Because of this cost differential, management needs a formal system for assigning costs to inventory as they transition to sellable goods. That means that it is not possible to frequently chop and change inventory costing methods. Regular alterations are frowned upon and, when necessary, must clearly be highlighted in the company’s footnotes to the financial statements.
Periodic LIFO
Periodic means that the Inventory account is not updated during the accounting period. Instead, the cost of merchandise purchased from suppliers is debited to the general ledger account Purchases. At the end of the accounting year the Inventory account is adjusted an assumption about cost flow is used 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. Changing cost flow assumptions can have a significant impact on a company’s Financial Statements.
Weighted-Average Cost Method
It would be inappropriate for a company to change cost flow assumptions year to year, simply to achieve a certain result in net income. Once the cost flow assumption is determined, it should be applied the same way each year, unless there has been a significant change in circumstances that warrants a change. A company may use different cost flow assumptions for different major inventory classes, but these choices should still be applied consistently. Last-In, First-Out (LIFO) is an inventory accounting method where the most recently purchased items are considered sold first, impacting taxable income and inventory valuation during periods of inflation. The average cost flow assumption assumes that all units are identical, even though that not might always be the case. Newer batches of the same product or material, for instance, might be slightly superior than older ones, and, as a result, may command a higher price.
Inventory
This method would thus achieve the perfect matching of costs to the revenue generated. First, unless items are easy to physically segregate, it may difficult to identify which items were actually sold. As well, although physical segregation may be possible, this method could be expensive to implement, as a great deal of record keeping is required.
Inventory and Cost of Goods Sold Outline
This means that at the beginning of February, they had 50 units in inventory at a total cost of $350 (50 × $7). During the month, they purchased 20 filters at a cost of $7, for a total cost of $140 (20 × $7). Figure 10.3 illustrates how to calculate the goods available for sale and the cost of goods sold. As purchase prices change, particular inventory methods will assign different cost of goods sold and resulting ending inventory to the financial statements. Specific identification achieves the exact matching of revenues and costs while weighted average accomplishes an averaging of price changes, or smoothing. The use of FIFO results in the current cost of inventory appearing on the balance sheet in ending inventory.
Comprehensive Example—Weighted Average (Perpetual)
- If you matched the $100 cost with the sale, the company’s inventory will have the higher costs.
- A cost flow assumption is a method used to determine the cost of goods sold and the value of inventory on hand by estimating how costs are assigned to inventory as it is sold.
- The average cost flow assumption assumes that all goods of a certain type are interchangeable and only differ in purchase price.
- The last cost incurred in buying two blue shirts was $70 so that amount is reclassified to expense at the time of the first sale.
- In addition to the practical problems of keeping track of the costs of the specific items in the inventory, there are theoretical problems with the specific identification method.
- As one of the biggest assets of the company, the way inventory is tracked can have an effect on profit.
As an example, a change in consumer demand may mean that inventories become obsolete and need to be reduced in value below the purchase cost. This often occurs in the electronics industry as new and more popular products are introduced. Using the same information, we now apply the FIFO cost flow assumption as shown in Figure 6.9. Next year, if management decides to minimize its income, it will sell those products with the highest acquisition prices.
In this case, the acquisition price of the inventory did not change between the last purchase on 15 December and its sale on 31 December. In terms of its effects on the balance sheet and income statement, LIFO has the opposite effect of FIFO. In fact, if a company switched to LIFO 20 years ago, the original LIFO layers, if unsold, would be costed at 20-year-old prices. The low gross margin results when the latest and highest costs are allocated to cost of goods sold.
Therefore, the cost of the ending inventory consists of the cost of the items of the earliest purchases. Under the LIFO method of pricing inventories, the cost attached to the last goods purchased is assumed to be the cost of the first goods sold. In filing income taxes with the United States government, a company must follow the regulations of the Internal Revenue Code1.
The estimated ending inventory at June 30 must be $100—the difference between the cost of goods available for sale and cost of goods sold. If white paper and coloured paper are considered a similar group, the calculations in Figure 6.15 above show they have a combined cost of $2,650 and a combined net realizable value of $2,700. In this case, the cost is equal to the LCNRV so no adjusting entry would be required if applying LCNRV on a group basis.
There is no way to identify the individual items specifically, and it is likely that over time, customers scooping out nails would mix together items stocked at different times. Weighted average costing would make the most sense in this case, as this would likely represent the real movement of the product. For a company selling heavy equipment, specific identification would likely make the most sense, as each item would be unique with its own serial number, and these items can be easily tracked. This method is too cumbersome for goods of large quantity, especially if there are not significant feature differences in the various inventory items of each product type. However, for purposes of this demonstration, assume that the company sold one specific identifiable unit, which was purchased in the second lot of products, at a cost of $27.
In this case, the income statement and balance sheet effects of LIFO and FIFO would be the opposite of the rising-price situation. For the past 52 years, Harold Averkamp (CPA, MBA) hasworked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online. For the past 52 years, Harold Averkamp (CPA, MBA) has worked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online. The last cost incurred in buying two blue shirts was $70 so that amount is reclassified to expense at the time of the first sale.
