As April 15 approaches, businesses are faced with a major challenge: They not only need to communicate their tax returns to the IRS, but also their previous year’s profits. Small businesses, self-employed individuals, and freelancers need to take the cash inflow and outflow principle into account when calculating their profit. But what exactly does this mean? This guide will help you through this...
Any company that is required to carry out double accounting has to submit not just one balance sheet, but also a profit and loss report to the Internal Revenue Service (IRS) and local tax authorities. While the balance sheet provides a precise overview of what comprises a company’s assets and liabilities, the profit and loss report represents expenditure and income.
In the USA, companies operate according to Generally Accepted Accounting Principles (GAAP). When it comes to valuing inventory or stock, GAAP allows a company to choose whether they want the weighted-average cost method, the First-In, First-Out (FIFO) method, and the Last-In, First-Out (LIFO) method. When applied correctly, both methods should produce similar results. The main difference is the criteria by which the calculation entries are broken down.
It is also worth noting that most other countries run their business using the International Financial Reporting Standards (IFRS), rather than GAAP. The IFRS and GAAP have different acceptable methods for inventory reversals and write-downs. The International Financial Reporting Standards (IFRS) prohibit the use of the LIFO method, which is often considered rather controversial. If you are running an international company, it may be worth keeping this in mind since your accounting methods will likely vary by country and not always be compatible with one another. In that case, it is recommended to use IFRS for the sake of comparability.
- How the weighted-average cost method works
- How the first-in, first-out (FIFO) method works
- How the last-in, first-out (LIFO) method works
- Why is calculating cost-of-sales important?
- Disadvantages of using a cost of sales method
How the weighted-average cost method works
This method applies a cost to all inventory items based on the entire cost of goods purchased or produced in each time period, divided by the entire number of goods purchased or produced. Put simply, the weighted-average cost method uses a simplified average for all similar goods in inventory, no matter when they were purchased, as well as a tally of all final inventory goods during a given accounting period. By multiplying the average cost per item by the final inventory tally figure, the company works out a sum for the cost of items available for sale at that time. The same average cost can then also be used with the number of goods sold in the previous accounting period to discern the cost of goods sold (COGS).
Advantages and disadvantages of the weighted-average cost method
The weighted-average cost method requires very little effort to undertake and is, therefore, the least expensive of the three available methods. As well as how simple it is to apply the average-weighted cost method, it is more difficult to manipulate income than with other methods. The average-weighted cost method is particularly beneficial to companies that produce almost-identical goods, or companies that find it hard to work out the cost of individual items, as well as when there are vast quantities of similar items passing through an inventory, making it time-intensive and laborious to track each individual item. Since the weighted-average cost method is based on average numbers, this means that the costs assigned to production are not actually the exact costs, and that materials being used in the production of goods may not be charged at the accurate price.
How the first-in, first-out (FIFO) method works
The First-In, First-Out (FIFO) method helps value and manage assets by selling, using and disposing of the first assets produced or acquired before the others. Concerning taxation, FIFO holds that inventory with the oldest costs are included in the income statement’s COGS. After that, the leftover inventory items are matched to the most recently bought or produced assets. This results in the monetary value of the total inventory decreasing due to inventory no longer being in the company’s possession. Put simply, FIFO stipulates that items bought or obtained first are disposed of first, and that the last items remaining are those bought or obtained last.
Advantages and disadvantages of FIFO
There are several advantages associated with utilizing the FIFO method. FIFO is a widely used and accepted method of inventory valuation and is a relatively simple concept to grasp – managers do not need specialist accounting training to use the FIFO method. FIFO makes manipulating the stock valuation with income declared in financial statements much more difficult there are set values to be used in the cost of sales calculations in the income statement. However, despite FIFO being an easy-to-understand cost of sales method, much data collection is required which can result in additional errors. There are also disadvantages to using FIFO if the goods you are valuing fluctuate often in price, or if your country is experiencing fluctuating inflation. When monetary values fluctuate with inflation, so too do the cost of goods which can result in misstated profits.
How the last-in, first-out (LIFO) method works
Last-in, First-out, or LIFO, works the opposite way to the FIFO method. LIFO assumes that the most recently acquired/produced items are sold first, instead of the oldest inventory. LIFO is a beneficial cost of sales method to use for large businesses with a great deal of inventory, such as dealerships or supermarkets. This is because those businesses deal with goods whose prices typically rise year after year, and LIFO helps them to match their income to costs more accurately, as well as permitting them to take advantage of lower taxes since it can lower a business’s net income.
Advantages and disadvantages of LIFO
The primary advantage of using LIFO is that it can help a company save on taxes, as well as make more accurate accounting predictions regarding revenue and costs. However, there are also notable disadvantages to using LIFO. Critics of the method claim that LIFO distorts balance sheet figures when inflation is fluctuating, and that the tax benefit LIFO offers is unfair. It is also important to note that the USA is one of the only countries where LIFO is permitted since businesses in the USA follow Generally Accepted Accounting Principles (US GAAP). However, Japan, Russia, Canada, India and the European Union (as well as many other countries) forbid the use of LIFO since they adhere to International Financial Reporting Standards (IFRS) which does not permit the use of LIFO. However, if your business is only operating within the USA, using the LIFO method is acceptable.
Under GAAP, the USA permits the weighted-average cost method, FIFO and LIFO as cost of sales methods. Countries that adhere to IFRS principles generally accept the use of the weighted-average cost method and FIFO, but do not permit the use of LIFO. If you are running a business which operates in an IFRS country, consult a tax professional to ensure that your accounting practices are legally compliant.
Why is calculating cost-of-sales important?
A decisive advantage of using a cost-of-sales process is finding out the gross profit. Since calculating the cost-of-sales only considers revenues and costs related to sale, it provides a reliable indication of a company’s market success and profitability. Knowing the cost of goods sold helps analysts, investors, and managers estimate the company's bottom line. If COGS increases, net income will decrease. A prudent company will try to keep COGS line with yearly budget forecasts.
Grouping the process into collective areas like sales, production and administration often correspond to structures within large companies. In this way, figures can be used as a basis for management’s decision-making, since they clearly show financial strengths and weaknesses in each area and can help to make more informed decisions about what measures may need to be taken to reduce costs.
Cost-of-sales procedures can be applied to individual product groups, sales areas or distribution channels. It provides the company with comparable results to show whether a product range is performing well on the market or whether individual product lines or sales strategies are unprofitable and should be abandoned.
The income statement should be internationally comparable, if the countries adhere to similar accounting principles (see previous paragraphs on LIFO method).
Disadvantages of using a cost of sales method
A major disadvantage of the process is the amount of effort required. The figures cannot be derived from double-entry accounting, instead, they must be calculated from cost accounting and statistical calculations. This is particularly problematic for small and medium-sized enterprises since they rarely carry out separate cost accounting in addition to their regular bookkeeping.
Cost of sales procedures often raise questions of when and why an asset is valued since operating expenses must be clearly assigned to functional areas (e.g. manufacturing, administration, distribution), which is not always easy. The allocation affects the number of expenses in each area. In addition, the decision regarding allocation should be adhered to throughout subsequent years to ensure consistency.
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