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IAI Actuarial Core Principles · Business Finance · Interpreting company accounting information

Two Indian retailers, Alpha Ltd and Beta Ltd, are in the same sector. Alpha values its inventory on a weighted average cost basis, while Beta uses FIFO. During the year, purchase prices rose steadily. Which statement best describes the effect on a comparison of their gross profit margins and inventory turnover?

Beta, using FIFO in a period of rising prices, will tend to report higher gross profit and higher closing inventory than Alpha, which uses weighted average. Differences in accounting policy make the ratios not directly comparable even if trading is identical.

  1. AThere is no effect, since the valuation method does not change reported profit
  2. BBeta will tend to show a lower gross profit than Alpha, for identical trading, and inventory turnover will be unaffected
  3. CBeta will tend to show a higher gross profit and higher closing inventory than Alpha, so ratios are not like-for-likeCorrect
  4. DAlpha will show a higher closing inventory than Beta, and a higher gross profit
  5. The methods affect only the cash flow statement, not any ratio

Explanation

With rising prices, FIFO charges older, cheaper costs to cost of sales, giving higher profit and higher closing inventory than weighted average. Margins, inventory-based ratios and turnover therefore differ purely because of the accounting policy, so the comparison is not like-for-like.

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