International Financial Reporting Standards (IFRS) are accounting rules that dictate the accounting process. These standards guide companies in preparing financial statements.
Primarily, the IFRS exists to ensure consistency, transparency, comparability, and relevance to the reporting process. Currently, these standards apply in over 160 jurisdictions worldwide. Apart from the US, IFRS plays a significant role in the accounting process in most countries globally.
The IFRS comes through the International Accounting Standards Board. This board operates under the IFRS Foundation. Essentially, the IFRS specify how companies must maintain their record and report their operations.
They aim to create a common accounting language that stakeholders can understand globally. The standards within this system are called IFRS. However, they also include IAS, which comes from the predecessor to the IASB, the International Accounting Standards Committee.
The IFRS guides companies in various areas through its specific standards. One such area includes inventory, which falls under IAS 2. For most companies, the stock is one of the most crucial current assets on the balance sheet.
However, its value may differ based on several inventory valuation methods. The IFRS dictates if companies can use these methods. Before understanding that, it is crucial to discuss inventory valuation.
What is Inventory Valuation?
Inventory is one of the most crucial current assets for companies holding physical goods. Usually, it is highly critical in the manufacturing and retail sectors.
However, companies may face issues when reporting those goods. One of the most common problems with inventory is its valuation. Companies may purchase goods at different prices, which go into the production cycle. However, using specific prices for each batch may not be possible.
Inventory valuation refers to a method used to assess the worth of closing stock. In other words, it is a process that helps companies establish the value of their unsold inventory.
This step is crucial to reporting inventory in the financial statements. The results obtained through inventory valuation impact the balance sheet and the income statement. Therefore, it is a critical area for companies.
Inventory valuation helps companies determine their financial position. Companies must ensure they perform this process accurately as it can have significant impacts.
One of the areas that it affects is profits. Specifically, inventory valuation plays a role in determining a company’s gross profits. If companies do not have a closing inventory value, they cannot calculate those profits. Consequently, they can’t establish their operating and net profits.
Inventory valuation considers various costs that go into stock. The most crucial of these includes the purchase or acquisition cost for the goods purchased. On top of that, conversion costs also contribute to the final value of the closing inventory.
Conversion costs include both labor and factory overheads. Similarly, transportation costs are also a part of the inventory valuation process. Administrative and selling expenses do not contribute to those costs.
Overall, inventory valuation refers to a process used by companies to evaluate their inventory. This process occurs every year when a company closes its books of accounts.
Inventory valuation is crucial to establishing the value of the closing stock. Consequently, it plays a role in the balance sheet and the income statement. Companies must ensure they perform this process precisely. Similarly, they can use several methods for inventory valuation.
What are Inventory Valuation Methods?
Not all companies use the same inventory valuation method. They can use one of the several established ways to calculate the value of their closing inventory.
Usually, companies can choose between three methods, including FIFO, LIFO, and Weighted Average. Each of these provides a different closing inventory valuation. However, the IFRS or other accounting standards may not allow all.
An explanation of each of the inventory valuation methods is as follows.
First In, First Out (FIFO)
First In, First Out, also known as FIFO, is an inventory valuation method. This method assumes that assets acquired first go into the cost of goods sold first.
In other words, it requires the companies to consider the first goods they purchase as the ones they sell first. This method solves the difference between timing for various purchases.
In FIFO, the inventory cost in the balance sheet represents the goods purchased recently. On the other hand, the cost of goods sold in the income statement includes the oldest acquired goods.
Usually, this method is most common for companies that sell perishable goods. It allows them to cost out goods with the oldest expiry dates first.
Last In, First Out (LIFO)
Last In, First Out, also known as LIFO, is the opposite inventory valuation method to FIFO. This method assumes that assets acquired first go last in the cost of goods sold.
In other words, it requires companies to consider the last goods they purchase as the ones they sell first. Like FIFO, LIFO helps companies solve the difference between timing for various stock purchases.
In the LIFO inventory valuation method, the inventory cost in the balance sheet includes the oldest acquired goods. However, these goods must still be a part of the company’s stock.
Similarly, the cost of goods sold in the income statement contains the latest purchased goods. LIFO is more common for companies that handle large inventories. For example, these companies may include auto dealers and retailers.
Weighted Average
The weighted average inventory valuation is not similar to FIFO or LIFO. It does not consider sold goods from the latest or oldest inventory.
Instead, it calculates several factors when calculating the cost of inventory and goods sold. This method involves calculating the average cost of those items. It does so by assigning those items a weight based on various numbers.
The weighted average inventory valuation method may include complex calculations. Another name for this method is the Average Cost method.
Usually, the weighted average cost provides a mean value for inventory and the cost of goods sold. It allows those items to stay normal during high or low price inflation. Consequently, it closely represents the actual cost of the items stored in inventory.
Does IFRS allow LIFO?
LIFO is an applicable inventory valuation method under GAAP, which applies in the US. However, the IFRS prohibits companies from using this method when evaluating inventory.
Companies can still apply it in internal calculations. For example, they can use it as a part of the managerial accounting process. However, companies following the IFRS cannot use LIFO for financial reporting. Instead, they can apply FIFO or Weighted Average method.
One of the primary reasons the IFRS does not allow LIFO is its potential impact. This method distorts a company’s profitability and misrepresents inventory. However, these may occur during specific scenarios.
Nonetheless, it gives companies more control over presenting inventories in the financial statements. It can show a more distorted view of the balance sheet and income statement.
On top of that, LIFO can also give companies significantly better tax advantages. It causes a reduction in taxes during inflationary periods.
It occurs since LIFO assumes that inventory bought recently goes into the production process first. Therefore, higher inventory items get included in the cost of sales. It creates lower profits, which can also reduce the taxable amount for a company.
Lastly, some experts believe the balance sheet focus also plays a role in excluding LIFO. The IFRS uses a balance sheet approach to financial statements.
Consequently, it requires companies to present figures on the balance sheet to reflect present market conditions. LIFO takes the opposite process to that focus. Therefore, the IFRS does not allow companies to use LIFO. Instead, they can use FIFO or Weighted Average method.
Conclusion
Inventory valuation involves establishing the value of the remaining stock. Companies can use three methods, including FIFO, LIFO, and Weighted Average.
While GAAP allows companies to apply LIFO, IFRS does not. There are several reasons why the IFRS does not permit using LIFO. Primarily, they involve the impact of LIFO on the financial statements.
