MGT101 Financial Accounting GDB 1 Solution Spring 2013

Discussion Question:

Mr. Arslan is a newly employed accountant of Good Company Limited (GCL). He records cost of goods sold at most recently purchase price and inventory at cost of earliest purchases to minimize the amount of tax burden in the period of inflation. Due to this, profitability of the firm is reduced as intended but current replacement cost of inventory is not showing a true and fair result in balance sheet and lower profit is also posing a poor impact on its share’s market price.

  1. Which costing method for inventory valuation is currently applied by Mr. Arslan?
Solution: He is using LIFO method  Here it is assumed that newer inventory is sold first and older remains in inventory. When prices of goods increase, cost of goods sold in LIFO method is relatively higher and ending inventory balance is relatively lower. This is because the cost goods sold mostly consists of newer higher priced goods and ending inventory cost consists of older low priced items.
  1. Which costing method for inventory valuation do you suggest to overcome the above mentioned problem? Support your answer with logical reasons.

Solution: Fifo method should be used to avoid this problem According to FIFO, it is assumed that items from the inventory are sold in the order in which they are purchased or produced. This means that cost of older inventory is charged to cost of goods sold first and the ending inventory consists of those goods which are purchased or produced later. This is the most widely used method for inventory valuation. FIFO method is closer to actual physical flow of goods because companies normally sell goods in order in which they are purchased or produced.