FIFO, weighted average or specific identification
Which cost formula IAS 2 allows for a client's inventory, how to choose between them, and what to do when the stock system holds one cost price per item.
By Achekam · · 5 min read · For Accountants & audit firms in South Africa, Nigeria, Kenya
Ask a hardware wholesaler how it values its stock and the answer is often "at cost". Ask which cost, and the conversation gets interesting. The bags of cement on the floor were bought in four deliveries at four prices. The figure in the stock system is whatever the last purchase cost, or whatever someone typed when the product was set up. Neither is necessarily the cost IAS 2 asks for.
The choice of cost formula decides how the year's purchase prices are split between cost of sales and closing inventory. Whenever purchase prices move during the year, whether for a retailer in Durban, a distributor in Kano or a hardware chain in Mombasa, the choice moves profit. This article covers what IAS 2 allows, how to apply it consistently, and how to handle a client whose stock system holds a single cost price per product.
Specific identification for items that are not interchangeable
Under IAS 2, the cost of inventory items that are not ordinarily interchangeable is assigned by specific identification of their individual costs. Each item carries its own actual cost from purchase to sale.
Investopedia describes the method, which it calls the special identification method, as using the actual cost of each unit sold, typically for unique items such as cars, real estate and precious jewels. In a client's world that is the motor dealer's vehicles, each with its own chassis number and purchase invoice; the property developer's individual units; the jeweller's one-off pieces; the plant-hire company's machines held for sale.
The test is whether the items are ordinarily interchangeable. If one unit could be substituted for another without anyone caring, specific identification is the wrong formula even if the system could track serial numbers.
FIFO or weighted average for everything else
For items that are ordinarily interchangeable, generally large quantities of individually insignificant items, IAS 2 assigns cost using either the first-in, first-out or the weighted average cost formula. Those are the two formulas the standard names for such items. A last-in, first-out method, sometimes found in older or foreign systems, is not one of them.
- FIFO assumes the earliest purchases are sold first, so closing inventory carries the most recent prices.
- Weighted average values goods at an average of the costs of the items available. Investopedia explains that the average cost method values goods sold at the average price of all goods in stock, smoothing out the effect of unusually high or low purchase costs.
Neither is more correct in general. FIFO tends to suit perishable or dated goods, where the physical flow matches the assumption: a pharmacy, a food distributor. Weighted average suits bulk items mixed together, such as fuel in a tank, grain in a silo or cement in a yard, where no one could say which delivery a given unit came from.
Why the formula is a policy choice to apply consistently
The formula is an accounting policy. Once chosen for a type of inventory, it should be applied the same way each year so that profits are comparable. Switching from weighted average to FIFO because this year's figures would look better is exactly what consistency is there to prevent.
Where a genuine reason exists to change, such as a new stock system that finally records purchase layers properly, treat the change as a change in accounting policy, with the consequences that brings for comparatives and disclosure. The difference between a change in policy and a change in estimate is set out in changes in estimate or policy.
A client may also use different formulas for different kinds of inventory, such as specific identification for vehicles and weighted average for parts, as long as each is applied consistently and described.
When the client's stock screens hold one cost price per product
Many small-business stock systems do not cost inventory by any IAS 2 formula. They hold one cost price per product and use it for every sale. That is true of a client keeping its books on Achekam: cost of sales uses the single cost price typed on the product, with no FIFO or weighted-average costing. It is a current limitation of the client's stock records, and the preparer has to work around it.
What the single price represents depends on how the client maintains it. If the price is updated to the latest invoice each time stock is bought, it approximates the most recent cost, which is neither FIFO for cost of sales nor a weighted average. If it is never updated, it may be years out of date. Either way, at year end:
- Ask the client how and when cost prices are updated, and record the answer.
- For the significant product lines, recalculate cost on the chosen formula from purchase invoices for the period.
- Compare the recalculated closing inventory with the system figure.
- If the difference is material, adjust closing inventory and cost of sales at year end, and keep the calculation in the working papers.
- Recommend that the client reviews its cost prices regularly, so next year's difference is smaller.
Building inventory figures from client stock records more generally is covered in inventory from client stock records. Once cost is right, it still has to be compared with net realisable value; see writing inventory down to net realisable value.
Wording the inventory policy
Achekam's Studio includes standard accounting policy wording based on IFRS for SMEs, labelled for review before issue, and staff can write the client's own policy. Whatever the starting text, the inventory policy should say plainly which formula applies to which kind of inventory, and it must match what was actually done at year end. A policy stating weighted average for a client whose figures came from a single typed cost price, unadjusted, is a misstatement in the notes even if the balance happens to be close. Notes take their figures from the mapped trial balance, so map the inventory adjustment correctly before reviewing the note.
The IFRS Foundation's IAS 2 page explains how the standard determines the cost of inventories and which cost formulas may be used. Begin this year's inventory work by asking the client one question: where does the cost price in the system come from?
General guidance only, not advice on your own circumstances. Tax and payroll rules change: check the current position with the authority or your adviser.
