From: Accounting and Finance Department
To: Production Department
Subject: Inventory Accounting Explanation
The accounting and finance department received a complaint from your department namely the production department regarding the ending inventory in the latest production cost report. According to the complaint received, your department contested the identified ending inventory in the report that indicated it was equivalent to 2,000 units. However, your department alleges that the ending inventory on hand is more than double of the 2,000 equivalent units reflected in the report. The misunderstanding on the reported ending inventory is due to the inventory accounting method that has been employed in computing the value of the ending inventory. The inventory accounting under the generally accepted accounting principles (GAAP) can be done using three different methods namely first in, first out (FIFO) method, last in, first out (LIFO) or weighted average cost method (Needles & Powers, 2011).
The FIFO approach determines the value of the inventory by assuming that the goods sold are the first to be produced (Deegan, 2013). Thus, the value of the ending inventory applies the recently cost of goods produced or purchased. In contrast, the LIFO approach assumes that the latest purchased or produced goods are the first to be sold (Needles & Powers, 2011). Thus, the value of the ending inventory employs the cost of the first purchased or produced goods. The last method of the weighted average cost method determines the value of the inventory by using the average cost of all goods that are similar, which have been produced or purchased in a given financial period (Trotman, 2018). This aspect of the weighted average cost method means that the total cost of all goods purchased or produced is divided by total number of units sold and remaining in determining the average cost of each unit.
Consequently, the value of the ending inventory is determined by multiplying the units available for sale by the average cost of each unit. Thus, the company’s accounting policy requires that the inventory accounting to be computed using the weighted average method (Trotman, 2018). The use of the weighted average accounting method is the one that has resulted in reporting of lower equivalent units compared to the actual inventory the production department is currently. The accounting for the ending inventory was done using the average cost of each unit for the entire financial period without undertaking a physical counting of the units been held by the production (Needles & Powers, 2011).
The reason behind the reporting of lower equivalent units is because the cost of purchasing the raw materials has increased significantly in the last three months. Consequently, the average cost per unit has skyrocketed that has seen the cost assigned to units produced before the increment of price overstated significantly. The high average cost of units compared to the prior financial periods has seen the assigned equivalent units reducing to 2,000 units. The reported equivalent units are lower compared to the units at hand because the cost of goods sold using the average cost per unit has increased significantly, which has an effect of reducing the reported equivalent units compared to the actual ending inventory on hand. Consequently, the reported equivalent units in the production report is accurate since the accounting policy of weighted average cost method has an effect of overstating or understating the value of the ending inventory depending on the cost fluctuation of produced or purchased inventories in a given financial period (Deegan, 2013).
Deegan, C. M. (2013). Financial Accounting theory. North Ryde: McGraw-Hill Education.
Needles, B. E., & Powers, M. (2011). Principles of financial accounting. Mason, Ohio : South-Western Cengage Learning.
Trotman, K. (2018). Financial Accounting. Melbourne: Cengage Learning.