Module 4: GAAPs in the Preparation of Financial Statements
Companies, both private and public, rely on GAAPs in the preparation of financial statements. An example of these guidelines is the principle of consistency, which requires firms to maintain one method of accounting. Consistency in accounting is essential because it helps shareholders compare an organization’s performance from one period to another to make investment decisions. Regardless of these accounting rules’ prescriptive nature, businesses can switch from one inventory costing method to another if the change is accounted for in the records.
Tax savings is one of the reasons why firms may decide to switch inventory accounting method. Companies that plan to incur lower taxes may adopt valuation procedures that generate a higher cost of sales and lower closing inventory (Edori & Ohaka, 2018). Such decisions may be made by businesses that suffer from huge financial losses. The nature of price stability may also influence a corporation’s choice. For instance, price fluctuations may impact a company’s decision to select the weighted average method (Edori & Ohaka, 2018). However, the financial statements should explain any changes in these methods.
Companies’ choice of financial accounting inventory method may either increase or reduce their tax savings. For instance, firms may choose FIFO to enjoy inflated prices (Edori & Ohaka, 2018). Profits generated from this method lead to increased tax expenses. The use of LIFO may result in higher costs of inventory, lower profits, and fewer taxes. However, the weighted average method may facilitate maximum tax savings.
Lastly, inventory accounting methods impact an organization’s income statements and balance sheets. The cost of goods sold, which are documented in the income statement, may vary depending on the selected accounting method. Similarly, the value of inventory recorded in the balance sheet depends on a company’s choice of valuation. A switch in this method may increase or decrease net income in the profit and loss account. For instance, a change from LIFO to FIFO during inflation may result in higher income and lower levels of inventory recorded in the income statement and balance sheet, respectively.
Edori, D., & Ohaka, J. (2018). Implication of choice of inventory valuation methods on profit, tax and closing inventory. Accounting and Financial Management Journal, 3(7), 1639-1645.