Question

2. Pick one of the cost flow assumptions and a product that would utilize that flow. Describe why it is the best of the four methods or LMC for that product.

Answer 1

Cost flow assumption can be defined as a method choosen or selected for determining the cost of goods sold during the accounting period and for inventory valuation purposes. There are basically four cost flow assumptions listed as belowq: -

1. First in first out (FIFO)

2. Last in first out (LIFO)

3. Specific identification method

4. Weighted average cost method (WAM)

Lets understand in detail FIFO: -

As per this cost flow assumption, inventory which are prucored at first will be realised, used, consumed, sold first instead of inventory purchased later. This method of accounting is used for goods which are procred regularly and cannot be specifically identified as seperate individual goods from entire inventory. For example goods purchased by traders like foodgrains (wheat, rice, sugar etc), perishable commodities ( ffod products, milk, flowers etc). All these products are purchased and sold in large quantities. Item sold cannot be specifically identified as seperately from which procured lot it belongs to.

Lets understand FIFO with the help of an example: -

Consider a dealer dealing in perishable commodities like flowers. Dealer purchases flower regularly from nursary as per demand in market and sells accordingly. In this case, valutaiojn of cost of goods sold and inventories at the end of accounting period will be best depicted by FIFO method of cost flow assumption. As these are perishable commodities which will get exhausted if not sold. Therefore, main aim of flower seller will be to sell the flowers which were purchased at the earliest period. If sales does not occurs from earlier purchased lot and happens from newly procured lots then, seller would be writing off stock on daily basis as old stock becomes valueless being perishable in nature which needs to be written off. Accordingly, to determine profits from sale of flowers, dealer need to account for cost of goods sold with the help of FIFO Cost flow assumption. Recognizing earlier purchased flowers as cost of goods sold will result in ascertainment of actual profits and correct inventory valuation.

One drawback of this cost flow assumption is that it leads to creation of higher profits in the period of increased inflation as inventories purchased earlier would be less costlier and lead to increased inventory valuation procured at later period. Both of this will have effect of increasing profits for that period.

Specific Identification Cost Flow Assumption: - This is more suitable for inventories whose cost can be easily identified and seperated from different products. Material procured will not be alike here and can be easily identified and seperated from each other. Example of commodity here is as follows: -

a car dealer purchases and sales two seperate models of a brand. Each model have its own purchase cost which can be seperately identified and recorded as expense. Accordingly, specific identification method will be more useful here in identifying, recording cost of goods sold, inventories and determining profits generated.