Question

Why is FIFO and LIFO both acceptable under GAAP? What is GAAP?

Answer 1

Answer:

What is GAAP?

GAAP stands for generally accepted accounting principles. It consists of certain accounting principles, guidelines, accounting standards and accounting practices, to be followed while organising, summarising and disclosing the financial information.

The general accounting principles, under GAAP, include the following.

Business Entity Assumption - This states that a business entity as separate from its owner and the financial transactions of the entity are different from those of the owners.

Monetary Unit Assumption - Only those transactions which can be expressed in terms of monetary unit (for example US dollars) are recorded in the books of account of the business.

Accounting Period - According to this principle, within a certain period of time, the accounting process of business should be completed. Companies usually follow financial year a calendar year.

Historical Cost Concept - As per this concept, the assets acquired by the company are recorded as per the amount of cash or the assets equivalent to cash actually spent to acquire the asset on the date of such acquisition. Otherwise, the market value of assets is not used to record them.

Going Concern Assumption - According to this principle, it is assumed that the business will continue to operate for the foreseeable amount of future.

Full Disclosure Principle - This principle makes it compulsory for the business entity to disclose all the materialistic and relevant financial information so that the investors and users of such information make effective decisions. This requires narration with every transaction at the journal level and notes to accounts while making financial statements.

Matching Concept - This concept states that for a particular period, the revenue has to be matched with the expenditure the corresponding period to show the true profit for such period.

Accrual Concept - As per the accrual basis of accounting, the revenue and expenditure are recorded in the period in which they are actually incurred, not when the cash receipt or payment is made.

Consistency Concept - As the name suggests, this concept requires an entity to follow accounting procedures consistently over the accounting periods in order to facilitate the comparison of such accounting periods. For example, if a company chooses to follow Written down value method of depreciation for its machinery, then the same method should be followed in the next accounting periods as well.

Conservatism Principle - this concept states that when a situation arises where there is two equal probability of occurrence of profit or loss, or income or expense, then Expenses and losses should be anticipated and recorded but not incomes and gains.

Why are FIFO and LIFO both acceptable under GAAP?

LIFO stands for “Last In First Out” and FIFO for “First In First Out”. These are inventory valuation methods.

GAAP allows companies a choice in deciding which system to choose for the valuation of inventory. The companies may choose that system which is most advantageous for reporting purposes. LIFO makes income statement better as it matches the cost with the revenue for the period. On the other hand, FIFO makes the balance sheet better, as the inventory is valued at more recent market value.