Inventory Cost Flow Assumptions for Accurate Financial Reporting

Thus, after two sales, there remained 30 units of beginning inventory that had cost the company $21 each, plus 45 units of the goods purchased for $27 each. The last transaction was an additional purchase of 210 units for $33 per unit. Ending inventory was made up of 30 units at $21 each, 45 units at $27 each, and 210 units at $33 each, for a total LIFO perpetual ending inventory value of $8,775. The first-in, first-out method (FIFO) of cost allocation assumes that the earliest units purchased are also the first units sold. For The Spy Who Loves You, using perpetual inventory updating, the first sale of 120 units is assumed to be the units from the beginning inventory, which had cost $21 per unit, bringing the total cost of these units to $2,520.

Some specific industries (such as select retail businesses) also regularly use these estimation tools to determine cost of goods sold. Although the method is predictable and simple, it is also less accurate since it is based on estimates rather than actual cost figures. Similarly, FOB destination means the seller transfers title and responsibility to the buyer at the destination, so the seller would owe the shipping costs.

  1. Assume the same information as above for Pete’s Products Ltd., except that now every item in the store is marked up to 160% of its purchase price.
  2. The following cost of goods sold, inventory, and gross margin were determined from the previously-stated data, particular to perpetual, LIFO costing.
  3. 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.
  4. 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.

It has grown since the 1970s alongside the development of affordable personal computers. These UPC codes identify specific products but are not specific to the particular batch of goods that were produced. This more specific information allows better control, greater accountability, increased cost flow assumption efficiency, and overall quality monitoring of goods in inventory. The technology advancements that are available for perpetual inventory systems make it nearly impossible for businesses to choose periodic inventory and forego the competitive advantages that the technology offers.

Changing cost flow assumptions can have a significant impact on a company’s Financial Statements. It is important to consult with a qualified accountant or tax advisor to understand the implications of changing assumptions. Depending on which assumption is used, a company’s reported income, assets, and liabilities can be significantly affected. In this article, the data for the Cerf Company shown below will be used to demonstrate the calculations that are needed to apply three cost flow assumptions and the specific identification method. With FIFO, it is assumed that the $5 per unit hats remaining were sold first, followed by the $6 per unit hats.

Determining the cost of each unit of inventory, and thus the total cost of ending inventory on the balance sheet, can be challenging. We know from Chapter 5 that the cost of inventory can be affected by discounts, returns, transportation costs, and shrinkage. Additionally, the purchase cost of an inventory item can be different from one purchase to the next. For example, the cost of coffee beans could be $5.00 a kilo in October and $7.00 a kilo in November. Finally, some types of inventory flow into and out of the warehouse in a specific sequence, while others do not.

Overview: What are cost flow assumptions?

Conversely, industries with stable or non-perishable products might choose LIFO to mitigate the impact of inflation on their reported earnings. To demonstrate this point, assume that the management of the Cerf Company wants to maximize its income for the current year. Management can manipulate income by selling lots with certain acquisition costs. Depending on the costs and benefits, other firms might want to maintain similar records. When the LIFO method is used, it is important to maintain separate layers of costs of ending inventory. Charlene Rhinehart is a CPA , CFE, chair of an Illinois CPA Society committee, and has a degree in accounting and finance from DePaul University.


For example, the food industry frequently employs FIFO due to perishability concerns, ensuring that older stock is used first to minimize waste. 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. For some companies, there are benefits to using the LIFO method for inventory costing. For example, those companies that sell goods that frequently increase in price might use LIFO to achieve a reduction in taxes owed. Petersen and Knapp allegedly participated in channel stuffing, which is the process of recognizing and recording revenue in a current period that actually will be legally earned in one or more future fiscal periods.

Information Relating to All Cost Allocation Methods, but Specific to Perpetual Inventory Updating

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.

While the LIFO inventory valuation method is accepted in the United States, it is considered controversial and prohibited by the International Financial Reporting Standards (IFRS). Textbook content produced by OpenStax is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike License . The OpenStax name, OpenStax logo, OpenStax book covers, OpenStax CNX name, and OpenStax CNX logo are not subject to the Creative Commons license and may not be reproduced without the prior and express written consent of Rice University. Any opinions, analyses, reviews or recommendations expressed here are those of the author’s alone, and have not been reviewed, approved or otherwise endorsed by any financial institution.

Cost of goods sold can then be valued at retail, meaning that it will equal sales for the period. From this, ending inventory at retail can be determined and then converted back to cost using the mark-up. In Chapter 5 the journal entries to record the sale of merchandise were introduced. Chapter 5 showed how the dollar value included in these journal entries is determined.

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