📚 PASS Research Analyst Certification Examination Difficulty: Intermediate ℹ️ Info   ~5 min read
📌 Chapter 8.4 — Basics of Profit and Loss Account (P/L)

Imagine you are analyzing two mid-cap manufacturing firms in the chemical sector. Company A uses the Weighted Average Cost (WAC) method for inventory, while Company B utilizes First-In, First-Out (FIFO). In a period of rising crude oil prices, you notice that Company B reports significantly higher gross margins than Company A, despite having identical production volumes and sales prices. This divergence isn’t a sign of operational superiority; it is a manifestation of how inventory accounting choices reshape the P/L statement.

Inventory accounting methods determine the order in which costs are assigned to the goods sold versus the goods remaining in stock. Under FIFO, the oldest, likely cheaper inventory is expensed first, leading to higher reported profits during inflationary cycles. Conversely, WAC smoothes out cost fluctuations by averaging the cost of goods available for sale, providing a more stable, albeit less precise, reflection of current market prices.

In India, while Ind AS 1 permits both FIFO and WAC, the Last-In, First-Out (LIFO) method is generally prohibited, as it can be used to manipulate earnings through the liquidation of old, low-cost inventory layers.

As an analyst, you must recognize that these accounting choices influence more than just net profit; they impact cash flow tax obligations and the quality of earnings. When comparing companies, never accept the ‘Cost of Materials Consumed’ at face value.

If you are building a valuation model, you might need to normalize these figures to adjust for inventory valuation gains or losses—often referred to as ‘inventory holding gains.’ Failure to adjust for these accounting nuances can lead you to overestimate a company’s fundamental competitiveness during commodity price rallies, ultimately resulting in an inflated valuation of the equity.

Consider the practical implication for your investment thesis. If a company shifts its accounting policy to appear more profitable, your DCF model’s terminal value and margin assumptions will be skewed. Always scrutinize the ‘Notes to Accounts’ in the annual report, where management discloses the accounting methodology. An astute analyst does not merely track price-to-earnings ratios; they track whether those earnings are being engineered in the warehouse or created on the factory floor.

Nuance

⚠️ Nuance
Candidates often mistakenly believe that inventory accounting affects the actual physical flow of goods; it only affects the flow of costs. A common trap is assuming that FIFO always leads to ‘better’ quality earnings. In reality, during periods of falling prices, FIFO results in lower reported profits compared to WAC, which could trigger an unfair ‘sell’ recommendation if the analyst fails to account for the deflationary environment.

Check Your Understanding

Practice Question 1

During a period of steadily rising raw material prices, which of the following is most likely to be true for two identical companies, where Company X uses FIFO and Company Y uses Weighted Average Cost (WAC)?

Practice Question 2

Why is the LIFO (Last-In, First-Out) method generally restricted or prohibited under Ind AS for financial reporting in India?

This is a companion read for Section 8.4 — Basics of Profit and Loss Account (P/L) from PASS Research Analyst Certification Examination by Akhilesh Gururani, available on Amazon Kindle.

Copyright © 2026 Akhilesh Gururani. All rights reserved.

  1. Indian Accounting Standards (Ind AS) are the converged version of International Financial Reporting Standards (IFRS) mandated for listed companies in India. ↩︎