How might the choice of cost flow assumptions affect the company's cost of goods sold and ending inventory balance?

The choice of cost flow assumptions can have a significant impact on a company's cost of goods sold (COGS) and ending inventory balance. There are several commonly used cost flow assumptions, including First-In, First-Out (FIFO), Last-In, First-Out (LIFO), and Weighted Average Cost (WAC). Let's explore how each of these assumptions can affect COGS and ending inventory:

1. FIFO (First-In, First-Out):
Under the FIFO assumption, it is assumed that the first units purchased are the first units sold. This means that the cost of the inventory sold is based on the oldest inventory available. In a period of rising costs, using FIFO will typically result in a lower COGS because older inventory with a lower cost is being used. The ending inventory balance will reflect the most recent purchases and will have a higher cost.

2. LIFO (Last-In, First-Out):
In contrast to FIFO, the LIFO assumption assumes that the last units purchased are the first units sold. This means that the cost of the inventory sold is based on the most recent purchases. In a period of rising costs, using LIFO will typically result in a higher COGS because the most recently incurred costs are being used. The ending inventory balance under LIFO will include the older, lower-cost inventory.

3. WAC (Weighted Average Cost):
The WAC assumption calculates the average cost per unit of inventory based on the total cost of inventory available for sale divided by the total number of units available. Under WAC, both the cost of goods sold and ending inventory are valued at the average cost. If the costs of inventory fluctuate significantly, WAC can reduce the volatility of COGS and ending inventory balances.

The choice of cost flow assumption should align with the company's objectives and the industry it operates in. For example, LIFO is often used by companies that want to minimize their income tax liability by matching higher costs with revenue, while FIFO may be preferred in industries where inventory obsolescence is a concern.

It is important to note that the choice of cost flow assumption may have tax and financial reporting implications. Companies need to ensure they comply with the relevant accounting standards and tax regulations when selecting the appropriate cost flow assumption for their business. Additionally, the choice of cost flow assumption does not affect the company's cash flows directly but can impact profitability and financial statement presentation.