Chapter 4: Inventories

Objective:

 Explain the special inventory valuation techniques.

4.1 Introduction to Inventory Valuation

Inventory represents goods held for sale or materials used in production. Proper inventory
valuation is crucial for determining the cost of goods sold (COGS) and the value of inventory on
the balance sheet. Inventory valuation affects both the income statement and balance sheet,
influencing profitability and financial position.

Inventory valuation methods differ depending on how a company tracks the flow of goods and
their associated costs. Various techniques provide flexibility but must adhere to consistent
application under accounting standards (IFRS and GAAP).

4.2 Inventory Valuation Methods

There are several techniques used to value inventory. Each method affects the company's
reported profit and tax liabilities differently. The three common methods are:

4.2.1 First-In, First-Out (FIFO)

FIFO assumes that the first items purchased (or manufactured) are the first to be sold. Therefore,
the cost of the earliest inventory items is assigned to the cost of goods sold, while the most recent
purchases remain in ending inventory.

 Application: FIFO is particularly useful when inventory items have a limited shelf life or
are perishable, such as food products.
 Effect on Financial Statements: During times of rising prices, FIFO tends to result in
lower cost of goods sold and higher ending inventory, leading to higher profits and
potentially higher tax liabilities.

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Example: If a company purchases 100 units of inventory at ETB 50 each and another 100 units
at ETB 60 each, and sells 120 units, the cost of goods sold under FIFO is:

𝐶𝑂𝐺𝑆 = (100 × 50) + (20 × 60)

= 𝐸𝑇𝐵 5,000 + 𝐸𝑇𝐵 1,200
= 𝐸𝑇𝐵 6,200

4.2.2 Last-In, First-Out (LIFO)

LIFO assumes that the last items purchased are the first to be sold. Therefore, the most recent
costs are assigned to the cost of goods sold, while older costs remain in ending inventory.

 Application: LIFO may be used in industries where inventory does not easily spoil, such
as raw materials or manufacturing components.
 Effect on Financial Statements: In periods of rising prices, LIFO results in higher cost
of goods sold and lower ending inventory, reducing net income and tax liabilities.

Example: Using the same data as the FIFO example, the cost of goods sold under LIFO would
be:

𝐶𝑂𝐺𝑆 = (100 × 60) + (20 × 50)

= 𝐸𝑇𝐵 6,000 + 𝐸𝑇𝐵 1,000
= 𝐸𝑇𝐵 7,000

In this case, LIFO results in higher cost of goods sold and lower net income compared to FIFO.

4.2.3 Weighted Average Cost (WAC)

Weighted Average Cost assigns an average cost to all inventory units, regardless of when they
were purchased. The total cost of goods available for sale is divided by the number of units
available to determine the average cost per unit.

 Application: WAC is commonly used in industries with homogeneous products, such as

chemicals or fuels, where individual units are indistinguishable.

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  Effect on Financial Statements: WAC smooths out price fluctuations, resulting in cost
of goods sold and ending inventory values between those reported under FIFO and LIFO.

Example: Using the same purchase data, the weighted average cost per unit is:

(100 × 50) + (100 × 60)

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐶𝑜𝑠𝑡 =
200
𝐸𝑇𝐵 11,000
=
200
= 𝐸𝑇𝐵 55

The cost of goods sold for 120 units would be:

𝐶𝑂𝐺𝑆 = 120 × 55 = 𝐸𝑇𝐵 6,600

The remaining inventory would be valued at:

𝐸𝑛𝑑𝑖𝑛𝑔 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 = 80 × 55 = 𝐸𝑇𝐵 4,400

4.3 Lower of Cost or Net Realizable Value (LCNRV)

The Lower of Cost or Net Realizable Value (LCNRV) method ensures that inventory is not
overstated on the balance sheet. If the net realizable value of inventory (the estimated selling
price less costs to complete and sell) falls below its cost, the company must write down the
inventory to its net realizable value.

 Application: LCNRV is important when inventory becomes obsolete or its market value
declines, ensuring that the company does not overstate its assets.
 Effect on Financial Statements: Inventory write-downs reduce the value of inventory on
the balance sheet and increase expenses, reducing net income.

Example: A company purchases inventory at a cost of ETB 5,000, but due to market conditions,
the inventory’s selling price is expected to be ETB 4,500. The inventory must be written down
by ETB 500 to its net realizable value:

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 𝑊𝑟𝑖𝑡𝑒 − 𝑑𝑜𝑤𝑛 = 𝐸𝑇𝐵 5,000 − 𝐸𝑇𝐵 4,500 = 𝐸𝑇𝐵 500

4.4 Impact of Inventory Valuation Methods on Financial Statements

Each valuation method affects the financial statements differently:

 FIFO results in higher profits during periods of rising prices, as older, lower costs are
matched with revenue.
 LIFO results in lower profits and tax liabilities when prices are rising, as newer, higher
costs are matched with revenue.
 Weighted Average smooths price fluctuations, providing a middle ground between FIFO
and LIFO.
 LCNRV ensures that inventory is not overstated and that any declines in value are
recognized.

The choice of inventory valuation method has a direct impact on profitability, tax liability, and
the value of inventory reported on the balance sheet.

Conclusion

Understanding the various inventory valuation techniques is crucial for accurate financial
reporting and decision-making. FIFO, LIFO, and WAC each have different implications for the
cost of goods sold and ending inventory, which directly affect a company’s profitability and tax
liabilities. Additionally, the LCNRV method ensures that inventory values are not overstated and
that any losses due to declining market conditions are recognized in the financial statements.

Key Terms and Definitions

1. FIFO (First-In, First-Out): A method that assumes the first inventory items purchased
are the first to be sold.
2. LIFO (Last-In, First-Out): A method that assumes the last inventory items purchased
are the first to be sold.

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3. Weighted Average Cost (WAC): A method that assigns an average cost to all inventory
units, regardless of when they were purchased.
4. Lower of Cost or Net Realizable Value (LCNRV): A rule that requires inventory to be
valued at the lower of its historical cost or its net realizable value (estimated selling price
minus costs to complete and sell).
5. Cost of Goods Sold (COGS): The direct costs attributable to the production or purchase
of the goods sold by a company.

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