Question

In looking at the various ways to account for Inventory and Depreciation for Fixed Assets, discuss some flaws of accounting that you have identified and your interpretation of the various methods that businesses can choose from when setting up accounting policies for these areas within their operations.

Answer 1

Inventories Accounting Policy:

Effects of Choosing Different Inventory Methods

There are 4 methods for valuing Inventory.The differences for the four methods occur because the company paid different prices for goods purchased. No differences would occur if purchase prices were constant. Since a company’s purchase prices are seldom constant, inventory costing method affects cost of goods sold, inventory cost, gross margin, and net income. Therefore, companies must disclose on their financial statements which inventory costing methods were used.

Advantages and disadvantages of FIFO The FIFO method has four major advantages: (1) it is easy to apply, (2) the assumed flow of costs corresponds with the normal physical flow of goods, (3) no manipulation of income is possible, and (4) the balance sheet amount for inventory is likely to approximate the current market value. All the advantages of FIFO occur because when a company sells goods, the first costs it removes from inventory are the oldest unit costs. A company cannot manipulate income by choosing which unit to ship because the cost of a unit sold is not determined by a serial number. Instead, the cost attached to the unit sold is always the oldest cost. Under FIFO, purchases at the end of the period have no effect on cost of goods sold or net income.

The disadvantages of FIFO include (1) the recognition of paper profits and (2) a heavier tax burden if used for tax purposes in periods of inflation. We discuss these disadvantages later as advantages of LIFO.

Advantages and disadvantages of LIFO The advantages of the LIFO method are based on the fact that prices have risen almost constantly for decades. LIFO supporters claim this upward trend in prices leads to inventory, or paper, profits if the FIFO method is used. During periods of inflation, LIFO shows the largest cost of goods sold of any of the costing methods because the newest costs charged to cost of goods sold are also the highest costs. The larger the cost of goods sold, the smaller the net income.

Those who favor LIFO argue that its use leads to a better matching of costs and revenues than the other methods. When a company uses LIFO, the income statement reports both sales revenue and cost of goods sold in current dollars. The resulting gross margin is a better indicator of management’s ability to generate income than gross margin computed using FIFO, which may include substantial inventory (paper) profits.

Supporters of FIFO argue that LIFO (1) matches the cost of goods not sold against revenues, (2) grossly understates inventory, and (3) permits income manipulation.

The first criticism—that LIFO matches the cost of goods not sold against revenues—is an extension of the debate over whether the assumed flow of costs should agree with the physical flow of goods. LIFO supporters contend that it makes more sense to match current costs against current revenues than to worry about matching costs for the physical flow of goods.

The second criticism—that LIFO grossly understates inventory—is valid. A company may report LIFO inventory at a fraction of its current replacement cost, especially if the historical costs are from several decades ago. LIFO supporters contend that the increased usefulness of the income statement more than offsets the negative effect of this undervaluation of inventory on the balance sheet.

The third criticism—that LIFO permits income manipulation—is also valid. Income manipulation is possible under LIFO. For example, assume that management wishes to reduce income. The company could purchase an abnormal amount of goods at current high prices near the end of the current period, with the purpose of selling the goods in the next period. Under LIFO, these higher costs are charged to cost of goods sold in the current period, resulting in a substantial decline in reported net income. To obtain higher income, management could delay making the normal amount of purchases until the next period and thus include some of the older, lower costs in cost of goods sold.

Tax benefit of LIFO The LIFO method results in the lowest taxable income, and thus the lowest income taxes, when prices are rising. The Internal Revenue Service allows companies to use LIFO for tax purposes only if they use LIFO for financial reporting purposes. Companies may also report an alternative inventory amount in the notes to their financial statements for comparison purposes. Because of high inflation during the 1970s, many companies switched from FIFO to LIFO for tax advantages.

