CHAPTER 16
CLOSING INVENTORY VALUATION
16.1LEARNING OUTCOMES
By the end of this chapter, students should be able to explain the methods of valuing inventory and the advantages and disadvantages of inventory valuation method. They are also expected to value inventory and explain the inventory taking methods.
16.1 INVENTORY VALUATION
You noted in chapter 14 that calculation of cost of goods sold in the trading account takes into account of opening and closing inventories. In this chapter, you will learn how to value inventories.
Valuation of inventories is important for the following reasons:
x It enables businesses to establish the value of closing inventories x Values attached to inventories form a basis for setting selling prices x It facilitates the calculation of cost of sales and profits
You can see that inventory valuation is important when preparing financial statements as the above reasons affect either the income statement or the statement of financial position.
Historical costs are generally used in the valuation of inventories. Historical costs are the costs which were incurred to produce or purchase inventories. The main ways of determining the historical cost of inventory are:
- First In First Out (FIFO) method
- Average Cost (AVCO) method
16.1.1 First In First Out (FIFO)
This method assumes that the first components of inventory to be brought into stock are the first ones to be sold out or issued out to production in the case of a manufacturing business.
The FIFO method is logical in the sense that it portrays what should happen in practice; goods acquired first should be used first. The method is very easy to use. It is also recommended by International Accounting Standard (IAS 2) Inventories.
However, the assumption that the inventories which have been acquired should be used first might not hold true if the goods have been mixed up in a warehouse or store room.
Average Cost (AVCO)
The AVCO method involves valuing items of inventory sold or issued to production at the average cost of all inventories in stock. This means that a new average cost will be calculated whenever additional items of inventories have been acquired or produced.
Unlike the FIFO method which assumes that goods acquired first will also be used first, the AVCO method implies that this assumption might not work. You have learnt that goods acquired on different times may be mixed up. In this case, it is difficult to identify the goods which were bought first. The use of average costs will be ideal in this scenario. This method is recommended by the IAS 2.
On the other hand, the use of the AVCO method is tedious as the business is required to calculate a new average cost upon receipt of additional inventories.
COMPARISON OF FIFO AND AVCO METHODS
Table 16.3: Comparison of FIFO and AVCO methods
| Method | Costofsales(K) | Closinginventory(K) | |
| 1 | FIFO | 7,750 | 1,100 |
| 2 | AVCO | 6,250 | 1,040 |
You can see that each method gives a different value of inventory and cost of sales. This means that the profit figures reported by each method will also be different. It is important for businesses to apply the method which they will adopt consistently. This is in line with the consistency concept which you covered in …..Applying accounting policies facilitates effective comparison of financial statements.
16.3 INVENTORY TAKING
Inventory taking is the process of verifying the quantity balances of the entire range of items held in stock.
It is vital to take into account of security issues when conducting an inventory taking exercise. These may include ensuring that inventories are located in a secure building (location), not allowing unauthorized persons not allowed access and proper custody of store keys.
Inventory taking is important because:
- It enables businesses to verify accuracy of stock records
- It provides support the value of stock in the statement of financial position.
- It may assist in the identification of fraud, theft or loss and other weakness in the management of inventory.
16.4 INVENTORY TAKING METHODS
There are two major methods of inventory taking. These are:
- Periodic
- Perpetual (Continuous)
16.4.1 Periodic Method
Under this method, inventory taking exercise takes place at the end of a given period. This can be at the end of the year or any other point in time. Thorough is preparation needed; programme drawn up and agreed with all concerned parties, Stocktaking sheets prepared and duties communicated to all concerned parties
16.4.2 Perpetual (Continuous) Method
Inventory taking is conducted continuously throughout the year. The procedures for this method are similar to periodic inventory taking except that:
- There is no need to close down stores while inventory taking
- Normal posting of receipts and issues on the inventory records can continue without interruption
- Inventory taking is done by few specially appointed, experienced and trained staff completely independent of stores staff
SUMMARY OF THE CHAPTER
This chapter was about the inventory valuation. You have learnt that you can use the First In First Out (FIFO) and the Weighted Average method (AVCO) to value inventories. You have also learnt that inventory taking is a very important exercise in inventory management.