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Companies need to determine the cost of goods sold and the value of ending inventory to be reported in the balance sheet. Based on your readings of the text book and other material, discuss the four important cost flow assumptions companies use to arrive at the cost of goods sold and the value of inventory on hand. Illustrate each cost flow assumption with examples.

Answer 1

Ans:

Cost flow assumptions means the methods or techniques which are available for moving the costs of a company products from its inventory to cost of goods sold. Companies uses cost flow assumptions for valuing the inventory because it is highly difficult for monitoring the flow of inventory physically.

The method which the company selects can make a difference in the reported costs of goods sold, inventory valuation and majorly the net income.

The four methods of cost flow assumptions are as follows:-

1. First-in-First-Out : if the company uses this method the units which are purchased first should be sold out first. In other words, the units which are purchased at the last are always the left ones inventory in stock and the last purchased items will be sold at last.

2. Last-in-first out : If the company uses this method, it is assumed that the last units purchased are to be first sold out. This would result that the first purchased units will remain in the inventory as stock remaining. This method usually produces different results depending on whether uses a periodic or perpetual systems. If the company uses the LIFO method, then the firm must provide extra disclosures in the financial statements. LIFO method is controversial as the firm can make an extra purchase of an inventory at the end of the period and change costs of goods without making another sale.

3. Weighted Average Method : In this method, the company should divide the total cost of goods available for sale by thr Total number of units available for sale. This method is also called average cost method.

4. Specific identification:- This method is mostly oftenly used for high priced inventory. In this method whire calculating costs of goods sold we must ignore the selling price because the selling has nothing to do with the cost.