Question

You are a Senior Managerial Accountant at Wild Water Sports Inc., a company that makes water sporting equipment. Currently the company uses the LIFO method to value inventory costs. Your boss has asked you to look into the advantages and disadvantages of switching to FIFO or the Weighted Average method. Prepare a 2-3 page memo explaining the advantages and disadvantages of LIFO, FIFO, and the weighted average method. Include the financial statement implications of switching from LIFO to each of the other valuation methods. Finally, make a recommendation based on your research as to which valuation method Wild Water Sports, Inc. should use. required at least 2 references

Answer 1

FIFO

Advantages

i) It is simple to understand and easy to operate.

ii) It is based on logical and sound principle that materials are issued in order of purchase.

iii) The closing stock is valued at a more recent price.

iv) Materials are priced at actual cost hence no unrealised profit or loss arises.

Disadvantages

i) The calculation becomes difficult and complecated when purchases are made very frequently at different prices.

ii) Issue price does not reflect current market price.

iii) Cost of production tends to be high during the period of falling prices.

Weighted Average Method

Advantages

i) Easy to calculate and operate.

ii) Closing stock value is acceptable.

iii) When prices fluctuate considerably, it smooths out the fluctuations.

Disadvantages

i) The issues are not priced at current market price.

ii) Issue price of materials does not represent actual cost price and therefore a profit or loss may arise.

iii) It involves considerable amount of clerical work.

LIFO

Advantages :

The following are the advantages of LIFO method.

i) It is simple to operate and easy to understand.

ii) It is appropriate for matching cost and revenue.

iii) Closing stock will be valued at earlier price and will not, therfore show unrealised profit.

Disadvantage :

The main disadvantages of LIFO method are as followes.

i) Calculations become complicated when rates of receipts are highly fluctuating.

ii) Closing stock are not valued at current market price. It is valued at unreal and outdated cost.

iii) The stocks require to be adjusted during falling prices.

Financial implications of changing from lifo to fifo:

Without inflation, all three inventory valuation methods would produce the same results. Unfortunately, prices do tend to rise over the years, and the company’s method costing method affects the valuation ratios.

During periods of inflation, the FIFO gives a more accurate value for ending inventory on the balance sheet. On the other hand, FIFO increases net income (due to the age of the inventory being used in cost of goods sold) and Increased net income can increase taxes owed.

Using LIFO during periods of inflation tend to show and ending inventory amount on the balance sheet that is much lower than what the inventory is truly worth at current prices, this means lower net income due to a higher cost of goods sold.

With average cost, the results fall in between FIFO and LIFO. Keep in mind deflation (falling prices) have an opposite effect on each method.

Recommendation

Since the company is already dealing in lifo and also its product is not of perishable nature as well as this market is not so inflation prone , therefore it is recommended to continue with lifo method only.