In the business world, companies and other related entities make some assumptions on the sold goods in inventory. Inventory cost flow is a system applied to conceal costs from a list of goods. However, all inventory cost flow assumptions are made only for financial reports and taxation purposes; thus it does not dictate the actual stocking of the products. The condition is that the total cost of items sold and the remaining stock in ending inventory must be equal to the real value of items available (Steven 2017). Some of the assumptions associated with inventory cost flow include the following.
First In; First Out (FIFO)
This assumption works on the basis that the goods which are sold first are those which are purchased first. The First In First Out cost flow assumption has a close mode of movement of products according to the actual flow in the market. In an ideal situation the items which remain in the inventory ending are the ones procured at the end of the accounting period.
Delegate your assignment to our experts and they will do the rest.
Last In; First Out (LIFO)
Under the LIFO cost flow assumption, it is assumed that at the start of accounting, the goods in the inventory period remain in the ending inventory. LIFO is a business strategy used for tax payments and reporting of financial statements. During times monetary inflations the business can defer income taxes until the starting inventory is sold. LIFO does not practically coincide with the actual flow of goods and requires careful record keeping on the purchases.
Weighted Average Cost
The Weighted Average Cost assumes that all goods of a given type are interchangeable but vary in the purchase prices. In this cost flow assumption, all costs are summed up and divided by the number of items bought. In determining the cost of goods sold, the number of items sold is multiplied by the price per item at the end of the accounting period.
If a company uses an alternative inventory cost flow assumptions, it will suffer the consequences dictated by the market structure. For instance, if the business prefers to use the Last In First Out assumption method, the deferred taxes during the period awaiting for sales of items in the inventory may be much greater resulting to high understated assets and cash flow. Additionally, the method may be favorable if the company keeps the records of purchases carefully for financial scrutiny.
Interpretation of GAAP and ethical issues
The Last In First Out (LIFO) method is highly prohibited in the International Financial Reporting Standards (IFRS) since it induces a distortion on the profitability of the company (Zaw 2018). Though acceptable by the Generally Accepted Accounting Principles, LIFO can significantly create stunted development to the net income during inflations. The LIFO liquidation profits practically create ethical issues that make the stakeholders vulnerable to punishments as the managers may manipulate and inflate earnings. The reason why LIFO liquidation is prohibited is that it uses obsolete inventory numbers to control the earnings as well as lowering the tax liabilities.
Some of the ethical issues raised by the use of LIFO liquidation profits include outdated and obsolete balance sheets and understated net income. Typically, the balance sheets formulated by the business are intended to lower the tax liabilities by using an obsolete inventory value. Therefore, the result of the inventory valuation is merely useless since it appears outdated. Secondly, since the LIFO depends on the principle that the last item purchased should be sold first, the management underreports the firm’s profits for the financial inventory transactions. Through the use of heavily outdated inventory values, the company can reduce tax liability at a single price, but then creating unethical business operations.
References
Steven Bragg (2017). “Inventory Accounting: Inventory Cost Flow Assumptions.” AccountingTools, Inc.
Zaw Thiha Tun (2018). “Why LIFO is banned under IFRS (XOM)” Financial analysis.
