Get rid of the plagarisms in this paper!

There are three basis approaches to valuing inventory that are allowed by GAAP - (a) First-in, First-out (FIFO): Under FIFO, the cost of goods sold is based upon the cost of material bought earliest in the period, while the cost of inventory is based upon the cost of material bought later in the year. This results in inventory being valued close to current replacement cost. During periods of inflation, the use of FIFO will result in the lowest estimate of cost of goods sold among the three approaches, and the highest net income. (b) Last-in, First-out (LIFO): Under LIFO, the cost of goods sold is based upon the cost of material bought towards the end of the period, resulting in costs that closely approximate current costs. The inventory, however, is valued on the basis of the cost of materials bought earlier in the year. During periods of inflation, the use of LIFO will result in the highest estimate of cost of goods sold among the three approaches, and the lowest net income. (c) Weighted Average: Under the weighted average approach, both inventory and the cost of goods sold are based upon the average cost of all units bought during the period. When inventory turns over rapidly this approach will more closely resemble FIFO than LIFO.

Firms often adopt the LIFO approach for the tax benefits during periods of high inflation, and studies indicate that firms with the following characteristics are more likely to adopt LIFO - rising prices for raw materials and labor, more variable inventory growth, an absence of other tax loss carry forwards, and large size. When firms switch from FIFO to LIFO in valuing inventory, there is likely to be a drop in net income and a concurrent increase in cash flows (because of the tax savings). The reverse will apply when firms switch from LIFO to FIFO.

Given the income and cash flow effects of inventory valuation methods, it is often difficult to compare firms that use different methods. There is, however, one way of adjusting for these differences. Firms that choose to use the LIFO approach to value inventories have to specify in a footnote the difference in inventory valuation between FIFO and LIFO, and this difference is termed the LIFO reserve. This can be used to adjust the beginning and ending inventories, and consequently the cost of goods sold, and to restate income based upon FIFO valuation.

First In, First Out

The first in, first out method most closely approximates the real-world purchasing cycle and parallels the actual flow of inventory from purchase to sale in a wide range of businesses. Under the FIFO method, the oldest costs are assigned to inventory items sold, regardless of whether the sold items were actually purchased at that cost. When the number of inventory items purchased at the oldest cost is sold, the next oldest cost is assigned to sales. For example, if a company buys 10 widgets at $20 each, then buys 10 more at $19 each, the company would assign the $20 cost to the first 10 widgets it sells, then begin to assign the $19 cost.

Last In, First Out

The last in, first out method is the exact opposite of the FIFO method, assigning the most recent inventory costs to items sold. Last in, first out is less practical in most businesses, but there are a few specific situations in which LIFO more closely approximates the actual flow of inventory. Consider gravel yards, for example, which dump new loads of gravel on top of a pile consisting of several older loads. When a gravel yard sells a load, it takes the materials from the top of the pile -- the most recently purchased inventory. Using the example above under the LIFO method, a company would assign the newest cost of $19 to the first 10 units sold, then move on to the $20 cost, assuming it had not made another purchase in the meantime.

Average Cost Method

The average cost method assigns inventory costs by calculating a moving average of all inventory purchase costs. This method can be ideal for companies that sell non-perishable inventory in a non-sequential manner, such as video game retailers. The average cost method can also provide a more steady, reliable cost recognition structure than other methods, assuming costs do not swing wildly up and down for inventory items. To continue the example above under the average cost method, a company would assign an average cost of $19.50 -- the sum of 20 and 19 divided by 2 -- to all 20 widgets sold.

Specific Identification Method

The specific identification method perfectly matches inventory costs with units sold, assigning the exact cost of each sold inventory item when the specific item is sold. This method is not suited for businesses that sell high volumes of relatively homogenous products, such as food producers, but it can be ideal for companies that sell high-dollar items with relatively low volume, such as automobiles or yachts. Consider a car lot, for example. When a salesperson sells a car, he can forward the exact VIN or invoice number of the car to the accounting department along with the sales information, allowing accountants to look up exactly how much the dealership paid for the car.

Average Cost Method

To put it real bluntly, the average cost method is rarely used. This method does not offer any real convenience or added accuracy.

The equation for average cost method is as follows.

Average Cost = (Total Quantity of Inventory Units) / (Total Quantity of Units)

where

Cost of Goods Sold = (Average Unit Cost) x (Number of Units Sold)

For example if 1,000 toys are produced on Monday at a cost of $1 and then on Tuesday another 1,000 toys are manufactured at a price of $1.05, the average cost method would value the inventory at $1.025 a piece.

FIFO Method

As mentioned previously on aggressive and conservative accounting policies, the FIFO method of valuing inventory is considered to be the aggressive method.

FIFO works like how you maintain your fridge at home. After you have bought some groceries, you tend to place what you just bought at the back of the fridge in order to finish off the older food before it spoils.

In other words, under FIFO, the oldest goods are sold first and the newest goods are sold last.

As a formula it would look like this

Unit Cost per batch = (Cost/Quantity) for each batch

where

Cost of Goods Sold = (Unit Cost x Quantity) for each batch

Using the toy example above, if 1,000 toys were then sold on Wednesday, the COGS would be $1 per unit. The remaining inventory on the balance sheet would then be worth $1.05 each.

LIFO Method

LIFO is the opposite of FIFO. Instead of the oldest inventory being considered as sold first, the newest product is sold first. While the factory analogy works for the FIFO, consider a bakery. By lunch or evening, the bread baked from the morning will not sell as well as the fresh ones from the afternoon batch.

This means that cost of the latest inventory now becomes the COGS with the cost of the oldest inventory being assigned to the inventory value on the balance sheet.

The equation is essentially the same as FIFO since both are calculated based on batches of unit sold.

Unit Cost per batch = (Cost/Quantity) for each batch

where

Cost of Goods Sold = (Unit Cost x Quantity) for each batch

Using the toy example, the 1,000 units sold on Wednesday would have a COGS of $1.05 per unit, with the remaining 1,000 toys being valued at $1 each.

How Inventory Valuation Affects Profits and Assets

As you can see from above, despite ending with the same 1,000 toys, FIFO assigns the inventory value to be $1,050 compared to the LIFO $1,000.

But another point is that the method of inventory valuation does not just affect the balance sheet. Gross profit also varies considerably. How?

Gross Profit = Sales COGS

COGS differ under FIFO and LIFO, and if your COGS is low, then that means gross profit will increase.