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. The retail inventory method of estimating ending inventory is easy to calculate and produces a relatively accurate cost of ending inventory, provided that no change in the average mark-up has occurred during the period. The gross profit method of estimating inventory is useful in situations when goods have been stolen or destroyed by fire or when it is not cost-effective to make a physical inventory count. 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.
1: Inventory Cost Flow Assumptions
Thus, the cost of the ending inventory is calculated as $2,640 and the cost of goods sold is $7,800. For example, an automobile dealer may hold records of the exact cost of every car sold and every car remaining in the inventory at the end of the year. In some situations, it is practical to determine the specific acquisition cost of the items remaining in the ending inventory. In a perpetual inventory system, the dates of the particular sales are important. These states have their own unique set of laws although they often resemble the tax laws applied by the federal government.
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Which cost would you match with the sale of one item at the end of the year? (If so, you are assuming a FIFO cost flow.) Would you match the $110 cost with the sale? (That’s the LIFO cost flow assumption.) If you would matched the average of $105, you would be using the weighted-average cost flow assumption. 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.
Comprehensive Example—Weighted Average (Perpetual)
The difference between cost of goods available for sale and cost of goods sold is the estimated value of ending inventory. A weighted average cost flow is assumed when goods purchased on different dates are mixed with each other. The weighted average cost assumption is popular in practice because it is easy to calculate. It is also suitable when inventory is held in common storage facilities — for example, when several crude oil shipments are stored in one large holding tank. To calculate a weighted average, the total cost of all purchases of a particular inventory type is divided by the number of units purchased. It is not possible to use specific identification when inventory consists of a large number of similar, inexpensive items that cannot be easily differentiated.
- Therefore, Company A’s merchandise turnover is more favourable than Company B’s.
- Next year, if management decides to minimize its income, it will sell those products with the highest acquisition prices.
- The reported inventory balance as well as the expense on the income statement (and, hence, net income) are dependent on the cost flow assumption that is selected.
- Income taxes may also be a consideration when choosing a cost flow formula.
- This laborious requirement might make use of the average method cost-prohibitive.
1: The Necessity of Adopting a Cost Flow Assumption
With the average or weighted average cost flow assumption an average cost is calculated using the cost of goods available for sale (cost from the beginning inventory plus the costs of all the purchases made during the year). This means that the periodic average cost is calculated after the year is over—after all the purchases for the year have occurred. This average cost is then applied to the units sold during the year and to the units in inventory at the end of the year. Under the average cost flow assumption, all of the costs are added together, then divided by the total number of units that were purchased.
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The average cost fell between these two extremes for all three accounts. This is because the acquisition price of the inventory consistently rises during the year, from $4.10 to $4.70. Our original example using units assumed there was no opening inventory at June 1, 2023 and that purchases were made as follows. The ‘2.5’ means that Company B sold its inventory 2.5 times during the year which is much slower than Company A. The faster a business sells its inventory, the better, because high turnover positively affects liquidity.
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. The report of the independent auditor never assures decision makers that financial statements are “presented fairly.” That is a hopelessly abstract concept like truth and beauty. Instead, the auditor states that the statements are “presented fairly…in conformity with accounting principles generally accepted in the United States of America.” That is a substantially more objective standard. Thus, for this men’s clothing store, all the following figures are presented fairly but only in conformity with the cost flow assumption used by the reporting company.
In merchandising companies, inventory is a company asset that includes beginning inventory plus purchases, which include all additions to inventory during the period. Every time the company sells products to customers, they dispose of a portion of the company’s inventory asset. Goods an assumption about cost flow is used available for sale refers to the total cost of all inventory that the company had on hand at any time during the period, including beginning inventory and all inventory purchases. Suppose that at the end of January 31, 2018, they had 50 oil filters on hand at a cost of $7 per unit.