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This is because it must replace the inventory at a cost of at least $85. These results are logical, given the relationship between ending inventories and gross margin. However, in some sectors of the economy, such as electronics, prices have been falling. This is because, in today’s economy, rising prices are more common than falling prices.

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Likewise, the retail inventory method estimates the cost of goods sold, much like the gross profit method does, but uses the retail value of the portions of inventory rather than the cost figures used in the gross profit method. 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. As discussed in the appendix to Chapter 5, the ending inventory amount will be recorded in the accounting records when the income statement accounts are closed to the Income Summary at the end of the year. The amount of the closing entry for ending inventory is obtained from the income statement.

• The First-In, First-Out (FIFO) method assumes that the first unit making its way into inventory is sold first.
• In summary, in a situation of rising prices, FIFO and LIFO have opposite effects on the balance sheet and income statement.
• 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.
• In an economy where prices are rising, LIFO results in the lowest gross margin and the lowest ending inventory.
• This assumption probably would not be used extensively except for the LIFO conformity rule that prohibits its use for tax purposes unless also reported on the company’s financial statements.
• Buyers of such products are indifferent as to which specific item or lot they buy, and so the firm’s management is free to the specific lot(s) it desires.

1 Inventory Cost Flow Assumptions

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. This relationship will always be true for each of specific identification, FIFO, and weighted average. 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. Remember that the costs can flow differently than the physical flow of the goods.

6 Appendix B: Inventory Cost Flow Assumptions Under the Periodic System

Information found in financial statements is required to be presented fairly in conformity with U.S. Because several inventory cost flow assumptions are allowed, presented numbers can vary significantly from one company to another and still be appropriate. Understanding and comparing financial statements is quite difficult without knowing the implications of the method selected. LIFO, for example, tends to produce low-income figures in a period of inflation.

As there is an increasing emphasis in standard setting on valuation concepts, this approach would result in the most useful information for determining the value of the company. If profitability is more important to a financial-statement reader, then weighted average cost would be more useful, as more current costs would be averaged into income. Let’s assume that Wexel’s Widgets Inc. utilizes the average cost flow assumption when assigning costs to inventory items. During the accounting period, Wexel sells 25 widgets from bucket A, each of which cost $25 to produce; 27 widgets from bucket B, each of which cost $27 to produce; and 30 widgets from bucket C, each of which cost $30 to produce. Companies have several methods at their disposal to roughly figure out which costs are removed from a company’s inventory and reported as COGS. This particular approach takes an average of the cost of items sold, leading to a mid-range COGs figure.

In contrast, financial reporting for decision makers must abide by the guidance of U.S. GAAP, which seeks to set rules for the fair presentation of accounting information. Because the goals are entirely different, there is no particular reason for the resulting financial statements to correspond to the tax figures submitted to the Internal an assumption about cost flow is used Revenue Service (IRS). Not surprisingly, though, significant overlap is found between tax laws and U.S. For example, both normally recognize the cash sale of merchandise as revenue at the time of sale. Depreciation, as just one example, is computed in an entirely different manner for tax purposes than for financial reporting.

As well, although taxes could be reduced in any given year through the cost flow assumption made, this is only a temporary effect, as all inventory will eventually be expensed through cost of goods sold. In a rising market, fifo is better for the balance sheet because it ensures that cogs will be higher than acb. In fact, fifo increases both cogs and ending inventory whereas the other two methods do not change ending inventory.In a falling market, lifo improves the balance sheet by increasing cogs and reducing ending inventory. This is because lifo increases both cogs and ending inventory whereas the other two methods do not change either of these figures. Let’s assume the Corner Bookstore had one book in inventory at the start of the year 2023 and at different times during 2023 it purchased four additional copies of the same book.

As before, we need to account for the cost of goods available for sale (5 books having a total cost of $440). With FIFO we assign the first cost of $85 to be the cost of goods sold. The remaining $355 ($440 – $85) will be the cost of the ending inventory. The $85 cost that was assigned to the book sold is permanently gone from inventory. Under the FIFO cost flow assumption, the first (oldest) costs are the first costs to leave inventory and be reported as the cost of goods sold on the income statement. The last (or recent) costs will remain in inventory and be reported as inventory on the balance sheet.

If you matched the $100 cost with the sale, the company’s inventory will have the higher costs. If you matched the $110 cost with the sale, the company’s inventory will have lower costs. The weighted-average cost would mean that both the inventory and the cost of goods sold would be valued at $105 per unit.

Advantages and Disadvantages of Average Cost Flow Assumption

Although this inventory consists of 2 distinct layers of 250 and 350 units, respectively, each purchased at different prices, it is usually not necessary to maintain these layers. Under the FIFO method, the costs attached to the first goods purchased are assumed to be the costs of the first goods sold; the cost of the ending inventories consists of the costs of the latest goods purchased. However, as the previous statistics point an assumption about cost flow is used out, this requirement did not prove to be the deterrent that was anticipated. For many companies, the savings in income tax dollars more than outweigh the problem of having to report numbers that make the company look a bit weaker. 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.

