Theoretical Pricing Model For Inventory Valuation Purposes
Why is it necessary for some form of a theoretical pricing model to be used for inventory valuation purposes?
Inventory evaluation ensures a business can provide a monetary value for the goods and items that makes up their inventory. Inventories are the main current assets of any business and thus they need a proper way of measuring them to ensure the financial statements are accurate. The concept of theoretical pricing helps forecast the potential market prices and thus benefits from the price movement (BOUABAN & RUBIN, 2016. 74). Items, which are judged and undervalued in respect to their theoretical value, are bought and those that are overvalued are sold.
What are some of the criteria to be applied when selecting the method to be used for allocating costs?
Cause and effect This criterion identifies the variables, which causes the cost items to incur cost i.e. through this the management is able to recognize the variables, which make the resources to be consumed. The cause and effect criterion is one of the most credible to the operating personnel and is the main criteria used in an activity based costing applications.
Benefits received. This is the best alternative criterion when the management cannot determine the cause and effect relationship. Through this criterion, the managers are able to identify the recipients of the outputs of the cost item. The costs of the costs items are allocated to the beneficiaries according to the benefits received by each (KINNEY & RAIBORN, 2009. 472). A good example is advertising where the costs of running the adverts can be allocated based on division of revenues whereby the higher the revenue the greater the division allocated to that beneficiary.
Fairness and equity.This criterion is widely used in the government contracts where the cost allocations are the basis of establishing a reasonable price that is acceptable to the government and its suppliers (KINNEY & RAIBORN, 2009. 474). Here the cost allocation is viewed as fair and reasonable way to establish a price between the two parties.
Ability to bear criterion is used to allocate costs to the costs items’ ability to bear the amount of cost allocated.
Evaluate and analyse the differences between inventory valuation methods and the advantages/disadvantages of each.
There are three major approaches use in valuation of inventory allowed by GAAP .
First-in, first out approach. In this approach, the cost of items sold is based upon the cost of the resources bought earliest in the period while the inventory cost is based on the cost of the resources, which were bought later on in the year, and the results are the inventories being valued close to the current replacement cost.
- it is easier to use and apply
- the assumed flow of costs corresponds to the normal physical flow of goods
- it is impossible to manipulate income
- balance sheet amount of inventory is mostly going to reflect the current market value
- The taxes are higher if it is used for tax purposes
Last-in, first-out In this approach, the cost of the items sold is based on the cost of the materials bought towards the end of the period, which results to costs that close estimate of the current costs (KINNEY & RAIBORN, 2009). However, on the other hand inventories are valued based on the resources, which were bought early during the year.
- Can lead to better matching of revenues and costs
- The subsequent gross margin is good indicator of the mangers capability to generate income.
- Lower profit margin than FIFO
- Business can have hard time finding investors due to lower profit reports
- Expensive and tedious method
Weighted average Under this method both the costs of the goods sold and the inventory are calculated based on the average cost of all units which were bought during the that period.
- Inventory is not understated as in case of FIFO
- Inventory not as up-to-date as in FIFO
- Companies can be able to manipulate incomes.
Provide a brief insight into the on going controversies surrounding the financial reporting of intangible assets and how this impacts the industry.
The argument is that the cost incurred by the business to create intangible assets has no relationship with the real value of the business. It is difficult to associate a specific value to the recording and accounting of the intangible assets. The purchased intangible assets are recorded as costs and it is clear that the accounting professionals face have a challenge when ot comes to addressing this issue. They have a major problem on how to respond to the criticism on how these assets are measured. Their failure will undermine the crediblity of the reported earnings and the association between these earning and the valuations.
BOUABANA-TEBIBEL, T., & RUBIN, S. (2016). Theoretical information reuse and integration. http://dx.doi.org/10.1007/978-3-319-31311-5.
KINNEY, M. R., & RAIBORN, C. A. (2009). Cost accounting: foundations and evolutions. Mason, OH, USA, Thomson/South-Western.