Evaluate the impact of using different inventory valuation methods on reported profits/losses and the financial position of a business

The choice of inventory valuation method directly affects the Cost of Goods Sold (COGS), which in turn determines the gross profit and net profit reported in the statement of profit or loss.

During Periods of Rising Prices

Why This Happens

• FIFO (First In, First Out): Assumes the oldest inventory is sold first. During rising prices, the cheapest items (bought early) are assigned to COGS, leaving the expensive items (bought recently) in closing inventory. This reduces COGS and increases profit.

• LIFO (Last In, First Out): Assumes the newest inventory is sold first. During rising prices, the most expensive items (bought recently) are assigned to COGS, leaving the cheapest items in closing inventory. This increases COGS and reduces profit.

• WAM (Weighted Average): Calculates an average cost of all items available for sale. This smooths out price fluctuations, producing results between FIFO and LIFO.

The value of closing inventory appears on the statement of financial position as a current asset. Different methods yield different inventory values, which affects the business's reported financial position.

During Periods of Rising Prices

Since reported profit becomes part of owner's equity, the choice of method also affects the equity section of the statement of financial position.

Using the data from Mzee Busara's carpet business (Example 2.1 from the textbook):

• Total sales: TZS 9,000,000
• Total purchases: TZS 8,320,000
• Units available: 1,300 units
• Units sold: 1,160 units
• Closing inventory: 140 units

Periodic System Results

Key Observations:

1. FIFO reports the highest profit (TZS 1,624,000) because COGS is lowest (TZS 7,376,000). Closing inventory is valued at TZS 944,000 (100 units × 6,800 + 40 units × 6,600).

2. LIFO reports the lowest profit (TZS 1,544,000) because COGS is highest (TZS 7,456,000). Closing inventory is valued at only TZS 864,000 (120 units × 6,200 + 20 units × 6,000).

3. WAM falls in between. Weighted average cost = TZS 8,320,000 ÷ 1,300 = TZS 6,400 per unit. Closing inventory = 140 × 6,400 = TZS 896,000.

Impact on Financial Position

If Mzee Busara prepared a statement of financial position using:

• FIFO: Current assets would show inventory of TZS 944,000 — a stronger position.
• LIFO: Current assets would show only TZS 864,000 — a weaker position.
• WAM: Current assets would show TZS 896,000 — a moderate position.

Important Note: Under IAS 2 (International Accounting Standard used in Tanzania), LIFO is not permitted for financial reporting. However, businesses must still understand how each method works because it affects decision-making, tax planning, and financial analysis.

A Form 5 student in Tanzania running a small shop (like a duka in Morogoro or a wholesale shop in Mwanza) can use this knowledge when deciding how to value their stock. For example, if prices of rice or cooking oil have been rising throughout the month, using FIFO will show a higher profit on paper, which may affect how much tax the business pays and how the business looks to a bank when applying for a loan. Understanding these impacts helps business owners and accountants make informed decisions about which valuation method best presents their financial situation.