Management accounting aims at providing the management with information for decision-making. There are several decisions that are made in an organization and they all need different types of information. Among the information required for various decision-making are the costs of products or departments (Marthur, 2009). There are three main techniques used to give the cost of a product or the cost of raw materials used in production. Some important decisions that need to be made using the cost of units of production include the price to charge for the finished goods, decisions whether to reject or accept special orders, buy or make decisions, evaluation of various departments among other decisions (Atrill & McLaney, 1994).
The three methods are the Last in First out Method (LIFO), First in First Out (FIFO) method and the Weighted Average Cost (WAM) method (Devine, 1980). The three costing methods provide different results on the cost of units produced. Under the FIFO method, the cost of units produced is determined depending on the cost of the earliest materials bought. This would result to lower estimates of cost of units produced during inflation. The LIFO method calculates the cost of units of production depending on the cost of material bought lately. This is the closest approximation of the current costs hence it is preferred by many organizations. During inflation, it will result to a higher estimate of the cost of units produced (Bragg, 2005).
Under the weighted average method, the cost of units of production is based on the average cost of all units purchased over the period. The costing method selected has a great effect on the cost of sales and gross margin hence it affects the decisions (Jackson, Sawyers & Jenkins, 2008). Some costing methods are known to be better than others in some situations are. It is therefore important to understand the implications of each costing method in order to assess its suitability. In this paper, the Weighted Average Method is discussed in detail and its implications discussed.
Overview Of Inventory Valuation
According to IAS 2, inventory means the goods bought and held for sale, finished goods awaiting sale and the work in progress in the manufacturing process (Husey & Ong, 2005). Raw materials and work in process includes raw materials, supplies for maintenance of an organization, tools and other material that will become component of the finished products. According to this accounting standard, inventory does not include the cost of fixed machinery, plant and equipment and any other material that does not become a component of the finished good. These items should be accounted in accordance to the guidelines provided in the IAS 10 (Accounting for fixed assets).
Inventory valuation has been used by organizations in order to manipulate and manage earnings. This is perpetrated through choosing a valuation method, which suits the organization time. This has been discouraged by the accounting standards and the international financial reporting standards (IFRS). Regulations have been provided to ensure that organization report objective cost of inventory in the financial statements (Needled & Powers 2009).
According to IAS 2, the valuation of inventory should result to the lower of net realizable value or the cost. The cost of purchase includes the cost, shipping costs, duties and taxes that cannot be claimed from the authorities and any other cost incidental to the purchase of a product (Epstein & Jermakowicz, 2008).
In order to facilitate inventory valuation, there are two main inventory systems, which are periodic inventory system and the perpetual inventory system. In the periodic inventory system, no records are kept about the amount of inventory and any time the organization wishes to know the inventory used and balance, a physical count is conducted. A perpetual inventory system involves keeping records of all purchases, assignment of goods to the production process and any write-offs. Under this system, the amount of inventory issued or remaining in the stores can be determined from the records without a physical count (Debarshi, 2011).
The major issues in inventory valuation and management are the uncertainties the inventory carry along that leads mangers to make unbiased estimates of the cost of inventory. The general guideline is conservatism which advices that it is better to avoid overstatement of assets and income and to understate liabilities. According to the International Financial Reporting Standards (IFRS), the items that make part of inventory are those items that are allowed under the Generally Accepted Accounting Principles (GAAPs). These items include raw materials, work in process, finished goods and other supplies make components of the finished goods (Husey & Ong, 2005).
The major objective of inventory valuation is to determine the cost that will be associated with the cost of goods sold and the ending inventory (Emmanuel, Otley & Merchant 1990). The cost of goods sold has a great effect on the profit margins for an organization. The inventory valuation has been a big issue in the accounting and reporting of financial performance of organizations. The process and methods of inventory accounting have evolved from simple methods to sophisticated methods that will be discussed in the next section.
Since the value of the inventory affects the cost of goods sold, it has a big effect on the financial statements of an organization. First, it affects the statement of affairs since it affects the value of the ending inventory. It also affects the profits reported hence the tax liability for an organization. The major ethical, issues in inventory valuation are income manipulation, earnings managements and tax avoidance (Jackson, Sawyers & Jenkins, 2008).
The History Of Inventory Accounting
Estimation of the cost of inventory started back in the 1400s when organizations saw the need to determine the cost of materials used in the production process. The methods used in this period as evidenced by accounts of Francesco di Marco were the cost or market price. Since then, inventory valuation has undergone tremendous changes to become what we know it today. One of the changes was that organizations began valuing inventory at end of the year at less than cot. The rationale was that once purchased, the goods could not be valued at cost due to uncertainties (Weygandt, Kimmel & Kieso, 2009).
The emergence of advanced inventory valuation methods can be traced back to early 1900 when the accounting profession was still young. The LIFO method was not recommended and it became popular and acceptable later (Bragg, 2010).
