A little US vs. International
Ah, inventory. Lots of businesses have it, so how do we account for it? Well, under the United States Generally Accepted Accounting Principles(GAAP - If anyone works for GAP and sees a misprinted shirt, I will so buy it.) the answer is... it depends. There are four different methods of inventory valuation. They are:
First in, first out (FIFO)
Last in, first out (LIFO)
Average Cost
Specific Identification
Under the International Accounting Standards, LIFO method is eliminated. Why would they do that?
LIFO assumes that whatever you bought at the end of the period was sold throughout the period. That means that no matter what the cost of your inventory actually was throughout the period, your ending inventory is reported at the value of the first thing you bought. Prices are definitely not the same as they were even years ago. So, your ending inventory is reported at inaccurate levels.
So why even have LIFO, if it's so inaccurate? I'm so glad you asked!
Under the US Tax Code, LIFO is allowable. A lot of companies use this method because as prices go up, their cost of goods sold is higher than under the other methods. This lowers their net income, and susequently, their taxes. However, as a part of the tax code, if a company uses LIFO method on their taxes, they must use the LIFO method for their financial statement filings. This keeps companies from reporting lower earnings to the IRS, and then reporting high earnings to Wall Street.
So, in order for the tax code to allow LIFO, GAAP will continue to have LIFO as well.
I believe that weighted average is the best method. It's the compromise. It assigns an equal value to every unit of something, based on the total units and the total costs associated with that unit. So, every period, the average cost is updated based on the new costs, and the old cost is slowly averaged out, whereas LIFO doesn't get rid of the old costs, and FIFO gets rid of them quickly.
Of course, specific identification would be ideal, but that's not cost effective. And isn't that what's really important?