The paper 'Financial Accounting Issues' is a wonderful example of a Finance and Accounting Assignment. Large Mart is legally allowed to change its inventory accounting system from FIFO to weighted average cost method. According to International Financial Reporting Standards, an entity shall change its policies only if the change results in financial statements providing reliable and more efficient information about the effects of transactions, events, or conditions on entity’ s financial position and cash flows. The change should be adopted retrospectively meaning adjustments should be made as if the new policy has always been in existence (Hussey, 2010).
Disclosure should be made on the reason for a change in policy, the amount of change for the current period, and prior periods. IRS allows one to choose an inventory accounting policy but requires the entity to use it consistently year to year. Nonetheless, the IRS mandates the company to apply the inventory changes method. In such a case, the IRS must be informed in order to acquire permission for the tax year when the initial implementation of the new method of inventory cost was done (Elliott & Elliott, 2008).
As such, it is required that Form 3115 of the IRS be completed and submitted at the beginning of the year when the change was initiated (Elliott & Elliott, 2008). The change should be attached to the tax return for the year in order for the changes to take place. More so, the business must have been ongoing for at least one year. Discuss what impact (if any) a change from the FIFO cost flow assumption to the Weighted-Average cost flow assumption would have on the financial position (balance sheet) of Large Mart.
PLEASE NOTE: You are NOT required to calculate the amount of impact of this change on the balance sheet. Instead, please discuss the POTENTIAL impacts of such a change in general. FIFO FIFO normally considers that the inventory bought is the inventory that should be sold first. As internal operations of the company continue, the FIFO calculates the actual cost. This is important for products that have a relatively shorter shelf life, such products are groceries. As such FIFO allows the realization of both cost and profit incurred on a product.
This also applies in the manufacturing industry because FIFO helps in accounting for the cost of the raw materials as well as the cost incurred in selling every product and hence the profit (Elliott & Elliott, 2008). If FIFO is used but the inventory is damaged or destroyed in any way, one should know exactly the loss in order to account for its value. Nonetheless, FIFO gives the product cost for each product manufactured. If the raw materials for the two units vary, then each of these units will have different costs.
If the cost of marked up to get the selling price, the units will have varying selling process(Elliott & Elliott, 2008). Average Costing Method The prices can be set based on the average inventory cost by increasing the price of the average. This allows for a lower profit margin for expensive inventory. Despite the fact that there will be a lower profit margin, this will be addressed by the higher profit margin on the side of the lower-cost inventory. This is specifically good for companies that are used to mixing their inventories as they come. This method is applied for average profit levels as well as a mean taxable income.
It also works well in assigning the average cost of production of a given product as well as when the inventories are mixed this not possible to assign a given cost to a unit. One main disadvantage of the average costing method is the mixing of the inventory and hence making it difficult to account for every product especially products that cost higher (Elliott & Elliott, 2008). In the event that some inventory bought has to be returned, the mean will be inaccurate using this method.
As such, the existing inventory may be sold for a lower price mark in order to make a reasonable price. Further to this, in the event that some inventory is to be disposed of by applying discounts, it should be based on the average cost. Notably, some will be sold at a loss because their buying price will be higher than others. In this event, the entire inventory must be sold in order to get the average cost back. Impact on The Balance Sheet FIFO normally reports higher inventory in current assets and therefore a higher current ratio.
In the period of the declining cost of materials. FIFO leads to a higher cost of goods sold, lower profit, and consequently lower income tax. The inventory method that is employed by a company in the event of a profitability ratio, the balance sheet is affected. As a result, the current ratio is higher, (the current ratio is computed by dividing the current assets with the current liabilities) (Elliott & Elliott, 2008).
On the contrary, a company employing the average weighted cost on the other hand reports an average ending inventory. This produces current ration. More so, the shareholder's equity is higher in this case under the FIFO method since the average weighted method yields a mean asset base (asset fewer liabilities leads to a higher FIFO). In addition, other balance sheet ratios to consider include, asset turnover (sales divided by assets), the return of equity (net income divided by mean sum of assets), and inventory turnover (COGS divided by the mean inventories) (Elliott & Elliott, 2008).
Elliott, B., & Elliott, J. (2008). Financial Accounting and Reporting. New York, NY: Financial Times Prentice Hall.
Hussey, R. (2010). Fundamentals of International Financial Accounting and Reporting. Michigan: World Scientific.