Question

Prepare a memorandum containing responses to the following items

1. describe the cost flow assumptions used in average cost, FIFO and LIFO methods of inventory valuation

2. Distinguish between weighted-average-cost and moving-average-cost for inventory costing purposes

3. identify the effects on both the balance sheet and the income statement of using the LIFO method instead of the FIFO method for costing purposes over a substantial time period when purchase prices of inventoriable items are rising. State why this takes place.

Answer 1

Q1)

Inventory cost flow assumptions

Inventory cost flow assumption states that the cost of an inventory item chnages from when it is acquired or built and when it is sold.Because of the cost differential,management needs a formal system for assigning costs to inventory as they trasition to sellable goods.

Whe can explain it with example,

Me limited buys a goods on January 1 for $60.On June 1 it buys an same goods for $80.and on November 1 it buys yet another stock of goods for $100.The goods are completly interchangable.On decemver 1 company sells one stock of goods.Which the company had bought for three different prices.

The Possible ways to interpret the cost flow assumptions are :-

* FIFO Cost flow assumption:- Under this first in, first out method, you can assume that the first item purchased is also the first item sold.Then, the cost of goods sold will be$ 60.Since this is the lowest cost item in the example.Profits would be higher in Fifo.

* LIFO Cost flow assumption :- Under last in first out method, you assume that the last item purchased is also the first one to be sold.Thus, the cost od goods sold would be $100.Since this is the highest cost item in the example, profits would be lowest under LIFO.

*Weighted average cost flow assumption:- Under the weighted average method,the cost of goods sold is the average cost of all three units, or $80.This cost flow assumption tends to yield a mid-range cost, and therefore also mid-range Profit.

Q2)

The major differece between Moving average cost and weighted average cost is that, Moving average is calculated only takes current inventory status into consideration.Weighted average is calculated for all purchases is a given time period.

Example:-

You buy 10 units at 10 per unit.you sell 4 units.cost of goods sold is 10 per unit.so you have 6 units left with total value 60.You buy another 10 units at 20 per unit.Now after the second purchase, value per item unit is calculated as follows:-

Moving Average :- (6×10+10×20)/16= 16.25

Calculation is based on current inventory status and value.

Weighted Average :-( 10×10+10×20)= 15.

Calculation. Is based on all purchases in a given period.

Q3)

Effects of Lifo method:-

Lifo method leads to a better matching of costs and revenues than the othe methods.when a company uses Lifo method,the income statement reports both sales revenue and cost of goods sold in current value.This resulting gross margin is betrer indicator of managements ability to generate income than gross margin computed using Fifo,Which may include substantial inventory (paper) profits.During inflation , Lifo shows the largest cost of goods sold of any of the costing methods because the newest costs charged to cost of goods sold are also hightest cost.The larger the cost of goods sold, the smaller the Net income.

Lifo method results in lowest tax income, and thus the lowest income taxes,when prices are rising.The internal Revenue servies allows companies to use Lifo for tac purposes only if they use Lifo for financial reporting purposes.many companies swich from fifo to Lifo for tax advantages.

Lifo grossly understates inventory .The increase usefullness of the income statement more than offsets of the negative effects of this undervaluation of inventory on balance sheet.

Lifo Permits income manipulation .Under Lifo the higher cowts are charged costs of goods sold in the current period,resulting in a substantial decline in reported net income.To obtain higher income,management could delay making the nirmal amount of purchases untill the next period and thus include some of the older, lowest costs incost of goods sold.