Advantages and disadvantages of weighted-average When a company uses the weighted-average method and prices are rising, its cost of goods sold is less than that obtained under LIFO, but more than that obtained under FIFO. Inventory is not as badly understated as under LIFO, but it is not as up-to-date as under FIFO. Weighted-average costing takes a middle-of-the-road approach. A company can manipulate income under the weighted-average costing method by buying or failing to buy goods near year-end. However, the averaging process reduces the effects of buying or not buying.

The four inventory costing methods, specific identification, FIFO, LIFO, and weighted-average, involve assumptions about how costs flow through a business. In some instances, assumed cost flows may correspond with the actual physical flow of goods. For example, fresh meats and dairy products must flow in a FIFO manner to avoid spoilage losses. In contrast, firms use coal stacked in a pile in a LIFO manner because the newest units purchased are unloaded on top of the pile and sold first. Gasoline held in a tank is a good example of an inventory that has an average physical flow. As the tank is refilled, the new gasoline mixes with the old. Thus, any amount used is a blend of the old gas with the new.

Although physical flows are sometimes cited as support for an inventory method, accountants now recognize that an inventory method’s assumed cost flows need not necessarily correspond with the actual physical flow of the goods. In fact, good reasons exist for simply ignoring physical flows and choosing an inventory method based on other criteria.

Advantages and disadvantages of specific identification Companies that use the specific identification method of inventory costing state their cost of goods sold and ending inventory at the actual cost of specific units sold and on hand. Some accountants argue that this method provides the most precise matching of costs and revenues and is, therefore, the most theoretically sound method. This statement is true for some one-of-a-kind items, such as autos or real estate. For these items, use of any other method would seem illogical.

One disadvantage of the specific identification method is that it permits the manipulation of income. For example, assume that a company bought three identical units of a given product at different prices. One unit cost $ 2,000, the second cost $ 2,100, and the third cost $ 2,200. The company sold one unit for $ 2,800. The units are alike, so the customer does not care which of the identical units the company ships. However, the gross margin on the sale could be either $ 800, $ 700, or $ 600, depending on which unit the company ships.

Which is the correct method? All four methods of inventory costing are acceptable; no single method is the only correct method. Different methods are attractive under different conditions.

If a company wants to match sales revenue with current cost of goods sold, it would use LIFO. If a company seeks to reduce its income taxes in a period of rising prices, it would also use LIFO. On the other hand, LIFO often charges against revenues the cost of goods not actually sold. Also, LIFO may allow the company to manipulate net income by changing the timing of additional purchases.

The FIFO and specific identification methods result in a more precise matching of historical cost with revenue. However, FIFO can give rise to paper profits, while specific identification can give rise to income manipulation. The weighted-average method also allows manipulation of income. Only under FIFO is the manipulation of net income not possible.

Generally, companies use the inventory method that best fits their individual circumstances. However, this freedom of choice does not include changing inventory methods every year or so, especially if the goal is to report higher income. Continuous switching of methods violates the accounting principle of consistency, which requires using the same accounting methods from period to period in preparing financial statements. Consistency of methods in preparing financial statements enables financial statement users to compare statements of a company from period to period and determine trends. If we switch inventory methods, we must restate all years presented on financial statements using the same inventory method.

Depreciation on Fixed Assets:-

Depreciation is the expired or used portion of a fixed asset during an accounting period.

This is taken into account to achieve the matching principle of matching revenues earned during an

accounting period with the expenses incurred during that period. Since plant assets have useful life

spreading over a number of accounting periods, the portion used in one accounting period is charged to

Income Statement of that accounting period in the form of Depreciation Expense.

Land is recorded at cost, other fixed assets are recorded at Book Value i.e. cost less

accumulated depreciation. For this, separate Depreciation Expense and Accumulated Depreciation

Accounts for different plant assets are maintained. It must also be noted that depreciation is a process of

cost allocation and not a process of valuation as such.

