When accounting for inventory, it is important to be consistent in selecting an accounting method as it can have a direct impact on key financial statements. The US GAAP allows businesses to use one of several accounting methods: average cost, first-in, first out (FIFO), and last-in, first-out (LIFO).
The average cost method assumes that the cost of goods sold (COGS) and ending inventory consists of a mix of different products/inventory. Thus it takes the weighted average of all units available for sale and uses that average to determine the value of COGS and ending inventory The average cost is computed by dividing the total cost of goods available for sale by the total units available for sale. Of the three methods, the average cost method is arguably the easiest and most inexpensive to maintain out of all the valuation methods. This method works well with businesses that have:
FIFO assumes that the oldest unit/first unit in inventory is the first one to leave the inventory (first one to be sold). For instance, a production plant produces 200 metal parts at the cost of $1 each on January 1st and produces another 200 units at the cost of $0.50 each on January 2nd . FIFO states that if the plant sold 200 units on January 3rd, the cost of goods sold is $1 per unit because that was the cost of the first 200 units in the inventory.
Of the three inventory accounting methods, FIFO serves as a better indicator of the value for ending inventory. Most businesses typically offload the oldest items within their inventory since they may become obsolete or may spoil. As such, FIFO reflects the natural flow of inventory making accounting easier with less chance of errors. Additionally, using the FIFO method allow companies to record higher profits on their financial statements, which appeals more to creditors and lenders.
The LIFO method assumes that the most recent products in a company's inventory are the ones sold first. Using the same example for scenario from FIFO, the cost of goods sold would be recorded as $0.50 because that is the cost of the last 200 units in the inventory. Since LIFO uses the most recently acquired inventory to value COGS, the older items left within the inventory faces the risk of spoilage or becoming obsolete. Thus this method is not practical or realistic for many companies, especially companies that sell perishable goods. However, this method is attractive in the sense that it gives a tax break to companies that are seeing an increase in the cost of purchasing or producing products.
Of the three methods, LIFO is arguably the most complex and most expensive to maintain. Additionally, while US GAAP allows for this method, international accounting standards does not making it difficult for American companies that uses this method to conduct business overseas.
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