Question

1) Which inventory method is best to use in accordance to the accounting principles? Is it FIFO or AVCO and why ? Pls give examples including numerical answers.

2) Explain the fundamental characteristics of accounting information in a lay man's terms and also the conceptual framework

Answer 1

1. In an inflationary period, FIFO leads to higher profits, because you are selling goods that cost you less when you purchased them compared to more recent items that you purchased at a higher per-unit price. The effect is the opposite in a deflationary period. If prices are dropping, you should not use the FIFO method.

Average cost, though, is great if you are operating in a period of relatively low or no inflation. If prices are stable, you might as well use the average cost method because it's much simpler to calculate. However, if prices are fluctuating, either up or down, you do not want to use the average cost method because it could potentially cost you money – possibly a lot of money.

Example

You can determine which accounting method might be best for you by calculating the value of a sample set of goods using the FIFO and average cost methods. Suppose you buy five bags of cement for $10 per unit. Then, the price increases, and you buy another five bags for $20 each. So that's:

• Five bags at $10 each = $50
• Five bags at $20 each = $100
• Total number of bags = 10
• Total cost = $150

Determining which accounting method to use can be tricky. If you use the average cost method, you have:

• Total cost of the bags ($150) ÷ total number of bags (10) = weighted average cost ($15 per bag)

If you used the cement to create birdbaths, and you sold the birdbaths at $50 each, you would earn:

• Total sales price - total cost for all units = profit, or
• ($50 x 10) - (10 x 15) = $500 - $150= $350

If you use the FIFO method, you start with the first five bags:

• Total cost of the first five bags ($50)
• Total number of the first five bags (5)
• Cost per unit for the first five bags ($50 ÷ 10 = $10 per unit)

You would then calculate the cost of the next five bags:

• Total cost of the last five bags ($100)
• Total number of the last five bags (20)
• Cost per unit of the last five bags ($100 ÷ 20 = $20)

If you sold those same birdbaths for $50 each, you would have:

• Total sales price - total cost for first five units = profit for first five units:
• ($50 x 5) - ($10 x 5) = $250 - $50 = $200 profit (for the first five bags)

Then you would calculate the profit for the second set of five bags:

• ($50 x 5) - ($20 x 5) = $250 - $100 = $150 profit (for the last five bags)

This doesn't seem like much of an accounting trick at first. Using either method, your total cost for 10 bags of cement was $150, and your total profit is $350. However, if you use the FIFO method, you book $200 profit for the first five birdbaths, whereas with the average cost method, you book only $175 in profit. This may not sound like much, but if you multiply this $25 by 10,000 items, you will book an extra $25,000 in profit earlier in the process. That's a lot of extra money to buy more supplies regardless of the cost of supplies. If prices keep going up – as they usually do – you can continue using FIFO to continue maximizing your profits.

Choosing the right inventory valuation method depends on a number of factors, like where your business is based, whether your costs are going up or down, and how much your inventory varies. Most businesses use the FIFO method because it usually gives the most accurate picture of costs and profitability. But there’s no one-size-fits-all solution – so it’s best to speak to an accounting professional to find out what’s best for your business and situation.

2. fundamental characteristics of accounting information

There are two fundamental characteristics of an accounting information system. In order to be useful, all financial data should be both relevant and reliable. Relevancy refers to the value the information provides in terms of making decisions. For example, if a company is thinking about purchasing a new piece of Machinery in order to increase production of a certain product, it will want to see the sales figures for that product over the last few quarters. If the figures show a trend of consistent sales or even steady growth, then they provide confirmatory value. The figures provide information about past events and with this sales track record, decision makers can make educated choices about the future. They can predict that sales will likely continue to be good and investors who may be considering making a loan to the company have a greater assurance that the company can pay them back. This forward looking ability is known as predictive value.

Another of the primary qualities of accounting information is reliability. This means that the information provided on financial statements must be complete, free from errors and without bias. This quality is also known as faithful representation. Information should not only be recorded in its entirety, but also reported truthfully. Figures should not be left off a report if they make the company's performance look bad, because then decision makers are not seeing an accurate picture of the business's financial standing. Similarly, any accounting errors should be fixed to provide a clear presentation of data. Also, numbers should not be adjusted or padded to make one area of the business look better than other area. This practice would add bias to the data and would again not paint an accurate picture or provide reliable information.