Inventory Cost Flows:
There are three assumptions used in accounting for inventory cost:
• Average Cost
▪ Average cost of inventory is determined and represents the cost of all the items available for store. • First-in, First-out (FIFO)
• Last-in, First-out (LIFO)
This method is quite straightforward; it takes the average of all units available for sale during the accounting period and then uses that average cost to determine the value of COGS and ending inventory. Under Average Method, a company would determine the weighted average cost of the inventory. This inventory accounting method is used primarily by companies that maintain a large supply of undifferentiated inventory items such as fuels and grains. FIFO METHOD:
Under FIFO (first-in, first-out), a company always assumes that it sells its oldest inventory first and that ending inventories include more recently purchased merchandise. It is assumed that the oldest inventory—i.e., the inventory first purchased—is always sold first. Therefore, the inventory that remains is from the most recent purchases. Companies selling perishable goods such as food and drugs tend to use this method, because cash flow closely resembles goods flow with this method. LIFO METHOD:
Under LIFO Method (last-in, first-out), it is assumed that the most recent purchase is always sold first. Therefore, the inventory that remains is always the oldest inventory. A company always assumes that it sells its newest inventory first. Nevertheless, this method represents the true flow of goods for very few companies.
Characteristics of These three methods:
• The factors that management should take into account when debating to switch between FIFO and LIFO include any potential income tax rate changes and any potential changes in the cost of units. • Changing between LIFO and FIFO will have effects on financial reports as it will have an impact on: – Cost of Goods Sold
- Ending Inventory
– Gross Margin
- Amount paid in income taxes
– Net Income
• FIFO allows that the costs accrued first (oldest costs) are assigned to revenues.
• This method is used under the assumption that goods are sold in the order in which they are available for sale as inventory
• LIFO allows the costs most recently accrued (newest costs) to be matched with revenues
• This method is used under the assumption that goods are sold in reverse order of their availability as inventory
Which method is better, FIFO or LIFO?
• Although the same number of units was sold, the Cost of Goods sold was less and subsequently Gross Margin would be higher when LIFO was used.
• Companies must notify on their published financial reports whether the company is using a FIFO or LIFO cost flow for their inventory account. o Managers make this decision on whether to use LIFO or FIFO and will sometimes choose a certain method to portray higher New Income on Financial reports or to avoid paying higher tax rates.
o Companies very rarely switch between FIFO and LIFO, but if they happen to, companies are required to highlight the change on the financial reports
• It is widely accepted that in a time of rising costs, FIFO should be used, since the COGS will be less.
• In times of decreasing costs, LIFO should be used as the COGS will represent the cheaper, more recent additions to the inventory account.
• The factors that management should take into account when debating to switch between FIFO and LIFO include any potential income tax rate changes and any potential changes in the cost of units.
• Changing between LIFO and FIFO will have effects on financial reports as it will have an impact on: o Cost of Goods...
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