IAS 2 permits the use of either the first-in, first-out (FIFO) formula or the weighted average cost formula to assign cost to interchangeable inventory items, except for items that are not ordinarily interchangeable, which are costed using specific identification.
When Is Specific Identification Used?
The Standard states that the cost of inventories of items that are not ordinarily interchangeable, and goods or services produced and segregated for specific projects, shall be assigned by using specific identification of their individual costs. Specific identification means that specific costs are attributed to identified items of inventory, which is the appropriate treatment for items segregated for a specific project, regardless of whether they have been bought or produced.
The General Rule: FIFO or Weighted Average
For all other inventories not covered by specific identification, the Standard provides that the cost of inventories, other than those dealt with under specific identification, shall be assigned by using the first-in, first-out (FIFO) or weighted average cost formula. An entity shall use the same cost formula for all inventories having a similar nature and use to the entity; different cost formulas may be justified for inventories with a different nature or use.
The Standard clarifies that a difference in geographical location of inventories, or in the respective tax rules, is by itself not sufficient to justify the use of different cost formulas.
How Does Each Formula Work?
- FIFO: This formula assumes that the items of inventory that were purchased or produced first are sold first, and consequently the items remaining in inventory at the end of the period are those most recently purchased or produced.
- Weighted average: Under this formula, the cost of each item is determined from the weighted average of the cost of similar items at the beginning of a period and the cost of similar items purchased or produced during the period. The average may be calculated on a periodic basis, or as each additional shipment is received, depending on the circumstances of the entity.
Illustrative example (assumed figures): Assume an entity purchased 10 units at 10 each, then a further 10 units at 12 each, and sold 12 units during the period.
- Under FIFO: the cost of the first 10 units (10 × 10 = 100) plus 2 units from the second batch (2 × 12 = 24) is charged; cost of sales = 124, leaving 8 units carried at 12 each, i.e. 96.
- Under weighted average: the average cost = (100 + 120) ÷ 20 = 11 per unit; cost of sales for 12 units = 132, leaving 8 units valued at 88.
Legal References
- IAS 2 — Inventories, paragraph 23 (specific identification method)
- IAS 2 — Inventories, paragraph 24 (definition of specific identification)
- IAS 2 — Inventories, paragraph 25 (FIFO or weighted average rule)
- IAS 2 — Inventories, paragraph 26 (geographical location alone is insufficient to justify different formulas)
- IAS 2 — Inventories, paragraph 27 (description of FIFO and weighted average)
For questions about your specific situation, you can ask the Private Sector Accounting Helper on Helpers, or consult a licensed chartered accountant.