1. INVENTORY VALUATION METHODS
Q: Discuss the types of inventory valuation methods – First-in-First-out (FIFO), Last-in-First-out
(LIFO), and Average Cost Method (AVCO), analyze them and explain their impact on the records
of the financial statements?
INTRODUCTION:
By definition, inventory is the term used to describe the assets of a company that are
intended for sale in the ordinary course of business, are in the process of being produced for
sale, or are to be used currently in producing goods to be sold. (Chasteen, Flaherty, & O'Connor,
1989)
Inventory in a business is a list of goods or products that is held in stock. It takes a lot of
time to keep inventory, but failure to do so could result in major financial disasters. Depending
on the size of your business, there are people whose sole job is to keep track of inventory. In a
small business, this would not have to be their only task.
Treatment in Financial Statement:
Inventory is converted into cash within the company’s operating cycle and, therefore, is
regarded as a current asset. In the balance sheet, inventory is listed immediately after Accounts
Receivable, because it is just one step farther removed from conversion into cash than
customer receivables. Being an asset, it is shown in the balance sheet at its cost. As items are
sold from this inventory, their costs are transferred into cost of goods sold, which is offset
against sales revenue in the income statement. (Meigs, Williams, Haka, & Bettner, 1999)
Having no inventory or having wrong inventory can lead to many problems. Because
inventory is reflected in the company’s books, a business owner may make decisions based on
the inventory numbers he sees in the books. If the number is wrong, he just made a wrong
decision that could be costly. In order to prevent this from happening in your business, there

2. are ways to keep proper inventory that any sized business can use. (Inventory and its
Importance, 2009)
Classifying Inventories:
Inventories can be classified according to type of business:
1. Merchandise Inventory: merchandise available of hand and available for sale to
customers. For e.g.: canned foods, meats, dairy products etc. Items in the merchandise
inventory have two common characteristics:
a: they are owned by the company
b: they are in the form ready for sale to customers in the ordinary course of business.
Inventory sold becomes the cost of merchandise sold. It is the ready-to-sell inventory of
merchandising firms.
2. Manufacturing Inventory: merchandise that needs to be produced in order to sell is
called manufacturing inventory. Although products may differ, manufacturers normally
have three inventory accounts, each of which is associated with a stage of the
production process: raw materials inventory, work-in-process inventory, finished goods
inventory.
a. Raw Materials Inventory: It consists of goods and materials that ultimately will
become part of the manufactured product but have not yet entered the
production process. For example, the raw materials of an automobile
manufacturer generally include sheet metal, nuts, bolts, and paint.
b. Work-In- Process Inventory: It consists of units in the production process that
require additional work or processing before becoming finished goods.
c. Finished Goods Inventory: It consists of units that have been completed and are
available for sale at the end of the accounting period. (Chasteen, Flaherty, &
O'Connor, 1989)

3. INVENTORY VALUATION:
Goods sold (or used) during ac accounting period seldom correspond exactly to the goods
bought (or produced) during that period. As a result, inventories either increase or decrease
during the period. Companies must then allocate the cost of all the goods available for sale (or
used) between the goods that were sold or used and those that are still on hand. The cost of
goods available for sale or use is a sum of
1. The cost of goods on hand at the beginning of the period.
2. The cost of goods acquired of produced during the period.
The cost of goods sold is the difference between the cost of goods available for sale during
the period and the cost of goods on hand at the end of the period.
Valuing inventories can be complex. It requires determining the following:
1. The physical goods to include in inventory (who owns the goods – goods in the transit,
consign goods, special sales agreements).
2. The cost to include in inventory (product vs. period cost)
3. The cost flow assumptions to adopt (specific identification, average cost, FIFO, LIFO,
retail, etc.). (Kieso, Weygandt, & Warfield, 2004)
INVERTORY VALUATION METHODS:
There are three methods of valuation of inventories under the accounting systems based on the
type and nature of products.
1. First-In-First Out (FIFO)
2. Last-In-First Out (LIFO)
3. Average Cost Method (AVCO)

