Geometric Smoothing Rule seems to be the best because it takes a smoothed % of the inflation adjusted average of the last year and the beginning MV this year and rolls down, meaning the recent year counts for more than the prior year so it reflects current info. I know they rank this as the best approach.
Now the 3 Year smoothing rule- in mock exams, I’ve seen mixed opinions. I know it can be more volatile since you’re using values for the past 3 years at an equal footing which can be outdated and irrelevant, however is this BETTER or WORSE than a simple smoothing rule? I don’t see consistency in the answers, and there’s not a lot of detail in the curriculum on these two.
Can anyone explain? since the Geometric smoothing rules gives more Weightage to current market values as compared to previous ones is it more useful when the market values are decreasing as compared to 3yr average (vice versa for increasing)?
I think Geometric is better than the 3 year smoothing rule in a declining market. With the 3 year, the years when the asset value hadn’t dropped as much will be included leading to a larger % of the current assets. Which is bad
When market values are decreasing, asset values are lowest in the 3rd year relative to the 2nd year or the 1st year. Given that Geometric gives greater weightage to the 3rd year, the geometric-average (weighted-average) asset value will be lower than the equal-average asset value. Therefore spending under geometric will be lower than under rolling average when market values are decreasing.
Also, if the 1st year was a highly turbulent one where market value was extremely high, geometric would place less emphasis on that year but rolling average would place equal emphasis on that year. By the 4th year coming, the spending under rolling average would take a massive fall, while spending under Geometric would fall by a lesser extent.
Great description thanks kevin. This thought process suddenly gave me nasty flashbacks to LIFO and FIFO in declining and rising price environments.
Yeah, I dont miss FIFO/LIFO AT ALL!