Question

What are the four different methods used to assign costs to ending inventory and cost of goods sold? How are the methods different? What impact does each method have on the calculation of net income and ending inventory? do not use the outside resources, please answer in your own words.

Answer 1

Answer-

The four different method of recognising closing inventory and cost of goods sold are-

1. First in first out method.
2. Last in first out method.
3. Weighted average method.
4. Specific identification method.

1) First in first out method-

This method of inventory valuation is based on the fact that first come goods must be sold first and last come goods must be sold last, this method of inventory valuation is in trend for various company,

This method will result into balance closing inventory because this method is based on relatively true assumption of inventory valuation.Cost of goods sold is calculated on the basis of forst come first serve basis.

Net income under this method remains at higher when comparing with other method, since due to inflation,rates of products generally increases where closing inventory are valued at higher rates due to higher acquistion price which result into higher closing inventory,being not consumed hence the net income uder this method is likely to remain at high compared to other method.

2) Last in first out method-

This method of inventory valuation is based on assumption that last in inventory are stored at the front of warehouse, which means the selling of these material is most likely than the inventory stored at the back of the warehouse. Hence the cost of goods sold musy be taken on the last in and first out basis.

This method of inventory valuation will have cost of goods sold of higher rate (later purchase) and closing inventory of lower rate (earlier purchase) , this would have effect of lowering net income.

This method of inventory valuation is used to defer the higher tax laibility, however this method of inventory valuation is prohobited under US GAAP. This method will have lower net income than other method of inventory valuation in general. Deferment of tax is always possible in this method and sometimes tax avoidance is also possible due to nature of inventory valuation.

3) Weighted average method-

Under this method a simple average of all inventory purcahsed along with opening balance balance, the cost of goods sold is calculated as multiplication from the wieghted average of inventory above mentioned.

Under this method the cost of goods sold and closing inventory remains at averaged and it generates a balanced net income. This method has lowered net income than FIFO and higher net income than LIFO method. This method of inventory valuation is the most used method by current manufacturing organisation.

4) Specific identification method-

Under this method, the value of inventory is calculated based on specific identification of items, there is manual cheking of each item along with rate assigned on them,

This method is used when there is high value of items are stored in the warehouse, under this method tax defferment and tax avoidance both are possible because value of each items are manually assigned on the sheet of inventory valuation.

The specific identification method is used as a replacement of LIFO method which has been prohobited under US GAAP. Since this method has not been exlcuded hence this is used as replacement.

Please comment for any additional explanation.

Thanks,