4. a. FIRST-IN-FIRST OUT METHOD (FIFO):
The FIFO method assumes that a company uses the goods in the order in which it
purchases them. In other words, the FIFO method assumes that the first goods purchased are
the first used (manufacturing concern), or the first sold (in a merchandising concern). The
inventory remaining must therefore represent the most recent purchases. (Kieso, Weygandt, &
Warfield, 2004)
FIFO often parallels the actual physical flow of merchandise because it generally is good
business practice to sell the oldest units first. That is, under FIFO, companies obtain the cost of
ending inventory by taking the unit cost of the most recent purchase and working backwards
until all units of inventory have been costed. (Kimmel, Weygandt, & Kieso, 2007) This is true
whether a company computes cost of goods sold as it sells goods throughout the accounting
period (perpetual system) or as a residual at the end of the accounting period (periodic system).
The example below illustrates this approach.
Receipts Issues Balance
Date Quantity Unit Cost Amount Quantity Unit Cost Amount Quantity Unit Cost Amount
Jan-09 40 $3 $120 - - - 40 $3 $120
40 @ $3
Mar-12 50 $5 $250 - - - 90 $370
50 @ $5
40 @ $5
Mar-15 - - - 80 $320 10 $5 $50
40 @ $3
10 @ $5
Jun-07 100 $7 $700 - - - 110 $750
100 @ $7
10 @ $5
Aug-05 - - - 105 $715 5 $7 $35
95 @ $7
5 @ $7
Oct-02 140 $9 $1260 - - - 145 $1295
140 @ $9
5 @ $7
Nov-03 200 $12 $2400 - - - 345 140 @ $9 $3695
200 @ $12
5 @ $7
- - - 320 140 @ $9 $3395 25 $12 $300
Dec-30 175 @ $12
TOTAL - - - - - $4430 - - $300
Cost of Good Sold Balance Sheet as an
(ending) inventory

5. b. LAST-IN-FIRST OUT METHOD (LIFO):
The LIFO method assumes the cost of the total quantity sold or issued during the month
comes from the most recent purchases. That is, the latest goods purchased are the first to be
sold. LIFO coincides with the actual physical flow of inventory. The method matches the cost of
the last goods purchased against revenue. Under the LIFO method, the costs of the latest
goods purchased are the first to be recognized in determining the cost of goods sold. The
ending inventory is based on the prices of the oldest units purchased.
Companies obtain the cost of the ending inventory by taking the unit cost of the earliest
goods available for sale and working forward until all units of inventory have been costed.
(Kimmel, Weygandt, & Kieso, 2007)
The example given above, when solved using LIFO will give a different result.
Receipts Issues Balance
Unit Unit
Date Quantity Amount Quantity Amount Quantity Unit Cost Amount
Cost Cost
Jan-09 40 $3 $120 - - - 40 $3 $120
Mar- 40 @ $3
50 $5 $250 - - - 90 $370
12 50 @ $5
Mar- 50 @ $5
- - - 80 $340 10 $3 $30
15 30 @ $3
10 @ $3
Jun-
100 $7 $700 - - - 110 100 @ $730
07
$7
100 @
Aug-
- - - 105 $7 $715 5 $3 $15
05
5 @ $3
5@3
Oct-
140 $9 $1260 - - - 145 140 @ $1275
02
$9
5 @ $3
140 @
Nov-
200 $12 $2400 - - - 345 $9 $3675
03
200 @
$12
200 @
Dec- 12 5@3
- - - 320 $3480 25
30 120 @ 20 @ 9 $195
$9
TOTAL - - - - - $4535 - - $ 195
Cost of Good Sold Balance Sheet as an
(ending) inventory

