Inventory Valuation FIFO and Cost of Sales WACE Accounting and Finance Unit 3
“Apply the first-in first-out (FIFO) method under a perpetual system to value closing inventory and cost of sales, and value inventory at the lower of cost and net realisable value”
The first-in first-out method assumes the oldest stock is sold first, so cost of sales is based on the earliest purchase prices and closing inventory is valued at the most recent prices. Under a perpetual system, the inventory record is updated at every purchase and sale. After valuing inventory at cost, you must compare it with net realisable value and report the lower of the two, so inventory is never carried above what it can be sold for.
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What this dot point is asking
SCSA wants you to apply FIFO in a perpetual inventory record, calculate cost of sales and closing inventory, and apply the lower of cost and net realisable value rule.
The FIFO assumption
FIFO is a cost-flow assumption that the first units purchased are the first units sold. It does not require the physical goods to actually move in that order; it is an assumption about which costs are assigned to cost of sales. As a result, cost of sales is measured using older costs and closing inventory is measured using the most recent costs.
Perpetual inventory under FIFO
Under a perpetual system the inventory account is updated continuously. Each sale removes units at the cost of the earliest layer still on hand, working forward through later layers as earlier ones are exhausted.
A perpetual record is laid out in three sections, often called a stock card: purchases (units in and their cost), cost of sales (units out, costed from the oldest layer first), and the running balance (the layers still on hand, each at its own cost). After every transaction the balance section shows exactly which cost layers remain, which is why FIFO is easy to track in this format: you simply read off the oldest remaining layer when costing the next sale. The perpetual system contrasts with the periodic system, where inventory is counted only at period end; for WACE you apply FIFO within the perpetual record so cost of sales is known after each sale.
Why the choice of cost-flow assumption matters
Because the same physical goods can be assigned different costs, the cost-flow assumption affects reported profit. In a period of rising prices, FIFO assigns the older, cheaper costs to cost of sales, so cost of sales is lower and gross profit is higher than under an average-cost method. The closing inventory, valued at the newest and higher costs, sits closer to current replacement cost on the Balance Sheet. The opposite happens when prices fall. None of this changes the cash the business holds; it changes how the total cost of goods available for sale is split between the Income Statement and the Balance Sheet. This is also why two otherwise identical businesses can report different profits purely because they chose different inventory methods, a point that matters when comparing companies through ratio analysis.
In a rising-price environment, FIFO charges the cheaper old costs to cost of sales, so cost of sales is lower and reported profit is higher than under an average-cost approach. Closing inventory, valued at the newest higher costs, sits closer to current replacement cost. The reverse holds when prices are falling. The total cost of goods available for sale is always split between cost of sales and closing inventory, so the two must add back to that total.
Lower of cost and net realisable value
Net realisable value is the estimated selling price in the ordinary course of business, less the estimated costs of completion and the costs necessary to make the sale. Inventory is reported at the lower of its cost and its net realisable value, so that a fall in selling price or obsolescence is recognised as a loss in the period it occurs, never carried forward as overstated assets.
Dunn Ltd uses perpetual FIFO. Opening inventory is 100 units at $20 each. During the period it purchases 60 units at $24, then later 40 units at $26. It sells 130 units.
Step 1: Cost the units sold using oldest layers first
Under FIFO, the earliest costs are assigned to sales first, exhausting each layer in order before moving to the next. The 130 units sold draw on two layers.
The first 100 units come from opening inventory at $20, costing $2 000. The next 30 units come from the $24 purchase layer, costing $720. Once those are added:
Step 2: Calculate closing inventory from remaining layers
After selling all 100 opening units and 30 of the 60 units at $24, the remaining layers are 30 units at $24 and all 40 units at $26. These are the most recent costs, which is what FIFO leaves in closing inventory.
Step 3: Verify against goods available for sale
The cost of everything available for sale must equal cost of sales plus closing inventory. This check confirms that no units or dollars have been counted twice or missed.
Step 4: Apply lower of cost and net realisable value
After confirming the FIFO cost, closing inventory must be compared with net realisable value. If net realisable value of the closing stock were only $1 600, the inventory would be written down to $1 600 because that is the lower figure. The $160 difference between cost and net realisable value is recognised as a loss in the period the decline occurs.
Final answer: Cost of sales is $2 720, closing inventory at FIFO cost is $1 760, and if NRV is only $1 600 the inventory is reported at $1 600 with a $160 write-down recognised as a loss.
Under FIFO the oldest costs flow to cost of sales, so the units left over are the most recently purchased ones. Students sometimes value closing inventory at the earliest prices, which is the LIFO logic, not FIFO. Always assign the newest costs to closing inventory and the oldest costs to cost of sales.
Exam-style questions
Questions in the style of SCSA exam questions on this dot point, each with a worked answer. They are written by ExamExplained unless tagged "Past paper"; the year shows the paper a question is modelled on.
WACE 2022-style8 marksHollis Ltd uses perpetual FIFO. Opening inventory is 80 units at $15. It buys 50 units at $18, then 70 units at $20, then sells 150 units. Calculate cost of sales and the value of closing inventory, and verify your answer against goods available for sale.Show worked answer →
An 8 mark response needs the FIFO cost of sales, closing inventory, and the reconciliation.
Cost of sales (oldest layers first for 150 units). 80 at = 1,20018 ; 20 at = 400= 1,200 + 900 + 400 = 2,500$.
Closing inventory (newest costs remain). After selling 150, units left are units, all from the $20 layer: $50 \times 20 = 1,000$.
Reconciliation. Goods available for sale . This equals cost of sales plus closing inventory . Markers reward oldest-first costing, newest-cost closing inventory, and the goods-available check.
WACE 2023-style5 marksExplain the lower of cost and net realisable value rule, and explain how applying it relates to the qualitative characteristic of faithful representation.Show worked answer →
A 5 mark response needs the rule, the mechanics, and the link to the Framework.
Rule. Inventory is reported at the lower of its cost and its net realisable value (the estimated selling price less the costs to complete and sell). If net realisable value falls below cost, inventory is written down to net realisable value and the difference is recognised as an expense or loss in that period.
Faithful representation. Carrying inventory above what it can be sold for would overstate assets and overstate equity, misrepresenting the entity's position. Writing down to net realisable value gives a complete, neutral and prudent depiction, recognising the loss when it occurs rather than carrying an inflated asset forward. Markers reward the rule, the write-down in the period of the fall, and the explicit link to faithful representation.