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Ending inventory would be $4, the cost of the unit purchased on June 21. 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. Read this section, which focuses on the four inventory costing methods and the impact each has on the financial statements. It is important to understand the impact of inventory valuation on your own company, and the companies that you partner with, sell to, buy from, and invest in.

Importance for inventory valuation and financial reporting

Using the information above to apply specific identification, the resulting inventory record card appears in Figure 6.6. To apply specific identification, we need information about which units were sold on each date. LIFO charges newest inventory costs to COGS, leading to higher COGS and lower profits during inflation, which can reduce tax liability. Used by manufacturers with uniform products to stabilize pricing amid variable raw material costs. 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.

The Influence of FIFO on Financial Statements and Taxation

Understanding how companies report inventory under US GAAP versus under IFRS is important when comparing companies reporting under the two methods, particularly because of a significant difference between the two methods. 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. Periodic systems assign cost of goods available for sale to cost of goods sold and ending inventory at the end of the accounting period. Specific identification and FIFO give identical results in each of periodic and perpetual.

• The lower of cost and net realizable value can be applied to individual inventory items or groups of similar items, as shown in Figure 6.15 below.
• Transportation costs are part of the responsibilities of the owner of the product, so determining the owner at the shipping point identifies who should pay for the shipping costs.
• Unfortunately, for many other types of inventory, no practical method exists for determining the physical flow of merchandise.
• An error in ending inventory in one period impacts the balance sheet (inventory and equity) and the income statement (COGS and net income) for that accounting period and the next.
• 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.

Weighted Average Cost Method

Inventory must be evaluated, at minimum, each accounting period to determine whether the net realizable value (NRV) is lower than cost, known as the lower of cost and net realizable value (LCNRV) of inventory. 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.

Weighted-Average Cost Method

The applicable average at the time of sale is transferred from inventory to cost of goods sold at points A ($110.00), B ($117.50), and C ($126.88) below. Auditors follow the Statement on Auditing Standards (SAS) No. 99 and AU Section 316 Consideration of Fraud in a Financial Statement Audit when auditing a company’s books. 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. Why choose any individual cost if no evidence exists of its validity? 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).

• Businesses with non-distinguishable products benefit from the ______ Average Cost method as it mitigates the effects of ______ price changes.
• The opposite effects occur when inventory is understated at the end of an accounting period.
• According to this reasoning, income is more properly determined with LIFO because a relatively current cost is shown as cost of goods sold rather than a figure that is out-of-date.
• Under the periodic inventory system, cost of goods sold and ending inventory values are determined as if the sales for the period all take place at the end of the period.

How do cost flow assumptions affect a company’s financial statements?

Further, different inventory cost flow assumptions produce different cost of goods sold and ending inventory values, just as they did under the perpetual inventory system. Under the periodic inventory system, cost inventory accounting of goods sold and ending inventory values are determined as if the sales for the period all take place at the end of the period. These calculations were demonstrated in our earliest example in this chapter.

• Specific identification allocates cost to units sold by using the actual cost of the specific unit sold.
• As well, it was more easily manipulated by management and did not result in accurate valuations on the balance sheet.
• The cost of the one remaining unit in ending inventory would be the cost of the fifth unit purchased ($5).
• Notice in Figure 6.7 that the number of units sold plus the units in ending inventory equals the total units that were available for sale.