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

The different inventory accounting methods that are used (and allowable) in GAAP – FIFO, LIFO, and WAC

First-in-first-out (FIFO) inventory valuation

According to the first-in-first-out (FIFO) inventory valuation method, it’s assumed that inventory items are sold in the order in which they’re manufactured or purchased. In other words, the oldest inventory items are sold first. The FIFO method is widely used because companies typically sell products in the order in which they’re purchased, so it best represents the actual flow of goods in a business.

Last-in-first-out (LIFO) inventory valuation

The last-in-first-out (LIFO) inventory valuation method assumes that the most recently purchased or manufactured items are sold first – so the exact opposite of the FIFO method. When the prices of goods increase, Cost of Goods Sold in the LIFO method is relatively higher and ending inventory balance is relatively lower

Weighted average cost (WAC) inventory valuation

With the WAC inventory valuation method, inventory and COGS are based on the average cost of all items purchased during a period. This method is usually used when a business doesn’t have much variation in its inventory

It’s important to note that companies in the US operate under the generally accepted accounting principles (GAAP), while most other countries adhere to the International Financial Reporting Standards (IFRS).

Most businesses use the FIFO method because it usually gives the most accurate picture of costs and profitability.

How do they differ from one another?

The weighted average method, which is mainly utilized to assign the average cost of production to a given product, is most commonly employed when inventory items are so mingled that it becomes difficult to assign a specific cost to an individual unit.

Under FIFO, the oldest cost of an item in an inventory will be removed first when one of those items is sold. This oldest cost will then be reported on the income statement as part of the cost of goods sold.

The LIFO accounting method assumes that the latest items bought are the first items to be sold. With this accounting technique, the costs of the oldest products will be reported as inventory. It should be understood that although LIFO matches the most recent costs with sales on the income statement, the flow of costs does not necessarily have to match the flow of the physical units.

Why would you choose one over another?

FIFO is preferable in times of rising prices, so that the costs recorded are low, and income is higher. Contrarily: LIFO is preferable in economic climates when tax rates are high because the costs assigned will be higher and income will be lower.

Taking example of a sample company, identifying which method they use, and explaining why?

Amount after valuation and LIFO reserves of inventory expected to be sold, or consumed within one year or operating cycle, if longer.

Apple Inc.’s inventories increased from 2016 to 2017 but then slightly declined from 2017 to 2018.