With the LIFO cost flow assumption, the latest (or most recent) costs are the first ones to leave inventory and become the cost of goods sold on the income statement. The first/oldest costs will remain in inventory and will be reported as the cost of the ending inventory on the balance sheet. Periodic means that cost flow assumption 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.
Chapter 5
Over the past decades sophisticated companies have made great strides in reducing their levels of inventory. The results would be different if costs were decreasing or increasing at a slower rate. Consult with your tax adviser concerning the election of a cost flow assumption. If the bookstore sells the textbook for $110, its gross profit under perpetual LIFO will be $21 ($110 – $89). Note that this $21 is different than the gross profit of $20 under periodic LIFO. If Corner Bookstore sells the textbook for $110, its gross profit using the periodic average method will be $22 ($110 – $88).
As prices rise, the cost of goods sold is calculated using older, lower-priced inventory units. Consequently, the remaining inventory on the balance sheet is valued at higher prices, potentially overestimating its worth. This can result in inflated profits and misleading financial statements. Therefore, it is crucial for businesses to carefully consider the impact of inflation when choosing their cost flow assumption method.
Each vehicle tends to be somewhat unique and can be tracked through identification numbers. Unfortunately, for many other types of inventory, no practical method exists for determining the physical flow of merchandise. Use N/E (No Effect), O (Overstated), or U (Understated) to indicate the effect of each error on the company’s financial statements for the years ended December 31, 2016 and December 31, 2017. Using information from the preceding comprehensive example, the effects of each cost flow assumption on net income and ending inventory are shown in Figure 5.14. A cost flow assumption where the first (oldest) costs are assumed to flow out first. Below is a recap of the varying amounts for the cost of goods sold, gross profit, and ending inventory that were calculated above.
It is particularly useful when there are fluctuating costs, as it results in a more accurate representation of the current value of inventory. For example, let’s say a computer hardware store purchases 10 units of a particular product at $100 each, and later purchases another 10 units at $120 each. If the store sells 5 units, the FIFO method would assume that the cost of goods sold is $100 per unit, reflecting the first batch of purchases. The weighted average method is a commonly used cost flow assumption in inventory accounting. It provides a way to calculate the cost of goods sold and the value of ending inventory by taking into account both the cost and quantity of each unit. This method is particularly useful when dealing with inventory items that have similar characteristics but different costs.
- Each of these assumptions determines the cost moved from inventory to cost of goods sold to reflect the sale of merchandise in a different manner.
- It is critical that the items in inventory get sold relatively quickly at a price larger than its cost.
- This method is straightforward and provides a balance between FIFO and LIFO.
- The purchase price differentials are attributed to external factors, including inflation, supply, or demand.
- An error in ending inventory is offset in the next year because one year’s ending inventory becomes the next year’s opening inventory.
- 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.
Demonstrating Cost Flow Assumptions
- By understanding the different methods of cost flow assumption, businesses can make informed decisions about managing inventory and calculating COGS.
- The purpose of the adjusting entry is to ensure that inventory is not overstated on the balance sheet and that income is not overstated on the income statement.
- It is time consuming and costly for companies to physically count the items in inventory, determine their unit costs, and calculate the total cost in inventory.
For example, a luxury car dealership would likely use the specific identification method to match the cost of each vehicle sold with its respective purchase price. As a historical note, a further cost flow assumption, last in, first out (LIFO), was once available for use. This method took the most recent purchases and allocated them to the cost of the goods sold first.
2: The Selection of a Cost Flow Assumption for Reporting Purposes
For an illustration of the cost flow assumption, see Explanation of Inventory and Cost of Goods Sold. Because the identity of the items conveyed to buyers is unknown, this final cost flow assumption holds that using an average of all costs is the most logical solution. If items with varying costs are held, using an average provides a very appealing logic. In the shirt example, the two units cost a total of $120 ($50 plus $70) so the average is $60 ($120/2 units). A key event in accounting for inventory is the transfer of cost from the inventory T-account to cost of goods sold as the result of a sale. For large organizations, such transactions can take place thousands of times each day.
