Inventory costing methods and their impact on financial statements​ ​

Today, companies operate in a highly competitive environment, especially in the commercial and manufacturing sectors.

As a rule, inventories are the most important and significant part of a company's assets, so it is important to study issues related to their valuation at the time of their disposal. The objectivity of the company's profit data depends on the choice of inventory valuation method. An incorrectly chosen depreciation method can lead to an overstatement or an understatement of the company's profit in the face of rising or falling market prices for certain inventories.

Thous, in most manufacturing or trading business, one of the most important cost items is the cost of selling inventory. On the one hand, there is a direct relationship between the cost of inventory and cost of goods sold, and on the other hand, there is also a direct relationship between sales revenue and cost of goods sold.

1.      Sales revenue and cost of goods sold.

Sales revenue is the company's income from the sale of goods or services and is one of the most important indicators in business that determines the viability of the company. It is recorded in the monthly income statement for the month following the delivery of the goods or the provision of the service. It is the most relevant indicator for a company of any size: the basis for calculating KPIs, forecasting development and making strategic decisions.

Another important economic indicator of a company is its cost price. The cost of goods sold (COGS) or cost of sales is the direct cost of producing the goods sold by a company. This amount includes the cost of materials and labor used directly to produce the goods. Cost of goods sold is an important financial reporting indicator. It is subtracted from a company's revenues to determine the company's gross profit.

Revenue is calculated by multiplying the quantity of goods sold by the selling price, while cost of goods sold is calculated by multiplying the quantity of goods sold by the unit cost of goods sold. At the same time, the cost of goods sold consists of the purchase price plus certain allocated landed costs that are included in the cost of goods sold.

The cost of inventories sold is recognized as an expense at the same time as the revenue from the sale is recognized. Three indicators are necessary for the determination of the cost of inventories sold:

1.     Inventories at the beginning of the period;

2.     Purchases during the period;

3.     Inventories at the end of the period.

But first, let's look at the different types of Inventory and see how they are determined to cost.

2.    Types of inventories and determination of their cost

Different types of inventories may be carried on the balance sheet in different business units, depending on the nature of the company's activities.

If a company is engaged in a commercial activity, the main type of inventory it has will be merchandise.

Goods are inventories held for sale. They are usually purchased in their finished state and are sold without any further processing or transformation being carried out.

The list of inventory types used by manufacturing companies will be much broader, as manufacturing companies are characterized by a production process in which inventories typically go through certain stages of transformation from raw materials to finished goods:

Finished goods are inventories that have been produced and are fully ready for sale.

Work in progress (WIP) is inventory in the process of production but not yet ready for sale.

Raw materials and supplies are inventory that is in need of further processing into products.

By definition (IAS 2, "Inventories"), the cost of inventories should include all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition.

However, many companies do not include in the cost of inventories some costs that they consider to be immaterial. Very often, the cost of inventories is equal to the cost of purchase from the supplier.

The costs of purchase of inventories comprise the purchase price, import duties and other taxes (other than those subsequently recoverable by the entity from the taxing authorities), and transport, handling and other costs directly attributable to the acquisition of finished goods, materials and services. Trade discounts, rebates and other similar items are deducted in determining the costs of purchase (IAS 2 inventories, par.11).

3.    Inventory costing methods

Inventory accounting has an impact on both the balance sheet and the income statement. Matching costs to sales is the primary objective of inventory accounting. What portion of the cost of inventories held for sale should be deducted from the amount of sales revenue is determined by the matching principle.

Decisions about how to account for inventories are made solely by the enterprise. However, in deciding how to account for inventories, management should determine the method of measuring and recognizing the cost of inventories:

- the method of measuring the cost of such inventories;

- the inventory accounting system (perpetual or periodic);

- the items included in inventories and their related costs

- Use of market value or other estimates.

Perhaps the biggest headache for all accountants in inventory accounting is the problem of determining the unit cost of inventory. This can be easily illustrated by the following example. Suppose you have a warehouse with a large number of goods. And if all the goods were purchased at the same price, the process of determining the cost would be relatively simple. However, if the same items were purchased at different costs, the question arises as to which amounts should be charged to Cost of Goods Sold (which affects the income statement) and which amounts should be charged to Inventory (which affects the balance sheet).

The cost of inventory and the cost of goods sold are generally allocated using three methods:

1.              Specific identification method;

2.              FIFO Method;

3.              Weighted average cost method.

In the past, LIFO was a very popular method, but it has been outlawed because of its potential for manipulation of financial statement data and distortion of data. Therefore, I will not discuss this method in this article.

