ExpertHard2 marksMultiple Choice
ACCA · Question 07 · Recording transactions and events
Section A
During a period of consistently rising purchase prices (inflation), a company switches its inventory valuation method from First-In, First-Out (FIFO) to Continuous Average Cost (AVCO).
What will be the effect of this change on the company's reported Gross Profit and Closing Inventory values?
Section A
During a period of consistently rising purchase prices (inflation), a company switches its inventory valuation method from First-In, First-Out (FIFO) to Continuous Average Cost (AVCO).
What will be the effect of this change on the company's reported Gross Profit and Closing Inventory values?
Answer options:
A.
Gross Profit will increase; Closing Inventory will increase
B.
Gross Profit will decrease; Closing Inventory will decrease
C.
Gross Profit will increase; Closing Inventory will decrease
D.
Gross Profit will decrease; Closing Inventory will increase
How to approach this question
Analyze how FIFO and AVCO allocate costs during inflation. FIFO leaves the newest (highest) costs in inventory, resulting in lower Cost of Sales and higher profit. AVCO averages them out, leading to higher Cost of Sales (lower profit) and lower closing inventory compared to FIFO.
Full Answer
B.Gross Profit will decrease; Closing Inventory will decrease✓ Correct
In times of inflation, FIFO results in the lowest Cost of Sales (using older, cheaper prices) and highest Closing Inventory (using newer, higher prices). Switching to AVCO means Cost of Sales will include a higher average cost, thus decreasing Gross Profit. Closing Inventory will be valued at an average cost, which is lower than the most recent prices used in FIFO.
Common mistakes
Confusing the impact of inflation vs deflation on inventory valuation methods.
Practice the full ACCA FA — Financial Accounting Practice Exam 1
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