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) AVERAGE METHOD: 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.
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Therefore, the inventory that remains is from the most recent purchases. Companies selling perishable goods such as food and rugs 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: Average Cost The factors that management should take into account when debating to witch 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 First-Len, First-Out 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 Last-Len, First-Out 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?
Answer: 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. 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. 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. NY 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 Sold – Ending Inventory o Gross Margin – Amount paid in income taxes o Net Income Advantage and disadvantage of these three methods: FIFO gives us a better indication of the value of ending inventory (on the balance sheet), but it also increases net income because inventory that might be several years old is used to value the cost of goods sold. Though increasing net income sounds good, but it also has the potential to increase the amount f taxes that a company must pay. LIFO isn’t a good indicator of ending inventory value because the left over inventory might be extremely old and, perhaps, obsolete. This results in a valuation that is much lower than today’s prices. LIFO results in lower net income because cost of goods sold is higher. Average cost produces results that fall somewhere between FIFO and LIFO. Of these inventory methods, the most popular methods used are FIFO and LIFO, even though LIFO does not reflect the actual flow of goods in most cases. The FIFO Method may be the closest to matching the actual physical flow of inventory.
Since FIFO assumes that the oldest inventory is always sold first, the valuation of inventory still on hand is at the most recent price. Assuming inflation, this will mean that cost of goods sold will be at its lowest possible amount. Therefore, a major advantage of FIFO is that it has the effect of maximizing net income within an inflationary environment. The downside of that effect is that income taxes will be the greatest. The LIFO Method is preferred by many companies because it has the effect of reducing a company’s taxes, thus increasing cash flow.
Nevertheless, these attributes of LIFO are present only in an inflationary environment. Under LIFO, a company always sells its newest inventory items first. Given inflation, these items will also be its most expensive items. So cost of goods sold will always be at its greatest amount; therefore, net income before taxes will be at its lowest amount, and taxes will be minimized, which is the major benefit of LIFO. Another advantage of LIFO is that it can have an income smoothing effect. Again, assuming inflation and a company that is doing well, one would expect inventory levels to expand.
Therefore, a company is purchasing inventory, but under LIFO, the majority of the cost of these purchases will be on. The income statement as part of cost of goods sold. Thus, the most recent and most expensive purchases will increase cost of goods sold, thus lowering net income before taxes as well as lowering taxes and net income. Net income may still be high, but not as high as it would if FIFO had been used. On the other hand, if a company is doing poorly, it will have a tendency to reduce inventories.
To do so, the company will have to effectively sell more inventory than it acquires. Since a company using LIFO assumes it sells its most recent purchases first, the inventory that remains is older and less expensive (given inflation). So when a company shrinks its inventory, it sells older, less expensive inventory. Therefore, the cost of goods sold is lower, net income before tax is higher, and net income is higher than it otherwise would have been. A disadvantage of LIFO is the effect it has on the balance sheet.
If a company always sells its most recent inventory first, then the balance sheet will contain inventory valued at the oldest inventory prices. For instance, if a many were to switch from FIFO to LIFO in 1955, then unless the inventory was zeroed out at some point in time, there may be units of inventory valued at 1955 prices, even though the physical inventory is comprised of the most recent units. As a result, the inventory account can be dramatically undervalued if a company has adopted LIFO, and if during that time, the cost of inventory has increased.
The LIFO Method is justified based upon the matching principle, as the most recent cost of inventory is matched against the current revenue generated from the sale of that inventory. FIFO does not, however, distort the valuation f inventory on the balance sheet like LIFO can potentially do. Companies generally disclose their inventory accounting methods in their financial statements, usually as a footnote or a parenthetical note in the relevant sections. Therefore, when examining financial statements, it is imperative that the inventory notes be read carefully, to determine the method of inventory valuation chosen by a company.
It is most likely that either FIFO or LIFO would have been chosen. Assuming inflation, FIFO will result in higher net income during growth periods and a higher and more realistic inventory balance. In roods of growth, LIFO will result in lower net income and lower income tax payments, thus enhancing a company’s cash flow. During periods of contraction, LIFO will result in higher income levels. LIFO also has the potential to greatly undervalue inventory over time.
Difference between FIFO and LIFO: The difference in the timing of cost assignment can cause a substantial difference in the cost of goods sold One method of visualization to envision the inventory account as being built of layers of costs over time FIFO will take the costs from the oldest layer and LIFO takes costs from the most cent layer This in turn can lead to a significant difference in taxable income Although both methods measure the same amount of physical sales and inventory, the net income can vary considerably Comparability: The financial statements of a company using the LIFO approach as opposed to FIFO generally reflect: Conservative profits, because LIFO buffers the effects of inflation. Better matching of current costs with current revenues. Lower liquidity, that is, a lower current ratio. Lower equity position, that is, a higher debt-to-worth ratio.