Question

Describe the allocation of inventoriable costs may be made under any of the following assumptions as to the flow of costs (a) first-in, first-out (FIFO), (b) last-in, first-out (LIFO), or (c) average cost.

Answer 1

A. First in first out (FIFO) is the sytem under which the oldest inventory is removed the first and the newest inventory, last. Hence, while calculating the cost of goods sold and the value of closing inventory, the oldest inventory remaining in the warehouse will be taken account of. Hence, it usually so happens that the cost of goods sold value is lower as compared to LIFO and the closing inventory is higher and therefore, the profit and assets figure for the current year seem healthy. But in the next accounting period it evens out in comparison to the other methods of inventory recording systems.

FIFO is preferable in times of rising prices, so that the costs recorded are low and income is higher.

B. Last in first out (LIFO) is the vice versa of FIFO wherein, the closing inventory value is lower and cost of goods sold is high thereby, in the current accounting period, the profit and assets figure is lower as compared to when adopting FIFO.

LIFO is preferable in times when tax rates are high because the costs assigned will be higher and income will be lower.

(The explanation provided in A an B is valid only in cases where there is price fluctuation such as inflation.)

C. Weighted average costs is the method wherein the average costs are calculated for the entire inventory thereby, reducing the risk of manipulation in the books of accounts. This method shows an accurate average costs of goods sold and closing inventory figures. This method is most widely spread and GAAP and IFRS approves of it.