Basic Accounting

Impact of choosing alternative accounting methods: Although GAAP is generally accepted accounting principles that have been codified over a period of time; there are some alternative choices for accounting treatment of different items. The largest cost in any enterprise is the cost of goods sold usually accounting for about 70% of the sales revenue, although the exact number may vary from industry to industry. Some methods of valuation of inventory will have a direct impact on how cost of goods sold is valued. In a typical working capital cycle, a current asset passes through different stages. Inventory is sold to a customer. This determines sales revenue. The next issue is to determine cost of goods sold.

GAAP requires that inventories are valued at cost or market value whichever is lower. Market value is generally consistent. The sale price of a product less the costs incurred in closing the sale is usually the market value. However, cost is subject to judgement. There could be different methods of valuing cost such as average cost, first in first out cost (FIFO), last in first out cost (LIFO).These are three basic methods and all three methods have theoretical support. Managers have a stake in determining how inventory is valued and its fall out in Cost of goods sold especially when it is the largest element in cost. The underlying principle is that costs should be matched with the revenue in the same period.

Let us now see how inventory valuation affects the cost of goods sold and profitability. Let us assume that for a business in a period, there are three transactions.

Jan 1, 07 1000 units sold for $30,000

Feb 1, 07 1000 units sold for $30,000

Mar 1, 07 1000 units sold for $30,000

Total sales in the quarter 3000 units for $90,000

Let us now look at purchases. Purchases or manufactured could be at different prices.

Jan 1, 07 1000 units at $ 20,000

Jan 31, 07 2000 units at $45,000

Feb 10, 07 2000 units at $50000

Total purchased is 5000 units at $115,000

3000 units have been sold in the period and 2000 units are in inventory. The way the inventory of 2000 units is valued at the end of the period will determine how much profit is reported in the period. If we follow average cost principle, the inventory will be valued at $46,000. Cost of goods sold in the period is $69,000 and a profit of $21,000 would be reported. If the FIFO method is used, inventory would be valued at $50,000, Cost of goods sold at $65,000 and profit would be $25,000. If the LIFO method is adopted, the Inventory would be valued at $42,500, cost of goods sold at $72,500 and profit would be $17,500.

Thus we observe that even following three different yet acceptable methods give us different results in our income statement for the period. In times of rising costs, FIFO has a tendency to overstate profits and LIFO has a tendency to understate profits.

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