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ACCA Applied Skills · Financial Reporting · Limitations of interpretation techniques

Entity X uses FIFO for inventory. Entity Y uses weighted average cost. Prices of inventory have been rising steadily. Both entities have identical purchases and sales volumes. Which statement is correct about comparing their gross profit margins?

X, using FIFO, will tend to report the higher gross margin when prices are rising, because older cheaper costs are charged to cost of sales. The difference arises from the cost formula alone, so the margins are not like-for-like.

  1. AY will report a higher gross profit margin than X
  2. BX will tend to report a higher gross profit margin than Y, so the margins are not like-for-likeCorrect
  3. CThe margins will be identical because the physical flows are identical
  4. DLIFO adjustments are needed to X because IFRS requires LIFO in rising prices

Explanation

With rising prices, FIFO charges older, lower costs to cost of sales, giving higher profit than weighted average. So X's margin looks higher purely because of policy. LIFO is prohibited under IFRS, so the last option is false, and identical physical flows do not mean identical cost allocation.

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