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This week we turn our attention to the various inventory methods allowed by GAAP and the variety of depreciation methods accountants are allowed to choose from when depreciating a firms assets. Accounting is not as strict as some believe in that it does allow for the selection of more than one approved method in each category. Who says accounting is not flexible!
One of the first things to recognize when we discuss inventory methods is that the method chosen to account for inventory has nothing whatsoever to do with the actual physical flow of materials through the firm’s warehouse and out to the customer. This seems to be a hard concept for those new to accounting to grasp, but it is true. A firm can choose to account for its physical flow of goods using the Last-In First-Out (LIFO) but can account for the inventory in the accounting records using the First-In First-Out method. If you owned a grocery store, as an example, wouldn’t you want to move the oldest inventory first (FIFO) so it doesn’t deteriorate and go bad?
In a period of rising prices, which is the norm for our economy, the FIFO method of inventory, when used for costing purposes, will result in the firm selling the cheaper goods first (on paper anyway) and leaving the goods purchased last, the more expensive goods, in inventory. This means the Balance Sheet will reflect an inventory value that is close to actual cost. However, by selling the goods that cost less first the cost of goods sold will be lower and as a result, profits will be higher.
LIFO will result in exactly the opposite action. Under LIFO, the firm would be selling the higher cost inventory (on paper anyway) first, so the Balance Sheet would reflect an inventory value that would contain the lower cost items so the inventory value would not reflect current replacement cost. At the same time the cost of goods sold would be higher under this method, resulting in higher expenses and lower profits. Lower profits also mean lower taxes, right?
Finally there is a method called average cost which ends up costing the sold merchandise at a price in between FIFO and LIFO. While this method can be a little tedious, inventory software makes this method less cumbersome to use than it otherwise would be. Under this method, every time new inventory is purchased the average price of those units and the units already in inventory are averages together to arrive at a new average cost to be utilized for inventory costing purchases.
One might get the notion that a firm could switch from one inventory method to another when it is financially beneficial to do so, but GAAP and the IRS have rules against that. Basically you can switch from any method to LIFO by just submitting a form to the IRS. Once you select LIFO however, you will be required to use it from that point on, except in very rare cases. So, the typical inventory method chronology is that most firms start out using FIFO because this results in the most profit being shown on the financial statements. As time goes on the firm becomes less concerned about higher profits and becomes more concerned about saving tax dollars. At that time they switch to LIFO, which results in a onetime large tax savings for the firm. Once this is done, the firm must remain with the LIFO method.
Switching gears now to depreciation: Depreciation is really nothing more than the systematic allocation of a fixed assets cost to expense over some predetermined period of time. Many make the mistake of assuming that depreciation is trying to keep the book value of the asset and the fair market value (FMV) at the same figure. Nothing could be further from the truth. Take a quick look at this video before you move on: https://www.youtube.com/watch?v=dkalfcO_TZg
When a firm purchases a depreciating asset, like equipment or a building, the IRS allows the firm to write off (expense) that value to expense in a systematic fashion. Three methods addressed by the text (there are others by the way) are straight line, double-declining balance, and units of output methods. Under the straight line method, the asset cost less the asset salvage value is divided by the estimated useful life of the asset. This becomes the annual depreciation expense that can be taken to the income statement. More expense means less profit and less tax, so everyone is happy, right?
The double-declining balance method is called an accelerated depreciation method and results in higher depreciation amounts being expensed in the early years of an assets life. Higher expense means lower taxes, making this method fairly popular among firms. Under this method the rate of straight line depreciation is doubled. For example, if equipment costing $100,000 with $20,000 salvage was depreciated over 5 years under straight line depreciation, you would say the rate of depreciation is 1/5 years or 20%. So the double declining-balance method takes the 20% straight line rate and doubles it to 40%. This 40% figure is then multiplied times the asset cost (no salvage value is deducted up front under this method) which results in $40,000 of depreciation expense being taken in the first year. Under the straight line method annual depreciation expense would have been (100,000 – 20,000)/5 = $16,000.
The units of output method takes the approach that an asset wears out through use, so to figure the rate to use for depreciation one would estimate the number of units (or miles perhaps for a vehicle) that the asset is good for and then divide the asset cost by the estimated units to get a per unit figure for depreciation. Anytime a unit is produced a portion of the depreciation is then allocated to expense.
The text does a good job of showing you examples of each of these, so take some time to do the reading and then we will discuss some of these concepts in the discussion threads this week.
This week’s deliverables include:
Read Chapters 5 & 6 in the text. ( ATTACHED)
QUESTION : MINIMUM 250 WORDS
LIFO vs. FIFO
The controller of Sagehen Enterprises believes that the company should switch from the LIFO method to the FIFO method. The controller’s bonus is based on the next income. It is the controller’s belief that the switch in inventory methods would increase the net income of the company. What are the differences between the LIFO and FIFO methods?
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