Example of Cost Flow Assumptions

Average cost flow assumption is also called «the weighted average cost flow assumption.» Then, on December 31, Year One, a customer buys one of these two shirts by paying cash of $110. Regardless of the cost flow assumption, the company retains one blue dress shirt in inventory at the end of the year and cash of $110.

Weighted-Average Cost Method

Weighted average allocates cost to units sold by calculating a weighted average cost per unit at the time of sale. The gross profit method is used to estimate inventory values by applying a standard gross profit percentage to the company’s sales totals when a physical count is not possible. The resulting gross profit can then be subtracted from sales, leaving an estimated cost of goods sold. Then the ending inventory can be calculated by subtracting cost of goods sold from the total goods available for sale.

Why Does a Company Need a Cost Flow Assumption in Reporting Inventory?

However, if inventory items are acquired at different costs, which cost is moved from asset to expense? At that point, a cost flow assumption must be selected by company officials to guide reporting. That choice can have a significant impact on both the income statement and the balance sheet. It is literally impossible to analyze the reported net income and inventory balance of a company such as ExxonMobil without knowing the cost flow assumption that has been applied. Recall that the order in which costs are removed from inventory (and reported on the income statement as the cost of goods sold) can be different from the order in which the goods are physically removed from inventory. Periodic systems assign cost of goods available for sale to cost of goods sold and ending inventory at the end of the accounting period.

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Specific identification and FIFO give identical results in each of periodic and perpetual. The weighted average cost, periodic, will differ from its perpetual counterpart because in periodic, the average cost per unit is calculated at the end of the accounting period based on total goods that were available for sale. Cost of goods available for sale must be allocated between cost of goods sold and ending inventory using a cost flow assumption. Specific identification allocates cost to units sold by using the actual cost of the specific unit sold. FIFO (first-in first-out) allocates cost to units sold by assuming the units sold were the oldest units in inventory.

In other words, if Corner Bookstore uses periodic LIFO, the owner may sell the oldest (first) copy of the book to a customer, and report the cost of goods sold of $90 (the cost of the most recently purchased book). If Corner Bookstore sells the textbook for $110, its gross profit using periodic FIFO will be $25 ($110 – $85). If the costs of textbooks continue to increase, FIFO will always result in more gross profit than other cost flows, because the first cost will always be lower. In 2020, the beginning inventory—consisting of 600 units at a total cost of $2,610—is included in the calculation of the weighted average unit cost of goods available for sale. It is very difficult for managers to manipulate income with this method, as the effects of rising or falling prices will be averaged over both the goods sold and the goods remaining on the balance sheet.

• The remainder of the cost of goods available is reported on the income statement as the cost of goods sold.
• It may seem that this advantage is offset by the time and expense required to continuously update inventory records, particularly where there are thousands of different items of various sizes on hand.
• However, if it is to stay in business, the firm will not have $40 available to cover operating expenses.
• 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.

Because each cost flow method allocates the cost of goods available for sale in a particular way, the cost of goods sold and ending inventory values are different for each method. In Figure 6.5, the inventory at the end of the accounting period is one unit. This is the number of units on hand according to the accounting records. A physical inventory count must still be done, generally at the end of the fiscal year, to verify the quantities actually on hand. As discussed in Chapter 5, any discrepancies identified by the physical inventory count are adjusted for as shrinkage. Under specific identification, each inventory item that is sold is matched with its purchase cost.

Consequently, a method of assigning costs to inventory items based on an assumed flow of goods can be adopted. Two such generally accepted methods, known as cost flow assumptions, are discussed next. As prices rise, companies prefer to apply LIFO for tax purposes because this assumption reduces reported income and, hence, required cash payments to the government. In the United States, LIFO has come to be universally equated with the saving of tax dollars.

It may seem that this advantage is offset by the time and expense required to continuously update inventory records, particularly where there are thousands of different items of various sizes on hand. However, computerization makes this record keeping easier and less expensive because the inventory accounting system can be tied in to the sales system so that inventory is updated whenever a sale is recorded. Recall that under the perpetual inventory system, cost of goods sold is calculated and recorded in the accounting system at the time when sales are recorded. In our simplified example, all sales occurred on June 30 after all inventory had been purchased. To demonstrate the calculations when purchases and sales occur continuously throughout the accounting period, let’s review a more comprehensive example. To illustrate the cost flow assumption, let’s assume that a company’s product had a cost of $100 at the start of the year, at mid-year the cost was $105, and at the end of the year the cost was $110.

Various other issues that affect inventory accounting include consignment sales, transportation and ownership issues, inventory estimation tools, and the effects of inflationary versus deflationary cycles on various methods. For example, if the Corner Bookstore uses the FIFO cost flow assumption, the owner may sell any copy of the book but report the cost of goods at the first/oldest cost as shown in the exhibit that follows. 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. 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.