Question

- Why in your opinion did Jim’s accountant recommend the average cost method and what difference is there with the three other methods?

-Explain the main characteristics of each method of valuation of the inventory and the consequences they may have on the valuation of the inventory and determination of the net income in case of price fluctuation.

Answer 1

There are three methods for the valuation of inventory. They are the FIFO method, LIFO method, Average cost method.

FIFO method

First In, First Out, commonly known as FIFO, is an asset-management and valuation method in which assets produced or acquired first are sold, used, or disposed of first. For tax purposes, FIFO assumes that assets with the oldest costs are included in the income statement's cost of goods sold (COGS). Characteristics of the FIFO method include: Assigns first costs incurred to COGS (cost of goods sold) on the income statement. Disallows manipulation by management and cost flow agrees with ideal, physical flow of goods, though the agreement of cost flow and ideal, physical flow of goods is arguably not important.

The first-in, first-out (FIFO) accounting method has two key disadvantages. It tends to overstate gross margin, particularly during periods of high inflation, which creates misleading financial statements. Inflated margins resulting from FIFO accounting can result in substantially higher income taxes.

FIFO can increase net income because inventory that might be several years old–which was acquired for a lower cost–is used to value COGS. However, the higher net income means the company would have a higher tax liability.

LIFO method

LIFO stands for “Last-In, First-Out”. It is a method used for cost flow assumption purposes in the cost of goods sold calculation. Under LIFO, the cost of the most recent products purchased (or produced) is the first to be expensed as cost of goods sold (COGS)—which means the lower cost of older products will be reported as inventory.

LIFO is more difficult to maintain than FIFO because it can result in older inventory never being shipped or sold. LIFO also results in more complex records and accounting practices because the unsold inventory costs do not leave the accounting system.

Under IFRS. ... The inventory valuation method is prohibited under IFRS and ASPE due to potential distortions on a company's profitability and financial statements. The revision of IAS Inventories in 2003 prohibited LIFO from being used to prepare and present financial statements.

The LIFO method assumes the last item entering inventory is the first sold. During periods of inflation LIFO shows ending inventory on the balance sheet much lower than what the inventory is truly worth at current prices, this means lower net income due to a higher cost of goods sold.

Average cost method

The average cost method assigns a cost to inventory items based on the total cost of goods purchased or produced in a period divided by the total number of items purchased or produced. The average cost method is also known as the weighted-average method. Biggest advantage of using the Average cost method over other cost formulas like FIFO or LIFO is that it significantly simplifies calculation and record keeping and can easily process even if entity has high frequency of inventory ordering. As bookkeepers don’t have to keep track of each and every batch bought and its respective price, volume of record and probability of human error greatly reduces.

An issue with the weighted average cost method is when your inventory prices vary widely, where you may not recover the costs of the more expensive units and may even suffering a loss with your sales price.