Inventories are usually the largest current asset of a business, and proper measurement of them is necessary to assure accurate financial statements. The accounting method that a company decides to use to determine the costs of inventory can directly impact the balance sheet, income statement and statement of cash flow.
The Free Accounting application is based on the periodic inventory system and proposes three main inventory costing methods: the average costing method (ACM), the first-in first-out method (FIFO), the last-in last-out method (LIFO).
When creating your company you can choose only one of these methods and it will be applied to all items in inventory for the company you create. Unfortunately, it is not possible now to set different costing methods to different types of items.
First In First Out
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Most businesses dispose of goods in the order in which the goods are purchased. This would be especially true of perishables and goods whose styles or models often change. For example, grocery stores shelve their milk products by expiration dates. Thus, the FIFO is often consistent with the physical flow or movement of merchandise.
Assuming positive inflation, FIFO increases profits (as the company charges a higher amount from customers) through recording lower costs (i.e. old prices) and increases the value of stocks recorded in the balance sheet. Under deflation FIFO would have the opposite effect.
If the company uses the FIFO method in Free Accounting, costs are included in the cost of merchandise sold in the order in which they were incurred. The cost of the oldest item is assigned to the first item sold; the cost of the newest item is assigned to inventory.
Example
Last In First Out
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This method may be treated as the opposite to FIFO. The use of the LIFO method was originally limited to rare situations in which the units sold were taken from the most recently acquired goods.
Given positive inflation, LIFO reduces profits as the most recent cost is recorded in the profit and loss account and it tends to understate the value of stocks in the balance sheet. Under deflation the opposite is true.
If the company uses the LIFO method in Free Accounting, the cost of the newest item is assigned to the first item sold; the cost of the oldest item is assigned to inventory.
Example
Average Costing Method
The average-cost method tends to level out the effects of cost increases and decreases because the cost for the ending inventory calculated under the method is influenced by all the prices paid during the year and by the beginning inventory price. The criticism for this method is that the more recent costs are more relevant for income measurement and decision-making.
If the company uses the Average Cost method in Free Accounting, item cost is assigned by dividing the total cost by the number of items.
Example
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