6. c. AVERAGE COST METHOD (AVCO)
Under the average cost method, the costs of goods are equally divided, or averaged,
among the units of inventory. It is also called the weighted average method. When this method
is used, costs are matched against revenue according to an average of the unit of cost of goods
sold. The same weighted average unit costs are used in determining the cost of the
merchandise inventory at the end of the period. For businesses in which merchandise sales may
be made up of various purchases of identical units, the average method approximates the
physical flow of goods.
This method is determined by dividing the total cost of the units of each item available
for sale during the period by the related number of units of that item. (Warren & Reeve, 2004)
Receipts Issues Balance
Date Quantity Unit Cost Amount Quantity Unit Cost Amount Quantity Unit Cost Amount
Jan-09 40 $3 $120 - - - 40 $3 $120
Mar-12 50 $5 $250 - - - 90 $4.1 $369
Mar-15 - - - 80 $4.1 $328 10 $4.1 $41
Jun-07 100 $7 $700 - - - 110 $6.73 $740
Aug-05 - - - 105 $6.73 $707 5 $6.73 $34
Oct-02 140 $9 $1260 - - - 145 $8.92 $1293
Nov-03 200 $12 $2400 - - - 345 $10.7 $3692
Dec-30 - - - 320 $10.7 $3424 25 $10.7 $268
TOTAL - - - - - $4459 - - $ 268
It is also refer as weighted average cost.
Cost of Good Sold Balance Sheet as
Average Unit Cost = Total amount (ending) inventory
Total quantity
Therefore: 40 @ $3 = $120
50 @ $5 = $250
90 $370
= $4.1 (taking values as on January 9th)
Average Unit Cost = 41 + 700 = $6.73
110
Average Unit Cost = 34 + 1260 = $8.92
145
Average Unit Cost = 1293.4 + 2400 = $10.7
345

7. COMPARISON BETWEEN THE METHODS OF INVENTORY VALUATION
a. FIFO – Advantages and Disadvantages
ADVANTAGES DISADVANTAGE
Confirms to the actual flow of inventory items Fails to match current costs against current
revenues on income statement
Simple assumption for valuation of inventory Company charges the oldest costs against the
more current revenue, distorting gross profit and
net income
Comparatively inexpensive to use Higher revenues leads to higher tax payments
Less subject to management manipulation The matching of old, comparatively low acquisition
costs against higher sales revenue can give an
inflated net income
Reports somewhat higher profits by assigning It ignores the cost of replacing inventory at higher
lower (older) costs to cost of goods sold in case of prices (during rising prices),
rising prices
Assets in balance sheet closely approximate its it leads to misleading figures probably for
current replacement costs investors, giving figures of inventory the company
doesn’t have
A company cannot pick a certain cost item to
charge to expense
Ending inventory is close to current costs
Inventory consistent with most recent purchases.
(Kieso, Weygandt, & Warfield, 2004);
b. LIFO – Advantages and Disadvantages
ADVANTAGE DISADVANTAGE
Matches most recent inventory costs against sales Lower profits reported during inflationary times
revenue serve for managers as a distinct disadvantage
Reported income is more likely to approximate the May have a distorting affect of company’s balance
amount that really is available for distributors or
sheet, which is usually outdated because oldest
owners costs remain in inventory, making working capital
position of the company appear worse than reality
By giving low net income during rising prices, it Does not approximate the physical flow of the
actually defers income taxes items except in specific situations
Cost flow often approximates the physical flow of It may match old, irrelevant costs against current
the goods in and out of inventory revenues, distorting net income
Matches current revenues to better measure of May cause poor buying habits – purchase more
current earnings goods against revenue to avoid charging the old
cost to expense
Future price declines do not affect company’s Net income can be altered by simply altering its

