Unit 3 Chapter 8
- AVCO and FIFO methods
- Valuation of inventory - IAS2
- calculating closing inventory
- effect on profits of different methods
- advantages/disadvantages - AVCO and FIFO
- importance of inventory count/reconciliation
- Created by: Melonball
- Created on: 31-05-14 14:05
Inventory valuation
It is important to value inventory correctly; it is a current asset in the balance sheet and is part of the cost of sales calculation in the income statement. It is important so the final accounts show accurate figures and therefore a "true and fair" view of the business is given.
Inventory counts are performed at the end of the year: inventory is physically counted. WHY?
- The balance sheet inventory should reflect the value of inventory that is physically present
- Theft and other losses can be identified by the physical inventory count
- The inventory system (computerised) can be reconciled with the physical count
The rule for valuing inventory:
Inventory should be valued at the lower of cost and net realisable value.
NRV = selling price - costs to get goods in a saleable condition
Cost = purchase price + cost incurred to get goods into current location and condition.
Options for valuation
There are two acceotable accounting methods to value inventory. they are the AVCO and FIFO method.
The AVCO method is the average cost. It is calculated by: Total cost of goods in inventory
--------------------------------------------
Number of items in inventory
FIFO method is first in, first out. In this method the oldest/ first inventory aquired are assumed to be used first. This means inventory should consist of the most recently aquired items.
FIFO method
Receipts Issues Balance
quantity cost total quantity cost total quantity cost total
200 10 2000 200 10 2000
------------------------------------------------------------------------------------------------------------------------------------
250 11 2750 200 10 2000
250 11 2750
-------- --------
450 4750
-------------------------------------------------------------------------------------------------------------------------------------
150 10 1500 50 10 500
250 11 2750
------- --------
300 3250
----------------------------------------------------------------------------------------------------------------------------------
Because we are using first in first out, the inventories recieved are kept separately. When we have sold some of our goods we take the quantity from the first lot of inventory first. Say if we sold 250 instead of 150, we would take 200 from the first lot of inventory first, then 50 from the second lot.
Note: notice that the different costs of inventory are kept separately, this is different to AVCO.
AVCO method
Receipts Issues Balance
quantity cost total quantity cost total quantity cost total
200 10 2000 200 10 2000
------------------------------------------------------------------------------------------------------------------------------
250 11 2750 200 10 2000
250 11 2750
------ ------ ----------
450 10.556 4750
------------------------------------------------------------------------------------------------------------------------------
150 300 10.556 3167
--------------------------------------------------------------------------------------------------------------------------------
The bold figure is calculated. We do total cost/ quantity - 4750/ 450 = 10.556
This is dont to fine the average cost as the AVCO method id based on all inventory being valued at the same average cost. When we sell inventory it is not taken from separate sections like the FIFO method, it comes from the whole inventory - 450 -150 = 300.
FIFO advantages/disadvantages
- Realistic - it assumes inventory is rotated
- Easy to calculate
- Easy to understand - inventory is valued at the cost it was bought at
- Closing inventory figure is based on the most recent prices
- IAS2 allows this valuation
- It is acceptable for tax purposes
Disadvantages:
- Inventory may be issued to production at prices that are different to current prices.
- When prices are rising, profits are higher - more tax is paid
- Time-consuming to calculate as lists of different costs must be recorded.
AVCO advantages/disadvantages
- The averaging process "smooths" prices and therefore avoids fluctuations.
- It assumes different units have the same value even if they were bought at different times.
- Calculations can be computerised quite easily.
- IAS2 allows this type of valuation
- Acceptable for tax purposes
Disadvantages:
- Complex - a new average needs to be calculated after every purchase
- Inventory id often values at a cost which never actually existed
- Issues may not be at current prices.
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