Methods of Inventory Accounting
Chapter Fifteen
Syllabus topic 4, "Methods of Inventory Accounting and Prepare Stock Ledger/ Account"
Pages 40 to 42 of 82
In one line
The same physical material can be priced out in different ways, and in a rising market FIFO charges the oldest, cheapest prices to production and leaves the newest, dearest in stock.
Why a method is needed at all
A store receives 200 units at Rs 20 and later 300 at Rs 25. Production draws 250. Which 250?
Physically it may not matter; the units are identical. But the cost charged to production, and therefore the profit, depends entirely on the answer. A method has to be chosen and applied consistently.
CAS-25 Valuation of Inventory is the standard on this. Its requirement, in our own words, is that inventory be valued by a method that is appropriate and applied consistently, and that the method used be disclosed, so that cost statements are comparable between periods.
First in, first out
The oldest stock is issued first. Issues take the earliest prices still unexhausted; the closing stock is made up of the most recent purchases.
| In a rising market | |
|---|---|
| Issues priced at | Old, low prices |
| Cost of production | Lower |
| Profit | Higher |
| Closing stock | Higher, at recent prices |
In a falling market every one of those reverses.
Its strength is that closing stock is at prices close to current cost, so the balance sheet figure is realistic.
Its weakness is that production is charged with out-of-date prices, so a quotation based on that cost can be too low when prices are rising.
Weighted average
A new average is struck after every receipt, and issues are priced at that average until the next receipt changes it.
Weighted average rate = Total value in stock divided by Total units in stock
It smooths. Issues and closing stock both sit between the extremes, so neither profit nor the balance sheet swings with each purchase.
Recompute the average after every RECEIPT, not after every issue. An issue removes units and value in the same proportion, so it cannot change the rate. That is the single commonest error in working a stock ledger.
The comparison, as a table
| FIFO | Weighted average | |
|---|---|---|
| Issues priced at | Oldest unexhausted prices | The current average |
| In a rising market, issue cost | Lower | Between |
| In a rising market, profit | Higher | Between |
| In a rising market, closing stock | Higher | Between |
| Closing stock reflects | Recent prices | An average |
| Effect of a price spike | Passes through later, in full | Smoothed |
| Recomputation | None; prices are used in order | After every receipt |
One sentence to carry: in a rising market FIFO gives the lowest issue cost, the highest closing stock and the highest profit; weighted average sits between; and in a falling market it is the other way round.
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