Methods Of Computing Depreciation:-

There are several methods for calculating depreciation. At this stage, we will discuss only two of them

namely:

�  Straight line method or Original cost method or Fixed installment method

�  Reducing balance method or Diminishing balance method or written down method.

Straight Line Method

Under this method, a fixed amount is calculated by a formula. That fixed amount is charged every year

irrespective of the written down value of the asset. The formula for calculating the depreciation is given

below:

Depreciation = (cost ­ Residual value) / Expected useful life of the asset

Residual value is the cost of the asset after the expiry of its useful life.

Under this method, at the expiry of asset's useful life, its written down value will become zero. Consider

the following example:

Advantages of Straight-Line Depreciation

Straight-line depreciation, also known as the fixed or equal-installment depreciation method, is the simplest and most widespread form of depreciation used by businesses. It is suitable for assets that operate uniformly and consistently over the life of the item. The fixed method is straightforward, uncomplicated, easy to understand and simple to apply. Each year the same amount of money is taken as a depreciable business expense on the company's tax return. Straight-line depreciation is suitable for less expensive items, such as furniture, that can be written off within the asset's defined legal, estimated or commercial life. The IRS sets guidelines for estimating an asset's useful life.

Disadvantages of Straight-Line Depreciation

Most pieces of office equipment, machinery and other items purchased do not perform exactly the same each year. As assets age they become less efficient. Repair costs usually increase over time. Straight-line depreciation does not account for the loss of efficiency or the increase in repair expenses over the years and is, therefore, not as suitable for costly assets such as plant and equipment. The functional life span of some assets cannot clearly be estimated. The straight-line depreciation method should not be used when the useful life of an asset is unpredictable.

Reducing Balance Method

Under this method, depreciation is calculated on written down value. In the first year, depreciation is

calculated on cost. Afterwards written down value is calculated by deducting accumulated depreciation

from the cost of that asset(cost ­ accumulated depreciation) and depreciation is charged on that value. In

this method, the value of asset never becomes zero. In this method, depreciation is calculated on written down value. In the first year, depreciation is calculated on cost. Afterwards written down value is calculated by deducting accumulated depreciation

from the cost of that asset (cost ­ accumulated depreciation) and depreciation is charged on that value.

ADVANTAGES OF THE WRITTEN DOWN VALUE METHOD OF DEPRECIATION:

1. This method is simple to understand and easy to operate. A separate calculation need not be made in respect of every addition to the main asset.
2. The amount of annual depreciation reduces with the reducing balance of the asset.
3. The amount of depreciation is higher in the earlier years when the machine is efficient and the cost of repairs is low. In later years amount of depreciation becomes lower and the amount of repairs increase due to extended use and wear & tear of the Asset. Thus the total charge for depreciation and repairs together remains more or less uniform over the years. This helps in eliminating huge variations in annual profits or losses.
4. This method takes care of the obsolescence problem related to the assets as the major part of depreciation is charged in the earlier years. Due to this feature replacement of the assets before the end of its estimated useful life becomes easy and feasible.
5. This method is recognised by tax authorities and other legal bodies.

In spite of having so many advantages this method is not free from demerits. Below we will see some of the demerits of the written down value method of depreciation.

DISADVANTAGES OF THE WRITTEN DOWN VALUE METHOD OF DEPRECIATION:

1. Under this method the book value of an asset cannot be reduced to zero.
2. The rate of depreciation has to be very high if the written down value is to be brought down to its estimated scrap value.
3. This method is not suitable for an asset having a very short life. The calculation of the rate of the depreciation becomes very difficult and creates problems in this case.

The management of the business selects the policy for charging depreciation. There is no law binding on

the management. The management is free to choose method of depreciation and policy of charging

depreciation. Normally two policies are commonly used:

�  Depreciation on the basis of use

�  In the year of purchase, full year's depreciation is charged; where as, in the year of sale no

depreciation is charged.

Now it is up to the management to decide, what method and what policy is better and effective for their

business