 - Inventories. You’ll learn the IFRS requirements, the main valuation methods (FIFO and AVCO), and how inventory valuation affects profit and assets.
Learning objectives
By the end of this chapter, you should be able to:
- Apply the requirements of IFRS Accounting Standards for valuing inventories.
- Calculate the value of closing inventories using ‘FIFO’ (first in, first out) and ‘AVCO’ (average cost) - both periodic weighted average and continuous weighted average.
- Identify the impact of inventory valuation methods on profit and on assets.
- Explain why inventories must be adjusted for at each period end, and record the cost of sales and closing inventory.
- Explain the use of continuous and period-end inventory record systems.
Cost of sales and the need for inventory adjustments
The matching concept requires you to recognise as an expense only the cost of the inventory that was actually sold during the period. Inventory that remains unsold is carried forward as an asset on the statement of financial position, where it’s matched against the revenue it will generate once it’s sold. This is why closing inventory must be valued and recorded at each period end.
The cost of sales for a period is calculated as:
At the end of each period, you record the closing inventory value with the entry: Dr inventory (statement of financial position), Cr cost of sales (statement of profit or loss). At the start of the next period, this entry reverses, moving the prior period’s closing inventory back into cost of sales as the new period’s opening inventory.
Two systems are used to track inventory:
- Continuous (perpetual) inventory records: a running inventory card is updated after every purchase and sale, so the balance is known at any time.
- Period-end (periodic) inventory records: inventory quantities are confirmed by a physical count at the end of the period, and cost of sales is calculated only then.
Valuation of inventories
Inventory valuation matters because it affects:
- Profit, through cost of sales (and therefore gross profit).
- Assets, through the closing inventory figure reported on the statement of financial position.
IAS 2 sets rules to keep reporting consistent and comparable.
- Normally, NRV is higher than cost, so inventories are measured at cost.
- However, if inventories are damaged, obsolete, or unsellable, the NRV may fall below cost. In that case, inventories must be written down to NRV.
- The comparison is made item by item (or for groups of similar items), not on the inventory total.
Cost of inventory
IAS 2 defines the cost of inventory as all costs of purchase, conversion, and other costs incurred to bring the inventory to its present location and condition.
The purchase cost comprises:
- the purchase price
- plus import duties and non-recoverable taxes,
- plus transport, handling, and other directly attributable costs,
- less trade discounts and rebates.
Conversion costs include direct labour and the systematic allocation of fixed and variable production overheads. These apply mainly in manufacturing, where raw materials are processed into work-in-progress or finished goods. The cost of conversion is added to purchase costs to determine the total cost of inventory.
Other costs are included only when they’re necessary to bring inventories to their present location and condition.
The following must not be included in inventory valuation under IAS 2:
- abnormal amounts of wasted materials, labour, or other production costs
- storage costs, unless those costs are necessary in the production process before a further production stage
- administrative overheads that do not contribute to bringing inventories to their present location and condition, and
- selling costs.
IAS 2 specifically excludes these to avoid overstating inventory.
Illustration: determining the initial cost
AGADYZ Manufacturing purchased raw materials for $50,000, paid $2,000 import duties, $1,500 shipping costs, and received a $3,000 trade discount. During production, they incurred $8,000 in direct labour, $5,000 in factory rent, and $2,000 in factory utilities. Additionally, they had $1,200 in abnormal material waste due to equipment failure, $800 in finished goods storage costs, $3,000 in administrative overhead, and $2,500 in sales commissions.Required: Calculate the total inventory cost per IAS 2, clearly identifying which costs should be included or excluded and why.
Suggested solution:
- Identify items to be excluded from the inventory cost. Do you know the list of items?
| Item | Amount ($) | Reason |
|---|---|---|
| Storage costs | 800 | Not necessary in the production process |
| Administrative overhead | 3,000 | Doesn’t contribute to location/condition |
| Sales commission | 2,500 | Selling cost - explicitly excluded |
| Abnormal waste | 1,200 | Abnormal amount - excluded per IAS 2 |
These costs are expensed in the statement of profit or loss rather than included in inventory.
- Compute the cost of inventory using the items to be included in the computations. Were you able to compute?
| Amount ($) | Amount ($) | |
|---|---|---|
| Purchase cost: | ||
| Purchase price | 50,000 | |
| Trade discount | (3,000) | |
| Import duties | 2,000 | |
| Shipping to factory | 1,500 | 50,500 |
| Conversion cost: | ||
| Direct labour | 8,000 | |
| Factory rent | 5,000 | |
| Factory utilities | 2,000 | 15,000 |
| 65,500 |
Net realisable value (NRV)
Illustration: determining the NRV
A company has inventory that can be sold for $100 per unit. The company needs to spend $15 per unit to complete the items and $10 per unit in selling costs. The items cost $80 per unit. If there are 500 units in inventory, what is the net realisable value per unit and in total, and at what amount should the inventory be measured?Suggested solution:
Computation of the NRV. Do you know the answer?
| Amount ($) | |
|---|---|
| Estimated selling price | 100 |
| Cost to complete | (15) |
| Selling costs | (10) |
| NRV per unit | 75 |
| Units of inventory (in units) | 500 |
| NRV in total | 37,500 |
Lower of cost ($80) and NRV ($75) = $75 per unit, so the inventory is measured at $37,500. It is written down by $2,500 (500 × $5), which is charged to cost of sales.