Each method is based on a particular inventory cost flow model. Each method is acceptable regardless of whether the actual physical movement of inventory matches the cost flow assumption. The type of product and how it is stored determine the physical movement of inventory. The physical movement and the cost flow do not necessarily have to match. This statement may seem strange, but according to the accounting standards, there are several types of cost flows that can be assumed. And in practice, because it leads to a more accurate calculation of profit, which is the main purpose of inventory valuation, it is better to use the assumed cost flow.

All methods are considered in the context of the periodic and perpetual inventory accounting system, although the periodic system is no longer in use, but it is still worth mentioning.

4.    Special identification method

The cost of inventories of items that are not ordinarily interchangeable and goods or services produced and segregated for specific projects shall be assigned by using specific identification of their individual costs. (IAS 2 Inventory, par.23 )

Specific identification of cost means that specific costs are attributed to identified items of inventory. This is the appropriate treatment for items that are segregated for a specific project, regardless of whether they have been bought or produced. However, specific identification of costs is inappropriate when there are large numbers of items of inventory that are ordinarily interchangeable. In such circumstances, the method of selecting those items that remain in inventories could be used to obtain predetermined effects on profit or loss. (IAS 2 Inventory, par.24 )

The specific identification method can be used to allocate costs when each unit of inventory can be traced to a specific purchase. This method is suitable for companies selling expensive custom-made goods or for the determination of the cost of individual orders (ships, airplanes ....).  Although this method seems to be very logical, the scope of its application is not very wide, because it has three major disadvantages:

- Tracking the purchase and sale of individual goods is very difficult and almost impossible for most companies;

-  If a company sells similar goods, the choice of goods for sale is arbitrary; the company can then choose products with higher or lower costs and thus manipulate profits;

- It may be difficult to correctly allocate the costs of shipping, storing, and discounting to a particular unit of goods.

To illustrate how each method affects accounting, consider a small case study:

Quantitative accounting is easy, but what is the cost of inventory sold? Acquisition cost is easy to calculate:

2000*40.00 +6000*44.00 +2000*47,5 = 80,000.00  +264,000.00 + 95,000.00 = 439,000.00 CAD. The cost of the batches from which the goods were sold was also: 80,000.00 +264,000.00 =344,000.00 CAD.

So what was the cost of goods sold?

To illustrate the specific identification method, suppose that 1000 units of the first arrival and 3000 units of the second arrival were sold. The cost of sales is therefore 1000*40.00 +3000*44.00 =172,000.00 CAD.

5.    Weighted-average-cost method

Under the weighted average cost formula, the cost of each item is determined from the weighted average of the cost of similar items at the beginning of a period and the cost of similar items purchased or produced during the period. The average may be calculated on a periodic basis, or as each additional shipment is received, depending upon the circumstances of the entity. (IAS 2 Inventory, par.27 )

The name of this method suggests that it measures inventory at the average cost of goods sold. The total cost of goods sold is divided by the total number of units of goods sold to obtain the average cost. The result of this computation is the weighted average unit cost applicable to the units of inventory at the end of the period.

5.1. Weighted-average-cost method in periodic accounting

In total, we received 10000 units of goods for the month. The total cost was 439,000.00 CAD. The cost of one unit of goods: 439,000.00 \10000=43.90. The inventory at the end of the period is 6000. This is the cost of inventory at period end: 6000*43.90=263,400.00. Cost of goods sold will be: 439,000.00 -263,400.00 =175,600.00 CAD.

If an enterprise has inventory at the beginning of the period, the inventory is included in finished goods and in the cost of finished goods for the purpose of calculating the weighted average unit cost.[М2] 

5.2. Weighted-average-cost method in perpetual accounting

This method is simple to use, objective and cannot be used to manipulate profits, as is possible with other inventory valuation methods. Proponents of this method also point out that it is often impossible to take into account the actual flow of inventory and therefore this method is preferable - this is particularly true for homogeneous inventories.

As we can see, the use of the weighted average cost method in different accounting systems produces different results. This difference is due to the fact that in the perpetual system the accounts are kept on a permanent basis and we know the value of the stock available for sale at the time the goods are sold. In the periodic system, the value of the stock is considered at the end of the period.

