Revise Inventory valuation for Cambridge 9609 (10.1.3)

Inventory valuation is the accounting process of assigning a monetary value to a business's unsold goods. This is critical for two primary reasons. Firstly, the value of closing inventory is recorded as a current asset on the Statement of Financial Position, affecting the overall assessment of the business's liquidity and net worth. Secondly, it is a key component in calculating the Cost of Goods Sold (COGS) for the Income Statement. The formula 'COGS = Opening Inventory + Purchases – Closing Inventory' shows that the value assigned to closing inventory directly impacts COGS, which in turn determines the gross profit and, ultimately, the net profit for the period. Accurate inventory valuation is therefore essential for reliable financial reporting and decision-making.

The First-In, First-Out (FIFO) method operates on the assumption that the first units of inventory purchased are the first ones to be sold. Consequently, any inventory remaining at the end of an accounting period is presumed to consist of the most recently purchased items. This method often mirrors the actual physical flow of goods, especially for businesses dealing with perishable items or products subject to obsolescence, such as food or electronics. By selling older stock first, a business minimises waste. For accounting purposes, this means the Cost of Goods Sold is calculated using the cost of the oldest inventory, while the closing inventory is valued at the cost of the newest inventory.

To calculate the value of closing inventory using FIFO, a business must track its inventory purchases chronologically. For example, imagine a business starts with 10 units costing £5 each, then buys 20 units at £6. If it sells 15 units, FIFO assumes the first 10 units sold were those costing £5, and the next 5 units sold were from the batch costing £6. The Cost of Goods Sold would be (10 x £5) + (5 x £6) = £80. The closing inventory would consist of the remaining 15 units from the second batch, valued at £6 each, giving a total closing inventory value of 15 x £6 = £90.

The choice of FIFO has a significant impact on a firm's financial statements, particularly during periods of changing prices. In an inflationary environment (rising prices), FIFO results in a lower Cost of Goods Sold because it uses the older, cheaper costs. This leads to a higher reported gross and net profit. Consequently, the closing inventory on the Statement of Financial Position is valued at the most recent, higher prices, presenting a more realistic and up-to-date asset value. However, the higher reported profit also means the business may face a larger corporation tax liability. During deflation (falling prices), the effects are reversed: COGS is higher, profit is lower, and closing inventory is valued at lower prices.

When units are sold, assign the oldest purchase costs to cost of sales. Closing inventory consists of the most recent unsold units at their purchase cost.

Cost of sales = Opening inventory + Purchases − Closing inventory