Before the inventory valuation methods came into place, the base-stock method was being used to determine the value of the percentage of the taxpayer’s inventory that was important in a business. This inventory was valued at the original cost basis since it was considered part of fixed assets. Upon depletion of the old asset, a new inventory would be written down at the original cost to replace the reserve of the depleted asset. Whenever an organization bought new inventory, the inventory was valued using the lower of cost or market cost (Salter & Sharp, 2006).
Inventory Valuation Methods
One major objective of the Generally Accepted Accounting Principles (GAAPs) is to ensure that the inventory sold during a period is matched with the expenses that were incurred during that period. There are however, differences in ideas on the cost, which should be associated with the inventory sold because of the fluctuations of the raw materials in the market. According to FIFO, the cost to be associated with the cost of goods sold and the ending inventory is the initial cost of inventory while according to LIFO, the cost should be the current cost of raw materials. However, the Weighted Average Method establishes the cost based on the standard cost of the resources used. There is no correct or wrong method among the three and an organization is free to choose any.
There are however some legal restrictions on the use of inventory valuation methods in various countries. Managers of organizations use the LIFO method to publish inferior balance sheet and income statements in order to take tax advantages. The book tax conformity rule thus discourages the use of the LIFO method but does not prevent its use (Jackson, Sawyers & Jenkins, 2008).
Each of the three inventory methods has its own benefits to an organization in various economic situations. For instance, when there is inflation in the economy, firms that use LIFO are advantaged because they report a lower income and thus advantage of tax benefits. On the other hand, when the prices are falling, it will be advantageous for the organizations to use FIFO method (Brechner, 2009). The weighted average method is a compromise and can be used in various scenarios.
It is worth noting that firms are not free to switch from one method of inventory valuation to another without seeking approval of the International Reporting Standards (IRS). This is to prevent organizations from earnings management and revenue manipulation through using different inventory valuation methods depending on changes in prices. In order to switch from one method to another, an organization has to notify and seek approval of the IRS and be prepared to meet the costs associated with the switch (Nandakumar, Mehta & Ghosh, 2009).
It can be concluded that the major consideration to make when choosing an inventory valuation method is the effect of the method on the income and balance sheet of the organization and in essence the effect on the taxable income. The LIFO method results to an understatement of the inventory on the balance sheet but reduces the reported income hence it makes an organization to enjoy lower taxes.
The Weighted Average Method Of Inventory Valuation
This gives the total cost of ending inventory and the total cost of goods sold respectively (Benerjee, 2008). The process of valuing inventory using the weighted average method is quite simple. It involves simple basic steps. The first step is the creation of a chart, which shows the date of purchase of raw materials, the number of units purchased the cost per unit and the total cost. Once a purchase is made, it is recorded on in the chart and all the fields filled. All the subsequent purchases of raw materials are recorded until the end of the period when all the totals for the quantity and purchase price are made (Warren, Reeve & Duchac, 2008). The number of units to give the average cost per unit divides the total purchase amount for the period.
Table 1: chart for calculating average cost
|PURCHASE DATE||NUMBER OF UNITS||COST PER UNIT||TOTAL COST|
Weighted average cost per unit = total cost for the period/total number of units purchase in the period.
The Weighted Average Method Debate –Proponents
The weighted average method is a compromise between the LIFO and FIFO methods and it seeks to eliminate the differences between the two methods of inventory valuation. The proponents of the weighted average method of inventory valuation claim that the method results to an objective and rational valuation of the ending inventory and cost of goods sold (Devine, 1980). By making use of this method, an organization is confident that there is neither understatement nor overstatement of the income of the organization.
Another argument by the proponents of the weighted average method of inventory valuation is that the method is simple to use and it eliminates the logistical difficulties of keeping track of the physical flow of goods in the organization. In the LIFO and FIFO methods, an organization must keep clear records that differentiate between the various batches, which are brought into the organization. The weighted average method needs just a simple record of the amount of goods purchased every time and the costs. Calculation of the average cost is quite simple (Young, 2003).
Another advantage of the weighted average method is that it eliminates the possibility of earnings management and revenue manipulation by organizations. Managers for organizations can use the LIFO and FIFO methods to report different revenue figures for different periods in order to advance their interests. It is important to note that this possibility of using the LIFO and FIFO methods for earnings management and revenue manipulation is sealed by several regulations but there are loopholes (Debarshi, 2011).
Organizations can rely on this method to match the costs of the goods sold with the revenue realized over the period. Through averaging, the method gives the best approximate of the cost that should be charged over the period. Scholars have always trusted the ‘average’ to be a representative of the entire dada hence the weighted average method provides a cost that represents the cost for the entire period in which the firm has operated. The weighted average method is therefore in line with the Financial Accounting Standard 157 (FAS 157) which provides that all the items in the financial statements should be given at the fair value. The average is a good measure of fair value (Epstein & Jermakowicz 2008). The weighted average cost of inventory method is a compromise between the LIFO and FIFO methods and it eliminates bias in reporting.
The Weighted Average Method Debate – Opponents
The opponents of the use of the weighted average method for inventory valuation argue that the method is an over-simplification of inventory valuation. They argue that the method does not have enough logical bases and it is only useful to lazy practitioners who cannot bear the pressure of working with LIFO and FIFO methods. It is therefore written off as a method ideal for organizations, which does not understand their inventory well (Salter & Sharp, 2006).