Valuation of closing inventories
Under IAS 2, both the continuous and period-end inventory systems require you to determine the cost of closing inventory for financial reporting.
Because inventory movements can be large and frequent, IAS 2 requires systematic valuation methods. The two main methods are:
- FIFO (first-in, first out) - assumes the earliest purchased items are sold first.
- AVCO (average cost) - values inventory at the weighted average cost of all items available.
Although methods like LIFO (last-in, first-out) exist, IAS 2 does not permit them.
Under FIFO:
- Cost of sales is valued using the cost of the earliest purchased or produced inventories.
- Closing inventory is valued using the cost of the most recent purchases.
Impact on profit and assets
- In inflationary environments, FIFO assigns lower historical costs to the cost of sales. This increases gross profit and overall profit for the period.
- Closing inventory is valued at more recent (higher) prices, resulting in a higher asset value on the statement of financial position.
- FIFO is particularly suitable where the physical flow of goods matches this assumption (e.g., perishables, food items, pharmaceuticals).
AVCO takes two forms:
- Periodic AVCO: calculated once per period (used in period-end inventory systems). Formula:
- Continuous AVCO: recalculated after each purchase for real-time updates (used in continuous inventory systems).
Formula:
Impact on profit and asset
- AVCO smooths price fluctuations, so reported profit is less volatile than under FIFO. When prices are rising, AVCO gives a higher cost of sales and lower profit (and tax) than FIFO; when prices are falling, the reverse applies.
- Closing inventory reflects average costs, so it is lower than under FIFO when prices rise and higher when prices fall.
Illustration: FIFO and AVCO
On 1 January 2024, DAANA Ltd held 200 units of finished goods valued at $10 each. During January, the following purchases and sales took place:
Date Activity Units Cost per unit ($) 5 January Purchases 300 11 10 January Sales 250 18 15 January Purchases 400 12 20 January Sales 400 18 25 January Purchases 200 13 28 January Sales 150 18 Required: Calculate the value of the closing inventory using the:
- FIFO method
- Average cost (continuous AVCO) method
- Average cost (period-end AVCO) method
Suggested solution
Method 1: FIFO (first-in, first-out)
- Step 1: Set up your inventory card with columns headed: Date, Receipts/purchase; Issues/sales, and Balance, each showing units, unit price, and total amount.
- Step 2: Record opening balance: Start with your opening inventory in the balance column.
- Step 3: Record each purchase under the receipts column, then update the balance. Keep each purchase batch separate because unit costs differ.
- Step 4: Record each sale using FIFO logic. When making sales, always take from the oldest inventory first. If the oldest batch doesn’t cover the full sale quantity, move to the next oldest batch until all units sold are accounted for.
- Step 5: Calculate your balance after each transaction. This shows what inventory remains after each purchase or sale.
Solution:
Based on the inventory card, the closing inventory as at 28th January, 2024 is 300 units, which amounts to $3,800 (i.e., $1,200 plus $2,600).
Method 2: AVCO continuous
In a continuous (moving average) system, you recalculate the average cost after every purchase. That updated average is then used to cost any sales until the next purchase occurs.
- Step 1: Set up your moving average inventory card in the same format as used in FIFO.
- Step 2: Record opening balance. Start with your opening inventory - this becomes your first average cost.
- Step 3: After each purchase, new average = (balance value + purchase value) ÷ (balance units + purchase units).
- Step 4: Cost each sale at the current average cost per unit and reduce the balance by the units sold. The average changes only after a purchase.
- Step 5: Repeat steps 3 and 4 for each transaction.
Based on the inventory card, the closing inventory as at 28th January, 2024, is 300 units, which amounts to $3,643.59.
Method 3: period-end AVCO
Period-end AVCO calculates one average cost for all inventory available during the period, regardless of when items were purchased.
Step 1: Calculate total goods available for sale by adding: Opening inventory (units and value) and all purchases made during the period (units and values). This gives you the total units and total cost available.
Step 2: Calculate the weighted average cost per unit by dividing total cost by total units.
Step 3: Calculate total units sold by adding all sales transactions.
Step 4: Calculate closing inventory units as opening units + purchase units - sales units.
Step 5: Value the closing inventory by multiplying the closing inventory units by the unrounded weighted average cost per unit. Using the rounded $11.55 figure here would introduce a small rounding error.
Comparing the three methods: prices rose from $10 to $13 during January. FIFO gives the highest closing inventory ($3,800), period-end AVCO the lowest ($3,463.64), and continuous AVCO falls between them ($3,643.59). Goods available for sale cost $12,700 under every method, so each $1 more of closing inventory is $1 less of cost of sales. FIFO therefore gives the lowest cost of sales ($8,900) and the highest profit.