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
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  • 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. 

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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. 

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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
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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. 

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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
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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. 

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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.
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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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