Another argument by the opponents of the use of weighted average method of inventory valuation is that the method does not reflect price changes well. During times of inflation or decreasing prices, the weighted average method cannot be counted on to produce a cost that reflects well on the current price of the market. This method is thus useful for periods of stable prices and since prices are rarely stable, the method is unsuitable.
The disadvantage of the weighted average inventory valuation method is that it is a compromise and it does not result to accurate reporting on the cost of sales and cost of ending inventory (Atrill & McLaney, 1994). The method may thus result to material misstatement in the income statement and balance sheet. This is because it times of great changes in prices, the weighted average method does not reflect the fair value of cost of goods sold and the ending inventory. According to the opponents, the method is only ideal for periods with minimal price changes.
Effect Of The Weighted Average Method On Financial Ratios
In order to understand the effect of the weighted average method of inventory valuation on the financial ratios, it is good to understand the elements that are affected by the inventory valuation first. These elements of the financial statements affected by inventory valuation are gross profit, net income, and the cost of goods sold, current assets and the owner’s equity. These elements are used to calculate various financial rations hence it is obvious that inventory valuation methods will affect the ratios and in effect decision making (Jackson, Sawyers & Jenkins, 2008).
The weighted average method does not have a big effect on the financial ratios since it provides a compromised figure for the cost of inventory. This is unless the LIFO and FIFO methods which provide either higher or lower cost estimates. The weighted average method provides a figure that is in between the figure that could have been provided by the LIFO or the FIFO method. The method does not result to overstatement or understatement of any element in the financial statements.
Usage Of Weighted Average Method Over The Past
The weighted average method has not been preferred over the past. There are several reasons for this and one of them is that the production process has been simple and the materials used were less. This therefore made the LIFO and FIFO methods easier to use thus management did not see the need to use the weighted average method, which is simpler (Devine, 1980).
Another reason why the weighted average method has not been popular among organizations is the fact that the method cannot be used to manipulate earnings and manage revenue. There were no strict regulations on earning management and thus organizations used the variations of figures in inventory valuation due to different valuation methods to perpetrate the vice. After the downfall of several big organizations like the Lehman brothers, strict regulations have been put in place to prevent earnings management and revenue manipulation (Jackson, Sawyers & Jenkins, 2008).
The Future Usage Of Weighted Average Method
In the future, the writer can foresee the weighted average method of inventory valuation becoming more popular with many organizations. This is because the production process is getting more complex day by day. More and more raw materials are being used in the production process hence usage of the LIFO and FIFO methods are becoming hard. Organizations will therefore opt for the simple weighted average method.
The increasing complexity of business environment increases completion and price instability making organizations to look for ways of smoothening the prices and enhance their competitiveness in a given time period (Brechner, 2009). The weighted average method therefore gives a good opportunity to smoothen the price changes and spread their effects uniformly across the period.
Various regulations have come into place discouraging the use of other inventory valuation methods. A good example is the book-tax conformity rule, which discourages the use of LIFO in disclosing financial performance. These regulations will certainly force organizations to shift to the weighted average method of inventory valuation. The IFRs and the IAS have also tried to discourage organizations from shifting from the use of one inventory valuation method to another in various reporting periods. Shifting from the LIFO to FIFO and vice versa is not easy thus, organizations will see the need to adopt a more compromised approach to inventory valuation (Benerjee, 2008).
According to the discussion in this paper, inventory valuation has a big impact on the financial statements of an organization hence it affects relationship between a firm and its stakeholders greatly. The stakeholders of a firm who need information from the financial statements for decision making are the management, customers, the shareholders, government, the suppliers and the general public (Dennis-Escoffier, 2006). The management needs the information for making decisions such as pricing decisions, profitability analysis, whether to discontinue some operations and the rank departments. Shareholders need to know the profitability of a firm in order to evaluate whether the organization will maximize their value (Bragg, 2010).
The government needs information for calculation of tax liability while the supplier and the general public need to know the general profitability of an organization. Customers need to understand the basis of pricing and know whether the prices charged to them are fair (Dunne & Lusch, 2007). Inventory valuation is thus an important activity since it affects the decisions of almost all the stakeholders in an organization.
The LIFO and FIFO methods of inventory valuation provide different figures while the weighted average method provides a figure that is in between the figures that would have been provided by the two methods. The weighted average method is therefore a compromise between LIFO and FIFO and this is the major reason why proponents of the method say it is more objective. However, the opponents of the method argue that it is an over-simplification of the inventory valuation process hence it is not desirable. Whichever side, the weighted average method is deemed to become the preferred method among the organizations (Dennis-Escoffier, 2006).
My opinion about the use of the weighted average method of inventory valuation is that this method is the best and that it has a great future. This is because nowadays the stakeholders are more concerned with a more rational disclosure in the financial institutions. This means that the LIFO and FIFO methods are losing favor with stakeholders because these methods provide an overstatement or an understatement in the financial statements. It is therefore the views of the writer that the weighted average method is the best and it should be preferred over the others.
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