8. future report earnings pattern of purchases
(Chasteen, Flaherty, & O'Connor, 1989)
c. Average Cost – Advantages and Disadvantages
ADVANTAGE DISADVANTAGE
Its very practical – easy to apply changes in current replacement costs are
concealed because these costs are averaged with
older costs
Does not lend itself to manipulation neither the valuation of ending inventory nor the
cost of goods sold will quickly reflect changes in
the current replacement costs of merchandise
identical items have the same accounting values
not necessary to keep track of inventory
(Chasteen, Flaherty, & O'Connor, 1989)
EFFECT OF THE VALUATION METHODS ON FINANCIAL STATEMENT
Since prices keep on changing, the three methods yield different amounts for (1) the cost of
merchandise sold for the period (2) the gross profit (net income) for the period (3) the ending
inventory. There is also a tax effect that varies with changes in net income among different
valuation methods. (Warren & Reeve, 2004)
a. Income Statement:
FIFO: FIFO gives the highest amount of gross profit (hence, net income) because the lower unit
costs of the first units purchased are matched against revenues, especially in times of inflation.
However in times of falling prices, FIFO will report lowest inventory. It also yields the highest
amount of ending inventory and the lowest cost of goods sold. This will give a false impression
of paper profit.
LIFO: LIFO gives the lowest amount of net income during inflationary times and the highest net
income during price declines. It gives the lowest amount of ending inventory and the highest
cost of goods sold. (Kimmel, Weygandt, & Kieso, 2007)
AVCO: Average Costs approach tends to produce cost of goods sold and ending inventory
results between the results by LIFO and FIFO. (Chasteen, Flaherty, & O'Connor, 1989)

9. To the management, higher net income is an advantage: it causes external users to view
the company more favorably. In addition, management bonuses, if based on net income, will be
higher. Hence during inflationary times, companies prefer using FIFO. (Warren & Reeve, 2004)
Methods Cost of Goods Sold Ending Inventory Net Income
FIFO Understated Overstated Overstated
LIFO Overstated Understated Understated
AVCO In between FIFO & LIFO In between FIFO & LIFO In between FIFO & LIFO
b. Balance Sheet:
FIFO: During periods of inflation, the costs allocated to ending inventory will approximate their
current cost. In fact, the balance sheet will report the ending merchandise inventory at an
amount that is about the same as its current replacement costs. As inventories are overstated
in FIFO, this will affect the total assets and hence the stockholder’s equity, overstating it.
LIFO: In a period of inflation, the costs allocated to ending inventory may be significantly
understated in terms of current costs. This is because more recent costs are higher than
the earlier unit costs. Thus it matches current costs nearly with current revenues. (Warren &
Reeve, 2004)In LIFO, inventories are understated. This, in turn, affects the stockholder’s equity
by understating the actual figures.
AVCO: Average cost approach for series of purchases will be same, regardless of direction of
price trends. In its effect on the balance sheet, however, it is more like FIFO than LIFO.
(Chasteen, Flaherty, & O'Connor, 1989)
Methods Inventory Current Assets Stockholder’s Equity
FIFO Overstated Overstated Overstated
LIFO Understated Understated Understated
AVCO In between FIFO & LIFO In between FIFO & LIFO In between FIFO & LIFO

10. References
(1989). Inventory Valuation: determing costs and using cost flow assumtions. In L. G. Chasteen, R. E. Flaherty, & M.
C. O'Connor, Intermediate Accounting (pp. 398 - 423). Mc-GRAW-HILL Publishers.
Inventory and its Importance. (2009, March 7). Retrieved March 19, 2008, from Contractor Blog:
http://www.contractorblabblog.com/2009/03/inventory-and-its-importance/
(2004). Valuation of Inventories - A cost-Basis Approach. In D. E. Kieso, J. J. Weygandt, & T. D. Warfield,
Intermediate Accounting (pp. 383 - 410). John Wiley and Sons.
(2007). Reporting and Analyzing Inventory. In P. D. Kimmel, J. J. Weygandt, & D. E. Kieso, Financial Accounting (pp.
273 - 290). John Wiley and Sons.
(1999). Inventories and the Cost of Goods Sold. In R. F. Meigs, J. R. Williams, S. F. Haka, & M. S. Bettner, Accounting
(pp. 330 - 339). Mc-GRAW-HILL Publishers.
(2004). Inventories. In C. S. Warren, & J. M. Reeve, Finanical Accounting (pp. 372 - 390). Thomsom.