The weighted average cost method is a cost flow assumption that prices inventory at an average rather than by tracing which physical unit was sold. Under the weighted average cost 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, and that average may be calculated on a periodic basis, or as each additional shipment is received, depending upon the circumstances of the entity (IAS 2 Inventories, paragraph 27, IFRS Foundation).
Averaging is one of the flow assumptions US generally accepted accounting principles have long accepted, and it is one of only two that IFRS Accounting Standards allow. Which pool gets averaged is the opening inventory plus the period’s additions, the subtotal drawn in cost of goods available for sale.
Why a Cost Flow Assumption Exists at All
The assumption exists because identity is normally lost. The cost to be matched against revenue from a sale may not be the identified cost of the specific item which is sold, especially in cases in which similar goods are purchased at different times and at different prices. In some lines of business specific lots are clearly identified from the time of purchase through the time of sale and are costed on this basis, but ordinarily the identity of goods is lost between the time of acquisition and the time of sale. In any event, if the materials purchased in various lots are identical and interchangeable, the use of identified cost of the various lots may not produce the most useful financial statements (ARB No. 43, Chapter 4, paragraph 6).
So the choice is not between an average and the truth. It is between an average and one of the other conventions, and the one convention that does trace individual units is set out in the specific identification method.
What US GAAP Permits
The permission is stated as a menu with a single selection criterion. Cost for inventory purposes may be determined under any one of several assumptions as to the flow of cost factors, such as first-in first-out, average, and last-in first-out, and the major objective in selecting a method should be to choose the one which, under the circumstances, most clearly reflects periodic income (ARB No. 43, Chapter 4, Statement 4).
That bulletin is not the current address of the rule. On the effective date of the Statement that created it, the Codification superseded all then-existing non-SEC accounting and reporting standards, and it became the source of authoritative US generally accepted accounting principles recognized by the FASB to be applied by nongovernmental entities, with the rules and interpretive releases of the Securities and Exchange Commission remaining authoritative for registrants alongside it. In the Board’s view the issuance of that Statement and the Codification would not change those principles, except for nonpublic nongovernmental entities that then had to apply one item of AICPA revenue recognition guidance (FASB Statement No. 168).
The other two named assumptions have their own entries, at FIFO and LIFO, and what separates them from each other is worked through in LIFO vs FIFO.
The Disclosure That Follows the Choice
Choosing an average is a disclosure event, not just a spreadsheet setting. It is important that the amounts at which current assets are stated be supplemented by information which reveals, for the various classifications of inventory items, the basis upon which their amounts are stated and, where practicable, indication of the method of determining the cost, such as average cost, first-in first-out or last-in first-out (ARB No. 43, Chapter 3A, paragraph 9). Where that block sits on the face of the statement is covered in current assets.
Standard costing does not remove the requirement, it changes the wording. Standard costs are acceptable if adjusted at reasonable intervals to reflect current conditions so that at the balance-sheet date standard costs reasonably approximate costs computed under one of the recognized bases, and descriptive language should then be used which expresses that relationship, as for instance at standard costs, approximating average costs (ARB No. 43, Chapter 4, footnote 3).
What IFRS Requires
IFRS narrows the menu to two and then adds a consistency rule. The cost of inventories, other than those dealt with in paragraph 23, shall be assigned by using the first-in, first-out 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, and for inventories with a different nature or use, different cost formulas may be justified (IAS 2 Inventories, paragraph 25, IFRS Foundation).
The carve-out that paragraph 25 points at is not optional either. The cost of inventories of items that are not ordinarily interchangeable, and of goods or services produced and segregated for specific projects, shall be assigned by using specific identification of their individual costs (IAS 2 Inventories, paragraph 23, IFRS Foundation).
Read the two together and an averaging entity under IFRS has to say which pools it averages and why any pool is treated differently, which is a sharper requirement than the GAAP disclosure above.
Where Federal Tax Diverges
The book answer does not carry to the return by itself.
The regulation’s default for goods that cannot be traced runs the other way. Goods taken in the inventory which have been so intermingled that they cannot be identified with specific invoices will be deemed to be the goods most recently purchased or produced, and the cost thereof will be the actual cost of the goods purchased or produced during the period in which the quantity of goods in the inventory has been acquired (26 CFR 1.471-2(d)). That is a first-in first-out presumption sitting where a book average would be.
Consistency outranks the method. In order to clearly reflect income, the inventory practice of a taxpayer should be consistent from year to year, and greater weight is to be given to consistency than to any particular method of inventorying or basis of valuation so long as the method or basis used is in accord with 26 CFR 1.471-1 through 1.471-11 (26 CFR 1.471-2(b)).
