Question

Exercise 6-49 Effects of Inventory Costing Methods Borgia Enterprises has the following statement of earnings data available for 2018: Sales revenue Operating expenses Interest expense $737,200 243,700 39,500 34% Income tax rate Borgia uses a perpetual inventory accounting system and the weighted average cost method. Borgia is considering adopting the FIFO method for costing inventory. Borgia's accountant prepared the following data: If Weighted Average Cost Used $ 61,850 403,150 If FIFO Used $ 80,200 384,800 Ending inventory Cost of goods sold

Answer 1

FIFO method:

When the FIFO method is used, costs are included in the cost of merchandise sold in the order in which they were purchased.

Weighted Average Cost Method:

When the weighted average cost method is used in a perpetual inventory system, a weighted average unit cost for each item is computed each time a purchase is made. This unit cost is used to determine the cost of each sale until another purchase is made and a new average is computed.

In a perpetual inventory system, each purchase and sale of goods is recorded in the inventory account and related subsidiary ledger.

In this way, the amount of merchandise available for sale and the amount sold are continuously updated in the inventory records.

Solution:

1. Computation of Income before Tax, Income Tax Expense, and Net Income

Description	weighted average cost method ($)	FIFO method ($)
Sales Revenue	737200	737200
Less: Cost of Goods Sold	403150	384800
Gross Margin	334050	352400
Operating Expense	243700	243700
Interest expense	39500	39500
Income before Tax	50850	69200
Income tax Expense@ 34%	17289	23528
Net Income	33561	45672

2. Why the ending inventory and cost of goods sold are different in each of the two methods?

Solution:

If costs (prices) remain the same, both methods would yield the same results. However, costs (prices) normally do change.

Under FIFO method, the ending inventory will be higher than the ending inventory under the weighted average cost method, If costs (purchase prices) increase.

In the given question,

The ending inventory under FIFO method ($80200) is higher than the weighted average cost method ($61850), Hence, the cost (Purchase prices) has increased in 2018.

3. Which method provides the most realistic amount of net income. for inventory?

Solution:

FIFO reports higher gross profit and net income than the weighted average cost method when costs (prices) are increasing, However, in periods of rapidly rising costs, the inventory that is sold must be replaced at increasingly higher costs. In such cases, the larger FIFO gross profit and net income are sometimes called inventory profits or illusory profits.

The weighted average cost method is, in a sense, a compromise between FIFO and LIFO. The effect of cost (price) trends is averaged in determining the cost of merchandise sold and the ending inventory.

The weighted average cost method gives realistic net income only if you purchase all available-for-sale units of the same merchandise item at identical prices.