Learning Outcomes
After reading this article, you will be able to describe inventory valuation systems, explain and apply the FIFO and weighted average (AVCO) methods, perform relevant calculations for closing inventory and cost of sales, and discuss the impact these methods have on reported profit and asset valuation. You will also understand the core definitions needed for ACCA exam success.
ACCA Maintaining Financial Records (FA2) Syllabus
For ACCA Maintaining Financial Records (FA2), you are required to understand how inventory is recorded and valued for financial statements. Focus your revision on the following areas:
- The need for inventory adjustments when preparing financial statements
- Recording opening and closing inventories
- Identifying and applying alternative methods of inventory valuation
- Explaining and applying the requirements of IAS 2 Inventories for inventory valuation
- Calculating closing inventory using FIFO and AVCO (weighted average) methods
- Determining the effect of inventory valuation methods on profit, assets, and capital
Test Your Knowledge
Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.
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Which inventory valuation method assumes the earliest goods purchased are the first to be sold?
- Last In, First Out (LIFO)
- First In, First Out (FIFO)
- Weighted Average Cost (AVCO)
- Net Realisable Value
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True or false? Under the weighted average (AVCO) method, all units of inventory are valued at the average cost per unit, including those sold and remaining in inventory.
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In a period of rising prices, which method typically gives the highest closing inventory value?
- FIFO
- AVCO
- LIFO
- Specific identification
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Briefly state why inventory is never valued at selling price in the financial statements.
Introduction
Inventory valuation is a key adjustment in preparing financial statements. The value assigned to unsold goods at year-end affects the reported cost of sales, profit, and the asset value on the statement of financial position. The ACCA FA2 syllabus requires you to calculate inventory using the FIFO and weighted average (AVCO) methods, and to understand the principles behind their use under IAS 2 Inventories.
This article explains why inventory is usually valued at cost, how to apply FIFO and AVCO methods, and the impact of each choice on the financial statements.
Key Term: Inventory
Inventory comprises goods held for sale, raw materials, or items used in production processes that remain unsold at the period end.Key Term: FIFO (First In, First Out)
A method that assumes the earliest goods purchased are the first to be sold, so closing inventory consists of the most recent purchases.Key Term: Weighted Average Cost (AVCO)
A method that values inventory by calculating the average cost of all inventory available during the period, applying this average to both units sold and in hand at period end.Key Term: Net Realisable Value (NRV)
The estimated selling price of inventory less all costs to complete, market, and sell that inventory.
INVENTORY VALUATION PRINCIPLES
Cost Principle and Prudence
IAS 2 Inventories requires inventories to be valued at the lower of cost and net realisable value. This avoids recognizing profit before a sale occurs and ensures that expected losses are recognized promptly.
Cost of Inventory
The cost includes:
- Purchase price (after trade discounts)
- Transport and handling costs directly attributable to bringing items to their present location and condition
Excluded: abnormal waste, storage costs, administrative expenses
Key Term: Cost of Inventory
All expenditure incurred in bringing an inventory item to its present location and condition, including purchase price and direct costs.
METHODS OF VALUING INVENTORY
Most entities cannot track the exact cost of each item sold or remaining in inventory, so a system is used:
FIFO (First In, First Out)
FIFO assumes the oldest inventory is sold first. Closing inventory comprises the most recent purchases, valued at their specific purchase cost.
Worked Example 1.1
A retailer buys and sells a product with these transactions in January:
- 1 Jan: Bought 100 units at $5 each
- 10 Jan: Bought 150 units at $6 each
- 25 Jan: Sold 180 units
Calculate the value of closing inventory using FIFO.
Answer:
Total units purchased: 250; units sold: 180; units left: 70 (all from the 10 Jan purchase at $6) Closing inventory: 70 units x $6 = $420
Weighted Average Cost (AVCO)
AVCO averages the cost of all similar inventory available for sale. This cost is used for both goods sold and those remaining.
Periodic Weighted Average
- Calculate a single average cost based on all purchases during the period.
- Use average to value both cost of sales and closing inventory.
Continuous (Perpetual) Weighted Average
- Recalculate the average cost after each purchase.
- Issue inventory at this current average when sales occur.
Worked Example 1.2
Using the same data as in Example 1.1, calculate closing inventory under the periodic AVCO method.
Answer:
Total purchases: (100 x $5) + (150 x $6) = $500 + $900 = $1,400 Total units: 250 Weighted average cost per unit: $1,400 / 250 = $5.60 Units left: 70 Value: 70 x $5.60 = $392
Net Realisable Value (NRV)
If inventory is expected to sell for less than purchase cost, it must be written down to NRV.
Worked Example 1.3
A company holds 200 units of a product. Each cost $10. Due to damage, units can only be sold for $9 each, with extra selling costs of $1 per unit.
How should this inventory be valued?
Answer:
NRV per unit: $9 selling price – $1 cost = $8 Since NRV ($8) is lower than cost ($10), value inventory at $8/unit. Total value: 200 x $8 = $1,600
THE IMPACT OF FIFO VS WEIGHTED AVERAGE (AVCO)
- In times of rising prices, FIFO gives a higher closing inventory and lower cost of sales (thus higher profit) compared to AVCO.
- In periods of falling prices, AVCO can produce higher closing inventory values.
Worked Example 1.4
During an inflationary period, an entity’s FIFO closing inventory is $1,000 and AVCO closing inventory is $950. What is the effect on profit?
Answer:
Higher closing inventory (FIFO) means lower cost of sales, thus reported profit under FIFO will be higher by $50.
Exam Warning
Always value each inventory line at the lower of cost (using your chosen method) and NRV. Examine the impact your method has on reported profit and asset values when answering exam questions.
RECORDING INVENTORY IN THE ACCOUNTS
At year-end, closing inventory is:
- Credited to cost of sales (reduces expenses)
- Debited to a current asset account (increases asset value)
Key Term: Cost of Sales
The cost of inventory sold during the period, after accounting for opening and closing inventory.
Summary
- Inventories are always valued at the lower of cost and NRV in the accounts.
- FIFO assumes earliest purchases are sold first; closing inventory equals recent purchases.
- AVCO (weighted average) blends unit costs across the whole period.
- Choice of method affects profit and asset values, especially when costs change.
- Both methods comply with IAS 2 and are required for ACCA FA2.
Key Point Checklist
This article has covered the following key knowledge points:
- Identify and apply the lower of cost and net realisable value for inventory
- Calculate closing inventory and cost of sales using both FIFO and AVCO methods
- Compare the effects of FIFO and AVCO on profit and inventory valuation
- Understand the criteria for cost inclusion in inventory valuations
- Record inventory adjustments correctly in the financial statements
Key Terms and Concepts
- Inventory
- FIFO (First In, First Out)
- Weighted Average Cost (AVCO)
- Net Realisable Value (NRV)
- Cost of Inventory
- Cost of Sales