Verifying Ending Inventory
The purpose of the adjusting entry is to ensure that inventory is not overstated on the balance sheet and that income is not overstated on the income statement. As can be seen, income is misstated in both 2022 and 2023 because cost of goods sold in both years is affected by the adjustment to ending inventory needed at the end of 2020 and 2021. Instead of the $2,000 that was reported, the correct value should have been $1,000. The effect of this error was to understate cost of goods sold on the income statement — cost of goods sold should have been $21,000 in 2022 as shown below instead of $20,000 as originally reported above. Because of the 2022 error, the 2023 beginning inventory was incorrectly reported above as $2,000 and should have been $1,000 as shown below. This caused the 2023 gross profit to be understated by $1,000 — cost of goods sold in 2023 should have been $19,000 as illustrated below but was originally reported above as $20,000.
Example of Average Cost Flow Assumption
There were 5 books available for sale for the year 2024 and the cost of the goods available was $440. The weighted average cost of the books is $88 ($440 of cost of goods available ÷ 5 books). The average cost of $88 is used to compute both the cost of goods sold and the cost of the ending inventory.
For example, a grocery retailer selling perishable merchandise may want to use FIFO, as it is common practice to place the oldest items at the front of the rack to encourage their sale first. Alternatively, consider a hardware store that sells bulk nails that are scooped from a bin. 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.
In Figure 6.5, the inventory at the end of the accounting period is one unit. As discussed in Chapter 5, any discrepancies identified by the physical inventory count are adjusted for as shrinkage. First-in, first-out (FIFO) assumes that the first goods purchased are the first ones sold. A FIFO cost flow assumption makes sense when inventory consists of perishable items such as groceries and other time-sensitive goods. From a practical standpoint, the weighted average method works by averaging the cost of each unit in inventory based on its proportionate weight. The weight assigned to each unit is determined by its quantity in relation to the total quantity of inventory.
The cost flow assumption is a fundamental concept in accounting that determines how costs are allocated to inventory and subsequently affect the financial statements. The choice of cost flow assumption can significantly impact the reported values of inventory, cost of goods sold, and ultimately, the profitability of a company. In this section, we will explore the various cost flow assumptions and their impact on financial statements, providing insights from different perspectives.
Advance Your Accounting and Bookkeeping Career
When it comes to managing inventory, businesses must adopt a cost flow assumption method to determine the value of goods sold and the remaining inventory. FIFO assumes that the first units purchased or produced are the first ones to be sold or used, resulting in a cost flow that aligns with the chronological order of the inventory transactions. In this section, we will delve into the details of the FIFO method, exploring its benefits, drawbacks, and how it compares to other cost flow assumptions. Each unit that is sold is specifically identified, and the cost for that unit is allocated to cost of goods sold.
This gross profit of $22 lies between the $25 computed using the periodic FIFO and the $20 computed using the periodic LIFO. Generally accepted accounting principles (GAAP), a common set of accounting principles, standards, and procedures that all public companies in the U.S. are required to abide by, champions consistency. Financial statements are expected to be easily comparable from one accounting period to the next to make life simpler for investors. The method utilized to assign costs to inventory and COGS can have a big bearing on a company’s key financials, reported profitability, and tax obligations.
Therefore, although the identity of the actual item sold is rarely known, the assumption is made in applying FIFO that the first (or oldest) cost is always moved from inventory to cost of goods sold. When recorded in the general ledger T-account “Purchases” (an income statement account), these transactions would be recorded as follows. Liquidity is the ability to convert assets, such as merchandise inventory, into cash. Therefore, Company A’s merchandise turnover is more favourable than Company B’s. A cost flow assumption where the last (recent) costs are assumed to flow out of the asset account first. The balance sheet reports the assets, liabilities, and owner’s (stockholders’) equity at a specific point in time, such as December 31.