Accounting

Which Cost Formula To Use For Inventory Valuation?

One question may burn you inside as to: Which Cost Formula To Use For Inventory Valuation? The choice of Inventory Valuation method is a matter for management judgment and depends upon the nature of the inventory, the information needs of management and financial statement users, and the cost of applying the formulas. For example, the weighted average method is easy to apply and is particularly suited to inventory where homogeneous products are mixed together, like iron ore or spring water.

On the other hand, first-in, first-out may be a better reflection of the actual physical movement of goods, such as those with use-by dates where the first produced must be sold first to avoid loss due to obsolescence, spoilage or legislative restrictions. Entities with diversified operations may use both methods because they carry different types of inventory.

Using diverse methods is acceptable under IAS 2, but paragraph 26 says that ‘a difference in geographical location of inventories (or in the respective tax rules), by itself, is not sufficient to justify the use of different cost formulas’. The nature of the inventory itself should determine the choice of formula.

Consistent application of costing methods

Once a cost formula has been selected, management cannot randomly switch from one formula to another. Because the choice of method can have a significant impact on an entity’s reported profit and asset figures, particularly in times of volatile prices, indiscriminate changes in formulas could result in the reporting of financial information that is neither comparable nor reliable.

Accordingly, paragraph 13 of IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors requires that accounting policies be consistently applied to ensure comparability of financial information. Changes in accounting policies are allowed (IAS 8 paragraph 14) only when required by an accounting standard or where the change results in reporting more relevant and reliable financial information. Therefore, unless the nature of inventory changes, it is unlikely that the cost formulas will change.

A switch from the FIFO to the weighted average method must be disclosed in accordance with the requirements of IAS 8, in particular paragraph 19. This paragraph requires the change to be applied retrospectively, and the information disclosed as if the new accounting policy had always been applied.

Hence, a change from the FIFO method to the weighted average method would require adjustments to the financial statements to show the information as if the weighted average method had always been applied. Adjustments can be taken through the opening balance of retained earnings. Comparative information would also need to be restated.

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