Blogging about forensic accounting, my life, and anything else I feel warrants it. Disclaimer: Anything found on this site is not intended to be professional advice. If you are in need of professional advice, please contact a professional to give it.
A little US vs. International
Published on February 16, 2006 By Jythier In Business
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?

Comments
on Feb 16, 2006

Damn!  I actually understood and agree with you! And I am not an accountant!

I do believe that is what the Oil companies are doing.  It is legal, but what if they did another method?  Ouch!  They would be tarred and feathered!

(BTW:  One of my best friends does that stuff for a living.  Down in Louisiana)

on Feb 16, 2006
To further complicate things, companies that use one method are allowed one inventory conversion during the life of the company...sort of a "get out of jail" free card.

However, granting that no method is 100% accurate, why shouldn't a company be allowed to select as long as they hold to a consistent method thereafter? If a company is in a high-volume business, high turnover of inventory, then LIFO is the more accurate. For a company as described, during periods of rising costs, FIFO or even averaging would understate inventory.

Is there a specific company practice, as the esteemed Dr. Guy suggests, that raises this question?
on Feb 16, 2006

To further complicate things, companies that use one method are allowed one inventory conversion during the life of the company...sort of a "get out of jail" free card.

Yea!  Kind of like microsofts conversion!  hehehehehe

However, granting that no method is 100% accurate, why shouldn't a company be allowed to select as long as they hold to a consistent method thereafter?

I dont think he is suggesting not granting it. Just pointing out the benefits of them.

on Feb 18, 2006
Accounting will never be 100% accurate. But why stick with a method practically guaranteed to be innaccurate? But, you're right, consistency is what really matters.

Dr Guy, I'm glad you understood without accounting training! That's one of my purposes here, to talk about accounting issues and see what the 'guy on the street' has to say about it. It's all well and good for just the super intelligent accountants to talk about it, but what does a regular Joe investor need to see on the financials?
on Feb 28, 2006

Dr Guy, I'm glad you understood without accounting training! That's one of my purposes here, to talk about accounting issues and see what the 'guy on the street' has to say about it. It's all well and good for just the super intelligent accountants to talk about it, but what does a regular Joe investor need to see on the financials?

I fly under false flag.  I had a year of accounting  in college.  Which makes me wise enough to be incompetant.  I guess!