What are the various methods of inventory valuation? Explain the effect of inventory valuation methods on profit during inflation. What are the provisions of Accounting Standard 2 (AS-2) with regards to inventory valuation?
Last-in, First-out (LIFO): Under LIFO, the cost of goods sold is based upon the cost of material bought towards the end of the period, resulting in costs that closely approximate current costs. The inventory, however, is valued on the basis of the cost of materials bought earlier in the year. During periods of inflation, the use of LIFO will result in the highest estimate of cost of goods sold among the three approaches, and the lowest net income. (c) Weighted Average: Under the weighted average approach, both inventory and the cost of goods sold are based upon the average cost of all units bought during the period. When inventory turns over rapidly this approach will more closely resemble FIFO than LIFO.
FIFO gives the highest amount of gross profit (hence, net income) because the lower unit costs of the first units purchased are matched against revenues, especially in times of inflation. LIFO gives the lowest amount of net income during inflationary times Hence during inflationary times, companies prefer using FIFO.