6.    FIFO (First-In-First-Out)

The FIFO formula assumes that the items of inventory that were purchased or produced first are sold first, and consequently the items remaining in inventory at the end of the period are those most recently purchased or produced. (IAS 2 Inventory, par.27 )

This method assumes that goods are used/sold in the order in which they are purchased and that the remaining stock represents the most recent purchases.

6.1. FIFO in periodic accounting

The cost of production available for sale, as we recall, is equal to 439000,00 CAD. The cost of realisation is equal to: 439000-271000=168000,00 CAD

6.2. FIFO in perpetual accounting

As we can see, when FIFO is used, the value of the cost of sales and the value of the inventory at the end of the period are the same in both accounting systems. This is because the same cost is the first to be received and the first to be disposed of, regardless of whether perpetual accounting is in place or not.

FIFO also allows you to approximate the physical flow of inventory. This method does not allow revenue to be manipulated because the entity cannot choose the value of goods sold at its discretion for revenue recognition purposes. Another advantage of this method is that the value of inventory at the end of the period is fairly close to its current value.

However, this method has a disadvantage in that current costs are not matched with current revenue in the income statement. The cost of goods sold is shown at the cost of earlier purchases, which may not be the current cost of goods sold.

7.    Comparison of inventory valuation methods

We have already seen an example of how different inventory valuation methods affect the cost of sales and the value of inventory at the end of the period. Let us present the data for comparison in the form of a table:

 As we can see from this example, the use of different inventory valuation methods results in different profit margins. In a period of rising prices, the use of the FIFO or weighted average method can lead to an overstatement of profit in the financial statements and the payment of higher taxes. Overstatement of profit occurs because the cost of goods sold is understated compared with current prices. This is particularly evident when FIFO is used. The LIFO method, does not have this disadvantage, but it is not currently recommended by IFRS so I have not considered it here.

8.    Problems in determining the cost of inventories and cost of sales

The valuation of inventory can be greatly influenced by two factors that need to be considered:

1.     Valuation at lower cost;

2.     Deterioration of the inventory;

8.1. The lower of cost method

In accordance with the cost principle, inventories should be measured at cost. However, if such goods can be acquired at a price lower than the book value, the valuation of such inventories should be based on the lower market value and not on the cost of acquiring such goods. This rule is known as the lower of cost or market (LCM) method.

Here is what IAS 2 Inventory says:

The cost of inventories may not be recoverable if those inventories are damaged, if they have become wholly or partially obsolete, or if their selling prices have declined. The cost of inventories may also not be recoverable if the estimated costs of completion or the estimated costs to be incurred to make the sale have increased. The practice of writing inventories down below cost to net realisable value is consistent with the view that assets should not be carried in excess of amounts expected to be realised from their sale or use. .(IAS 2 Inventory, par.28 )

The amount of the difference between the purchase price and the market value is charged to the loss of the enterprise in the period in which it is identified and is not deferred until such inventories are realised.

Three valuation methods may be used in applying this requirement:

1.     The item-by-item method - comparing the cost and market value of each item of inventory (for example, each model of television set);

2.     Major category method - comparing the total cost and total market value of each category of goods (e.g. all models of televisions).

3.     The total inventory method (e.g. for all TVs and laptops).

8.2. Spoiled inventory

Inventories that are perishable, worn, damaged or obsolete should not be valued at their original cost. If their net realisable value is less than cost, they should be stated in the financial statements at net realisable value.

Net realisable value is the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale.

8.3. In summary.

Inventory accounting in International Financial Reporting Standards is governed by Standard 2 Inventory, the provisions of which I have quoted several times in this article. Its main provisions are summarised below:

• Inventories are measured and recognised at the lower of cost and net realisable value.
• The cost of inventories includes all directly attributable costs of preparing the inventories for sale, including directly attributable overheads.
• The cost of inventories is generally determined using the first-in, first-out (FIFO) or weighted average cost method. The use of the last-in-first-out (LIFO) method is prohibited.
• Other formulas for calculating the cost of inventories, such as the normal operating cost formula or the retail method, may also be used if the results of such calculations approximate the actual cost.
• When inventories are sold, their cost is recognised as an expense in the income statement.
• Part of the cost of inventories is written down to net realisable value when this is lower than the cost.
• If there is a subsequent increase in the net realisable value of an item of inventory previously written down, the write-down

Mariia Ivaniuk – Head of ERP Department

Reference article by Anton Piskun in Ukrainian: https://www.antonpiskun.pro/metody-opredeleniya-stoimosti-zapasov-i-ih-vliyanie-na-pokazateli-finansovoj-otchetnosti/  

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