Question

Prepare a memorandum containing responses to the following items.

(a) Describe the cost flow assumptions used in average-cost, FIFO, and LIFO methods of inventory valuation.

(b) Distinguish between weighted-average-cost and moving-average-cost for inventory costing purposes.

(c) Identify the effects on both the balance sheet and the income statement of using the LIFO method instead of the FIFOmethod for inventory costing purposes over a substantial time period when purchase prices of inventoriable items arerising. State why these effects take place.

Short answer

The cost flow assumption is related to matching cost flow with the physical flow of goods. Under LIFO ending inventory would be lower during the inflation period, and average cost computation is different under periodic and perpetual systems.

Step-by-step solution

Cost flow assumption

Cost flow assumption is the way of taking the flow of cost for every issue or withdrawal of inventory from the pool. Inventories are acquired at different costs at different times. But the physical flow of goods may be in any sequence. So through the cost flow assumption, the physical flow of goods is matched with the cost flow of goods.

Cost flow assumption under FIFO

Under the FIFO system, it is assumed that the inventories are issued or withdrawn in the same way they were acquired. So the cost flow is matched in the same manner of acquisition,

Cost flow assumption under LIFO

Under the LIFO system, inventories issued or withdrawn are assumed to be in the opposite direction of acquiring them. So, in this system, the cost flow matches the recently acquired inventories.

Cost flow assumption under Average

The average method of inventory valuation assumed that irrespective of the acquisition date, the inventories are always utilized based on average cost. This average cost may be a moving average or weighted average.

Weighted average and the moving average cost

Weighted average cost

The weighted average cost is applied in the periodic system. Under this method, all the inventories are average at the end of the period, and the COGS is also determined on that basis.

Moving average cost

The moving average cost is different from the weighted average cost. This is applied under the perpetual system. Under this method, the inventories are averaged at each purchase or sale. The ending inventory and COGFS would be based on the latest average cost.

LIFO vs. FIFO effect

Under LIFO, the COGS are valued based on the reverse order of acquiring them. Thus ending inventory under this method would always be lower than the market price. Under FIFO, the ending inventory matches with the current market prices, and COGS would be lower than the market rate.

In the given case, as market prices are rising, there would be a widening gap between the market value of inventory and ending inventory on the balance sheet. Further, the COGS would be kept on increasing. As a result, net gross profit would be lower year on year, and current assets would also start falling.