The reason is that the last costs will always be higher than the first costs. It is critical that the items in inventory get sold relatively quickly at a price larger than its cost. Without sales the company’s cash remains in inventory and unavailable to pay the company’s expenses such as wages, salaries, rent, advertising, etc.
Different Methods of Cost Flow Assumption
LO6 – Calculate cost of goods sold and merchandise inventory using specific identification, first-in first-out (FIFO), and weighted average cost flow assumptions periodic. LO1 – Calculate cost of goods sold and merchandise inventory using specific identification, first-in first-out (FIFO), and weighted average cost flow assumptions—perpetual. LO1 – Calculate cost of goods sold and merchandise inventory using specific identification, first in first-out (FIFO), and weighted average cost flow assumptions — perpetual. This chapter reviews how the cost of goods sold is calculated using various inventory cost flow assumptions.
At the end of the accounting year the Inventory account is adjusted to the cost of the merchandise that is unsold. The remainder of the cost of goods available is reported on the income statement as the cost of goods sold. As before, we need to account for the cost flow assumption cost of goods available for sale (5 books having a total cost of $440). The remaining $355 ($440 – $85) will be the cost of the ending inventory.
An entry is needed at the time of the sale in order to reduce the balance in the Inventory account and to increase the balance in the Cost of Goods Sold account. With perpetual FIFO, the first (or oldest) costs are the first costs removed from the Inventory account and debited to the Cost of Goods Sold account. Therefore, the perpetual FIFO cost flows and the periodic FIFO cost flows will result in the same cost of goods sold and the same cost of the ending inventory. When the periodic inventory system is used, the Inventory account is not updated when goods are purchased. Instead, purchases of merchandise are recorded in the general ledger account Purchases.
The second disadvantage of this method is its susceptibility to earnings-management techniques. If a manager wanted to manipulate the current period net income, he or she could do this very easily using this method by simply choosing which items to sell and which to retain in inventory. Lower cost items could be shipped to customers, which would result in lower cost of goods sold, higher profits, and higher inventory values on the statement of financial position. Because of this potential problem, this technique should be applied only in situations where inventory items are not normally interchangeable with each other. Each item would have a separate serial number and could not be substituted for another item.
The First-in, First-out (FIFO) Cost Flow Assumption
Understanding this relationship is the key to estimating inventory using either the gross profit or retail inventory methods, discussed below. When costs are assigned to these items and these individual costs are added, a total inventory amount is calculated. Being able to estimate this amount provides a check on the reasonableness of the physical count and valuation. There are two components necessary to determine the inventory value disclosed on a corporation’s balance sheet.
- It is determined by dividing the total cost of inventory available for sale by the total number of units.
- Inventory represents all the finished goods or materials used in production that a company has possession of.
- In the shirt example, the two units cost a total of $120 ($50 plus $70) so the average is $60 ($120/2 units).
In the United States, LIFO has come to be universally equated with the saving of tax dollars. When LIFO was first proposed as a tax method in the 1930s, the United States Treasury Department appointed a panel of three experts to consider its validity. They eventually agreed to recommend that LIFO be allowed for income tax purposes but only if the company was also willing to use LIFO for financial reporting. Cost of goods sold is usually the largest expense on the income statement of a company selling products or goods. Cost of Goods Sold is a general ledger account under the perpetual inventory system.
Financial Accounting
Periodic means that the Inventory account is not routinely updated during the accounting period. At the end of the accounting year the Inventory account is adjusted to equal the cost of the merchandise that has not been sold. When the textbook is sold, the bookstore removes the cost of $85 from its inventory and reports the $85 as the cost of goods sold on the income statement that reports the sale of the textbook. Figure 6.8 highlights the relationship in which total cost of goods sold plus total cost of ending inventory equals total cost of goods available for sale. The fundamental principle of the FIFO method is to assign the cost of the oldest inventory units to the cost of goods sold (COGS) first.
Introduction to Inventory Cost Flow Assumptions
- Understanding the different cost flow assumptions can help businesses make informed decisions about their inventory management and financial reporting.
- At the end of the accounting year the Inventory account is adjusted to the cost of the merchandise that is unsold.
- One of the main financial statements (along with the statement of comprehensive income, balance sheet, statement of cash flows, and statement of stockholders’ equity).
- For an illustration of the cost flow assumption, see Explanation of Inventory and Cost of Goods Sold.
Under specific identification, each inventory item that is sold is matched with its purchase cost. This method is most practical when inventory consists of relatively few, expensive items, particularly when individual units can be identified with serial numbers — for example, motor vehicles. When it comes to managing inventory, one of the key decisions businesses have to make is selecting a cost flow method. A cost flow method determines how costs are assigned to goods sold and ending inventory, which in turn affects the calculation of profits and the valuation of inventory.
This method is based on the assumption that older inventory costs are less relevant in determining the cost of goods sold, especially in times of inflation when newer inventory costs tend to be higher. A further consideration would be the effects on the income statement and balance sheet. FIFO results in the inventory reported on the balance being reported at more current costs.
Perpetual FIFO
FIFO, LIFO, average are assumptions because the flow of costs out of inventory does not have to match the way the items were physically removed from inventory. However, it can be a more complicated system to implement especially if costs change frequently. In addition, it does not offer the benefits that make FIFO (higher reported income) and LIFO (lower taxes in the United States) so appealing. Company officials often arrive at such practical decisions based on an evaluation of advantages and disadvantages and not on theoretical merit. Although no shirt did cost $60, this average serves as the basis for both cost of goods sold as well as the cost of the item still on hand. For some types of inventory, such as automobiles held by a car dealer, specific identification is relatively easy to apply.
Example of Average Cost Flow Assumption
By assigning the cost of goods sold based on the oldest inventory, businesses can reduce their taxable income, as the cost of goods sold will be lower compared to using other cost flow assumptions. This can lead to lower tax liabilities, providing a financial benefit to businesses. One of the key advantages of using the FIFO method is that it tends to result in a balance sheet that better reflects the current market value of inventory. Since the cost of goods sold is calculated using the oldest inventory units, the remaining inventory on the balance sheet is valued at the most recent prices paid. This can be particularly beneficial in industries where the cost of inventory fluctuates significantly, allowing businesses to present a more accurate financial picture to stakeholders. The weighted average method calculates the average cost of all units in inventory and assigns this average cost to both COGS and ending inventory.
Often this is done by using either the periodic inventory system or the perpetual system. The recorded cost for the goods remaining in inventory at the end of the accounting year are reported as a current asset on the company’s balance sheet. Cost is defined as all costs necessary to get the goods in place and ready for sale. For instance, if a bookstore purchases a college textbook from a publisher for $80 and pays $5 to get the book delivered to its store, the bookstore will record the cost of $85 in its Inventory account. The recorded cost will not be increased even if the publisher announces that additional copies will cost $100. We will illustrate the FIFO, LIFO, and weighted-average cost flows along with the periodic and perpetual inventory systems.
