Question

Discuss the different inventory accounting methods that are used (and allowable) in GAAP. How do they differ from one another? Why would you choose one over another? Choose a sample company, identify which method they use, and explain why.

Answer 1

First we need to see each of the method:

FIFO (first-in, first-out) – The FIFO method assumes that the costs of the first goods purchased are those charged to cost of goods sold at the time of selling. Simply, the first goods purchased are the first goods sold. Such items as fresh dairy products, fruits, and vegetables should be sold on a FIFO basis.

Characteristics:

• Cost of goods sold has first costs incurred
• Price manipulation is rare
• Underestimates or overestimates the cost of goods sold if prices are rising or falling, respectively

Target: Its a departmental store chain company. So for this not only price fluctutions, the manufacturing date/expiry date of the products are also important. through FIFO method they can easily sell the products which came early in their system.

Advantages:

• Easy moving of old products
• Easy moving of recent expiring products
• Inventory will have new and fresh stock all the time which the company will like

LIFO (last-in, first-out) - The LIFO method assumes that the costs of the most recent purchases are the first costs charged to cost of goods sold when the company actually sells the goods. In simple terms, the recently purchased will be sold first.

Characteristics:

• Cost of goods sold has last costs incurred
• Disallows manipulation by management and uses the most relevant cost for the income statement
• Underestimates or overestimates cost of goods sold if prices are falling or rising, respectively. Also, cost flow disagrees with ideal, physical flow of goods

Amazon: Its an ecommerce company. It doesn't have to bother about the fresh stocks as it has tie-up with different vendors. So, here the price is more important.

Advantages:

• Focus on prices so always higher priced product will be sold first
• Multiple vendors with different prices, so inventory can be easily sorted

Weighted-average – In this method of ending inventory costing using a weighted-average unit cost. Preferably done for similar kind of products. Since the units are alike, firms can assign the same unit cost to them.

Characteristics:

• Cost of goods sold has average costs incurred
• Disallows manipulation by management and better estimation of the cost of goods sold than FIFO or LIFO if prices are rising or falling
• Tends to ignore extreme costs of inventory and there is no theoretical reasoning for using this method

Fedex: A courier company. The products are courier/parcels, which are sorted on different criteria such as weight, place etc. So, assigning a weight is beneficial here. Hence, weighted average method is suitable for it.