Question

Describe why you think different inventory cost flow assumptions affect the income statement and the balance sheet. Include in your answer a description of the matching concept that applies to the inventory cost flows and another description with an example about how the inventory flow assumptions affect the income statement and the balance sheet

Answer 1

Inventory Cost Flow Assumptions are Assumptions based on which the Cost of goods sold ( COGS ) is charged to the Profit & Loss Account of the Organization. COGS is the Sales minus the margin over the goods sold. Since profit is a pre decided factor by the Organization for dealing with the Customers; COGS is the factor which is examined and used in the Analysis , Ratios and Examination of the working of the Organization.

There are different cost flow assumptions viz FIFO , LIFO, Average Cost etc . All the assumptions have different impact over the Financial statements, consisting of the Profit and Loss Account and the Balance Sheet.

In FIFO , the cost of goods sold is worked out with the price of inventory , purchased at the First in First Out basis . In other words, the Inventory cost incurred First is charged to Cost of goods sold. Since we know the price of purchases is never the same and it keeps changing , frequently. Generally the pricing is increasing in chronological order while it may so happen the it is decreasing due to certain economic development , across the globe.

Some organizations follow the Average Cost or Weighted average so as to show the variations at the minimum as the impact is almost half when the Average Cost method is adopted.

Yes , we think that different cost assumptions impact the income statement and the balance sheet.

The reasons is as under:

Let us assume that there are purchases @ 50$ , 60$ and 70$ , simultaneously. Now under FIFO ,the COGS shall be affected @ 50$ , while in LIFO , the COGS will be calculated @ $70 . When the Cost assumption is Average Cost, the COGS will be calculated @ $ 60.

In above three different assumptions, the impact over Income statement will go in COGS as well as Inventory . Since Inventory is shown in Income statements as well as balance Sheet , it affects both the income statement as well as the balance sheet.

Matching principle : Matching principle means that the income or expenditure must be recorded into the Financial Statement on “ accrual basis “. Accrual basis is shown by an example below.

The Interest on Bank Borrowings have been booked at $ 9000 pertaining to 9 months but still not received the statement for 3 months. Accrual basis says that the Interest for 12 months has to be recorded , even if the bills have not been received but it has been accrued.

Inventory Flow Assumptions will impact the Income statement as well as balance sheet , as discussed above.

COGS is part of Income statement and Inventory is part of Balance Sheet as well as Income statement . The valuation of Inventory and COGS will be different in each of the case and the impact will also be different.