There is an express average cost permission, and it is narrow. A taxpayer eligible to use, and that chooses to use, the small business taxpayer exemption may account for its inventory by either of two routes: a method that treats its inventory as non-incidental materials and supplies, or the method for each item that is reflected in the taxpayer’s applicable financial statement, or where there is no such statement for the year, the taxpayer’s books and records prepared in accordance with its accounting procedures. The average cost permission sits in the first route only. Within it a taxpayer may determine the amount of the costs recoverable through cost of goods sold by using either a specific identification method, a first-in, first-out method, or an average cost method, provided that method is used consistently (26 CFR 1.471-1(b)(3) and (b)(4)(ii)). A taxpayer on that method may not use any other method described in the section 471 regulations, and may not use the last-in, first-out method described in section 472, to identify or value that inventory (26 CFR 1.471-1(b)(4)(ii)).
The Rolling-Average Safe Harbors
A larger taxpayer that averages on its books has a separate route, and it is conditional on the books. The Service traditionally viewed rolling-average inventory valuation as a method of accounting that does not clearly reflect income, especially when inventory is held for several years or costs fluctuate substantially, and it now generally views a rolling-average method that is used to value inventories for financial accounting purposes as clearly reflecting income for federal income tax purposes. That general view keeps its original qualifier: where inventory is held for several years or costs fluctuate substantially, a rolling-average cost method may or may not clearly reflect income, depending on the particular facts and circumstances. Where a taxpayer does not use a rolling-average method for financial accounting purposes, the rolling-average method may not accurately determine costs or clearly reflect income for federal income tax purposes (Rev. Proc. 2008-43, section 1).
That procedure applies to a taxpayer that is required to account for inventories under section 471 and uses a rolling-average method to value those inventories for financial accounting purposes (Rev. Proc. 2008-43, section 3). Both limbs are needed, not either one.
The safe harbor itself has two requirements and both must hold. First, the taxpayer recomputes the rolling average cost of an inventory item either each time it purchases or produces an additional unit or units of that item, or on a regular basis but no less frequently than once per month (Rev. Proc. 2008-43, section 4). Second, and in addition, the taxpayer satisfies one of two conditions: the variance percentage does not exceed one percent, or the entire inventory of the taxpayer’s trade or business turns at least four times per year (Rev. Proc. 2008-43, section 4).
The variance percentage is determined by subtracting the cost of the ending inventory of the trade or business computed using the taxpayer’s rolling-average method from the cost of the ending inventory computed using either the FIFO method or the specific identification method to determine the variance, and then dividing that variance by the aggregate rolling-average cost of the inventory (Rev. Proc. 2008-43, section 4.02).
Inventory turns are the cost of goods sold divided by average inventory, meaning the average of beginning and ending inventory, and a taxpayer using a last-in first-out cost flow assumption for tax purposes must calculate inventory turns using rolling-average cost and a first-in first-out cost flow assumption (Rev. Proc. 2008-43, section 4.03).
What the Weighted Average Cost Method Is Not
It is not the weighted average cost of capital. That is a financing rate rather than an inventory price, and it is drawn in cost of capital. The two share the words weighted average and nothing else.
It is not a separate method from the moving average. The standard treats the timing of the recomputation as a circumstance of the entity rather than as a different formula, so an average struck once at period end and an average struck as each shipment arrives are the same formula run at two frequencies (IAS 2 Inventories, paragraph 27, IFRS Foundation). The federal safe harbor above treats the two frequencies as alternatives inside one requirement, which reads the same way.
It is not a reversed mark-up method. In some situations a reversed mark-up procedure of inventory pricing, such as the retail inventory method, may be both practical and appropriate (ARB No. 43, Chapter 4, paragraph 6), and that method starts from selling prices rather than from costs. It has its own entry at the retail inventory method.
Common Questions
Average the two pools the standard names. 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 (IAS 2 Inventories, paragraph 27, IFRS Foundation). Weighted is doing the work in that sentence: each pool enters at the quantity behind it and not at its unit price alone, so the average is the total cost of the two pools over the total units in them. Those two pools together are cost of goods available for sale, and the resulting rate prices both what sold and what remains.
Yes, as one of the named flow assumptions, with the selection criterion being which one most clearly reflects periodic income in the circumstances (ARB No. 43, Chapter 4, Statement 4). The tax answer is a separate question, and the section above shows it is narrower.
Neither is better in the abstract, because the standards do not rank them. GAAP puts the test at which assumption most clearly reflects periodic income in the circumstances (ARB No. 43, Chapter 4, Statement 4), and IFRS allows both without preference while requiring one formula across inventories of similar nature and use (IAS 2 Inventories, paragraph 25, IFRS Foundation). For a US filer the deciding constraint is usually the tax side, where the return default is a first-in first-out presumption and averaging has to be brought inside one of the routes above.
Accountably places trained offshore accountants inside US CPA and EA firms, and a firm can put a block of its own inventory costing and cost of goods sold workpapers through a trial task before anything client facing depends on it.
