Level 1 CFA® Exam:
Inventory Valuation Methods
Before we start discussing different methods, let’s have one important CFA exam formula that shows the inverse relationship between the cost of goods sold and ending inventory:
You should remember that when ending inventory increases, the cost of goods sold decreases and vice versa. When ending inventory decreases, the cost of goods sold increases. Of course, this will hold if we assume that the beginning inventory and the cost of goods acquired or produced during a certain period (aka. purchases) are constant.
Now we can discuss inventory valuation methods in detail.
The choice of an inventory valuation method exerts a direct impact on the items of the company’s balance sheet, income statement, and cash flow statement. As a result, also values of some financial ratios are directly affected. It is important what kind of method the company chooses because the price of inventories changes over time, which means that particular units are acquired at different prices.
The company has to decide the cost at which inventories should be recognized. This decision dictates the choice of inventory valuation method. Depending on what kind of inventory valuation method the company chooses, the cost of goods sold reported in the income statement and the ending inventory carrying amount presented in the balance sheet will differ.
Note: Inventory valuation methods are called cost formulas in terms of IFRS and cost flow assumptions in terms of U.S. GAAP.
There are 3 cost formulas available under IFRS:
- specific identification,
- weighted average cost, and
- first-in, first-out (FIFO).
According to U.S. GAAP, we can use 4 cost flow assumptions:
- specific identification,
- weighted average cost,
- first-in, first-out (FIFO), and
- last-in, first-out (LIFO).
(...)
The table presents information related to the company’s inventory in 2022:
| Date of acquisition | Number of units | Price per unit | Value |
|---|---|---|---|
| 1 January | 40 | USD 3 | USD 120 |
| 12 June | 60 | USD 4 | USD 240 |
| 17 November | 20 | USD 5 | USD 100 |
| Total | 120 | USD 460 |
On 20 December, 80 units were sold.
We will compute the cost of goods sold and ending inventory on 31 December 2022 assuming different valuation methods, namely:
- FIFO,
- LIFO, and
- weighted average cost.
We assume here that we are dealing with a retail company. Thanks to this assumption we don’t have to take raw materials, work in process, or finished goods into consideration which would be the case if we dealt with a manufacturing company.
So, in our example, we have one type of account, namely inventory. We also assume that at the beginning of the year inventory balance was 0.
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When the cost of inventories increases over time like in the example above, the value of the cost of goods sold is the highest for the LIFO method, whereas the ending inventory value is the largest for the FIFO method. Thus, the LIFO method results in the lowest operating profit, which is positive news when we think of taxes. On the other hand, when there’s deflation the company will report a higher value of the cost of goods sold if it uses FIFO and the ending inventory value will be the greatest under LIFO.
When valuing their inventories, companies also choose between 2 systems:
- periodic inventory system, which assumes that inventory valuation should be conducted at the end of the accounting period, and
- perpetual inventory system, under which inventory values are continually updated. It means that according to the perpetual inventory system we compute the COGS immediately after a given part of the inventory is sold.
The choice between these two systems is particularly important because of the differences in valuation both for the LIFO and for the weighted average cost methods. When it comes to FIFO no differences in valuation will occur. It is because under FIFO we always start with the inventories that were stored first, so regardless of the system we apply, we will always use the same sequence of inventories for calculating COGS.
In Example 1 the choice between the periodic inventory system and perpetual inventory system has no impact on the obtained results. This is because the sale of inventories occurred after the last inventory acquisition. Thus, both systems will give us the same results for all valuation methods in Example 1.
However, have a look at an example in which the choice of the inventory system makes a difference. We will assume that the company uses the LIFO method.
The table presents information related to the company’s inventory in 2022:
| Date | Purchased | Sold |
|---|---|---|
| 10 April | 15,000 units at USD 10 per unit | |
| 14 May | 12,000 units at USD 9 per unit | |
| 21 July | 13,000 units | |
| 27 September | 8,000 units at USD 11 per unit | |
| 21 November | 6,000 units |
We assume that the inventory balance at the beginning of 2022 was equal to 0.
Compute COGS and ending inventory balance assuming 2 scenarios:
- LIFO & the periodic inventory system, and
- LIFO & the perpetual inventory system.
(...)
To compare the financial statements of various companies using different inventory valuation methods, adjustments are made. The most commonly used adjustment is the conversion from LIFO to FIFO because the LIFO method gives lower net income and higher ending inventory than the FIFO method assuming that prices are rising.
LIFO to FIFO conversion is made using the LIFO reserve, which is included in the notes to financial statements. The LIFO reserve is the difference between the FIFO inventory value and the LIFO inventory value.
Here are formulas related to LIFO reserve that you should know for your level 1 CFA exam:
- When ending inventory increases, the cost of goods sold decreases, and vice versa, when ending inventory decreases, the cost of goods sold increases.
- Inventory valuation methods are called cost formulas in terms of IFRS and cost flow assumptions in terms of U.S. GAAP.
- There are 3 cost formulas available under IFRS: specific identification, weighted average cost, and first-in, first-out (FIFO).
- According to U.S. GAAP, we can use 4 cost flow assumptions: specific identification, weighted average cost, first-in, first-out (FIFO), and last-in, first-out (LIFO).
- Periodic inventory system assumes that inventory valuation should be conducted at the end of the accounting period.
- Perpetual inventory system assumes that inventory values are continually updated.
- The LIFO reserve is the difference between the FIFO inventory value and the LIFO inventory value.