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.

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.

Without a clear standard, entities could choose inventory values that make results look better. IAS 2 sets rules to keep reporting consistent and comparable.

Definitions

Measurement of inventory

According to IAS 2, inventories must be valued at the lower of cost and net realizable value (NRV).

• 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.

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 costs comprises:

• the purchase price
• plus import duties and non-recoverable taxes,
• plus transport, handling, and other directly attributable costs,
• less trade discounts and rebates.

Definitions

Conversion costs

Includes direct labor 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.

Definitions

Other costs

Only costs necessary to bring inventories to their present location and condition are included.

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 labor, $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:

1. Identify items to be excluded from the inventory cost. Do you know the list of items?

2. Compute the cost of inventory using the items to be included in the computations. Were you able to compute?

Net realisable value (NRV)

Definitions

Net Realisable Value (NRV)

It is the estimated selling price of inventory in the ordinary course of business, minus costs to complete and costs to sell. The estimated selling price represents the fair value of the inventory. Formula:

NRV = Fair Value − Cost of Completion − Selling Costs

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. If there are 500 units in inventory, what is the net realizable value per unit and the total net realizable value?

Suggested solution:
Computation of the NRV. Do you know the answer?

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.

Definitions

FIFO method

This inventory valuation method assumes the oldest inventory items are sold first.

Based on this, 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 net income. However, because profits are higher, companies may face higher income tax liabilities.
• 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).

Definitions

Average Cost (AVCO) Method

AVCO values inventory by calculating a weighted average cost per unit, applied to both COGS and closing inventory. The two main forms are:

• Periodic AVCO: calculated once per period (used in period-end inventory systems). Formula:

$$\text{Weighted Average Cost per Unit}=\frac{\text{Cost of Opening Inventory}+\text{Cost of Inventory purchased in the year}}{\text{Units of Opening Inventory}+\text{Units of inventory purchased in the year}}$$

• Continuous AVCO: Recalculated after each purchase for real-time updates (used in continuous inventory systems).

Formula:

$$\text{Weighted Average Cost per Unit}=\frac{\text{Cost of Inventory in stock}+\text{Cost of Inventory received}-\text{Cost of inventory issued out}}{\text{Units of inventory in stock}+\text{Units of inventory received}-\text{Units of inventory issued out}}$$

Impact on profit and asset

• AVCO method smoothens price fluctuations, preventing extreme profit swings, thus lowering corporate tax liability.
• Closing inventory reflects average costs, avoiding overstatement (understatement) caused by FIFO during inflation (deflation) periods.

Illustration: FIFO and AVCO

On 1 January 2024, a DAANA company 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:

1. FIFO method
2. Average cost (continuous AVCO) method
3. Average cost (period-end AVCO) method

Suggested solution

Method 1: FIFO (First-In, First-Out)

FIFO assumes that the oldest inventory is sold first. This matches situations where older items are issued before newer ones.

• Step 1: Set up your stock sheet 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 stock 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:

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 stock sheet 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: Recalculate the average after each purchase:
  • Add the new purchase to your existing balance.
  • Calculate new total units (old balance + new purchase).
  • Calculate new total cost (old balance value + new purchase value).
  • Recalculate average cost per unit = New total cost ÷ New total units.
  • This new average applies to all units in stock.
• Step 4: Record sales using the current average:
  • Use the current average cost per unit for all units sold.
  • Don’t recalculate the average during sales - only during purchases.
  • Reduce your balance by the units sold.
• Step 5: Repeat steps 3 and 4 for each transaction.

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.

$$\begin{array}{rl}\text{Goods available for sale (units)}& =200\text{ units}+900\text{ units}=1,100\text{ units}\\ \text{Goods available for sale (\$)}& =\$2,000+\$10,700=\$12,700\end{array}$$

Step 2: Calculate the weighted average cost per unit by dividing total cost by total units.

$$\frac{\$12,700}{1,100\text{ units}}=\$11.55\text{ per unit (2 decimal places)}$$

Step 3: Calculate total units sold by adding all sales transactions.

$$250\text{ units}+400\text{ units}+150\text{ units}=800\text{ units}$$

Step 4: Calculate closing inventory units as = Opening units + Purchase units - Sales units.

$$200\text{ units}+900\text{ units}-800\text{ units}=300\text{ units}$$

Step 5: Value the closing inventory by multiplying the closing inventory units by the weighted average cost per unit.

$$300\text{ units}\times \$11.55=\$3,465$$