Discussion questions: structure, purpose, and pedagogical applications

¶ … cost flow methodology. These are related both to enterprise-related issues and to macroeconomic, determined by the economic environment in which the company is evolving. Let's refer to the first category in the beginning. Basically, there are two enterprise-related factors to be considered: volume of goods/inventory and their intrinsic value. For example, in the case of small volume and high value inventories, the specific identification of the goods, using their specific purchase invoice, should be considered.

In terms of macroeconomic factors, the state of the economic, most importantly the prices on the market. In periods of prices on an ascending trend, the FIFO methodology (first in, first out) will result in high gross and net profit, as well as in the lowest cost of goods sold. On the other hand, in the same period, LIFO usage (last in, first out) will result in lowest profit levels, both gross and net profit, and the highest reported cost of goods sold. In this sense, the company needs to determine which methodology is best applied in its case during such period, considering the factors previously explained.

2. In order to determine the best suited method of depreciation that is to be used within a company, there are several relevant factors to be taken into consideration. First of all, we can refer to the amount of time that can be spent on depreciation in the company, as this will determine the level of complexity that the depreciation method will have. In this sense, a company that has a simple business, with a small accounting department, will be using the simplest method of depreciation, the straight-line method. This implies dividing the initial cost minus the residual value by the number of years of estimated life. Due to its simplicity, it is commonly used with small companies.

The second factor that needs to be taken into consideration is asset usage. If the use of an asset is fluctuant from year to year, the units-of-production method is recommended, because it will use a calculated rate of unit-of-production. In this way, the depreciation method used is more adequate to the actual usage of the asset during its existence.

The third factor that needs to be accounted for when deciding on the proper depreciation method is the rate with which the asset's usefulness for the company declines. Thus, if the asset's usefulness will decline consistently after the first year of usage, it is best to use one of the accelerated depreciation methodologies, which will calculate a higher depreciation rate in the first year of usage (when the asset is producing most for the company) and a lower one in the subsequent years, when the asset is less useful for the company. Accelerated methods include the declining balance method and the sum-of-the-years-digits methods.

3. Answering this question first requires a differentiation between accounting (and accounting related activities) and physical reality. For example, cost flow assumption may not always reflect physical flow. In accounting, inventory errors generally correct themselves in the following years, mainly because the accounting methodologies can regulate the values in the following years. But physically, of course, is something different.

4. Basically, GAAP allows various methods of inventory valuation because it seems appropriate for the company to choose the accounting methodologies it sees fit, according to the business it activates in. In this sense, it may be the case that the company activates on markets with fluctuations in the price of goods, perhaps with high inflation. In such a situation, the company will need to adapt its inventory valuation methodologies to best fit its interest. It shouldn't be proper to impose a LIFO valuation method when a FIFO is better applicable in a given possibility. GAAP properly decided to give a free hand to companies so that, given a certain situation, they can choose according to their own needs.