Question

Explain how two identical companies using the same accounting methods could show different net incomes because they used different inventory methods.

Answer 1

Solution:

Selection of inventory method depends on size and type of the firm. For example some method is suitable for small business. some method is suitable for large business.

The accounting method is the one that must be chosen and it should be acceptable as per accounting standard and gives the exact net income. This will help in understanding the real profitability of the business and also help in understanding the future prospect of the business.

Inventory valuation is a major method required to analyze the proper valuation of the inventories. It include finished goods, raw material inventory and work in process inventory. There are many methods used for inventory valuation but the commonly used are FIFO, LIFO, and Weighted Average. Understand their effect on income statement is given.

FIFO : Under this method, net income and closing inventory are on higher side if there is inflation in the market where as it will be on lower side if it is in deflation in the market. Reason is that in FIFO it is assumed that the stock which came first will be disposed off first. Now suppose there are 10 items in stock worth $12each and we purchases 10 additional items for $18 each, the FIFO method will assume that items in the first sales transaction come from the $12 lot. Thus there will be higher net income margin and higher closing stock amount in the books.
LIFO : Under this method stock which came last will be disposed off first and if the sale is from $18 transaction than there will be lower income margin and lower closing stock in the books. So, in the deflationary market suppose the later purchase was of $10 only then it would have resulted in to higher net income and lower stock valuation in the books.
Weighted Average: under this method, average costs are directly related to purchasing cost as we compute the price per unit by dividing total purchase cost by number of units in the inventory. Therefore when prices are high in the market it shows higher value of stock and lower income and vice versa when market is in recession.

There are many uses of the balance sheet. Changes of inventory in the balance sheet can result in reporting inaccurate value of assets and owners equity eventually. Then there is no effect of the same in the liabilities side of the balance sheet