What are the cost-flow assumptions used in inventory measurement?

Answer 1

COST-FLOW ASSUMPTIONS

The accounting records typically contain information on the cost of the beginning inventory for a period, which was the ending inventory of last period, and information on purchases made or production costs incurred during the current period. Thus, firms can easily measure the cost of goods available for sale or use. Firms can usually match units sold and units in ending inventory with specific purchases by using product bar codes or other identifiers. Using the identifier, the firm can trace the unit back to its purchase invoice or cost record. This is an example of the specific identification system for computing cost of goods sold.

If a firm does not have a system for the specific identification of units sold and units remaining in inventory, it will have records of the cost of the beginning inventory and the cost of purchases, but it will not have records for the cost of goods sold or for ending inventory. It can use a physical count of the ending inventory to obtain the number of units in ending inventory, but it will not have records of the costs of those units. Instead, it has records of the costs of units available for sale during the period (the cost of beginning inventory plus the cost of purchases). It could compute the cost of the units in ending inventory (or, conversely, cost of goods sold) using the most recent costs, the oldest costs, or the average cost of the units available for sale. Once it determines a cost for one unknown quantity—either ending inventory or cost of goods sold—the inventory equation automatically

When a firm computes the cost of goods sold each time it sells an inventory item, it uses a perpetual inventory system. When a firm computes the cost of goods sold at the end of each period by taking a physical inventory and assumes that it sold any items not in ending inventory, it uses a periodic inventory system.

Comparison of Cost-Flow Assumptions Historical Cost Basis

The firm must know, or make an assumption about, which units it has sold or which units remain in inventory. Specific identification avoids making an assumption but is not feasible for all firms. Inventory items of some firms are sufficiently similar and fluid that the firm cannot feasibly use specific identification, for example, for gasoline in a storage tank or rock salt in a quarry. Even when technology, such as product bar codes, allows firms to track the cost of each item in inventory, it may not be cost effective to do so. For example, a home improvements store likely does not develop and implement a bar code system to track pieces of lumber or hammers sold.

Neither U.S. GAAP nor IFRS requires firms to use specific identification; both allow firms to select a cost-flow assumption.That cost-flow assumption need not match the actual physical flow of units within the firm.

Typical cost-flow assumptions are as follows:

(1) Weighted average.

(2) First-in, first-out (FIFO).

(3) Last-in, first-out (LIFO), which U.S. GAAP permits, but IFRS does not.

Under the weighted-average cost-flow assumption, a firm calculates the average of the costs of all goods available for sale (or use) during the accounting period, including the cost applicable to the beginning inventory. This weighted-average cost applies to the units sold during the period and to the units on hand at the end of the period.

The first-in, first-out (FIFO) cost-flow assumption assigns the costs of the earliest (or first) units acquired to the withdrawals and assigns the costs of the most recent acquisitions to the ending inventory. This cost flow assumes that the firm uses/sells the oldest materials and goods first—a good business practice, especially in managing the physical flow of items that deteriorate or become obsolete.

The last-in, first out (LIFO) cost-flow assumption assigns the costs of the latest (or last) units acquired to the withdrawals and assigns the costs of the oldest units to the ending inventory. Some argue that LIFO matches current costs to current revenues and, therefore, that LIFO better measures income.

LIFO is like a stack of trays in a cafeteria: the last tray deposited on the stack is the first one taken off, and the lowest tray in the stack remains there as long as any trays remain. Note that LIFO does not reflect typical physical inventory flows; that is, the next product a firm sells is typically not the last one that it purchased or produced. Firms use LIFO because it produces a cost of goods sold figure based on more recent purchase prices and, therefore, results in lower net income and reduced tax payments.

IFRS prohibits use of the LIFO cost-flow assumption. The U.S. taxing authorities permit a firm to use LIFO for tax purposes as long as it also uses LIFO for financial reporting purposes.

In periods of rising purchase prices and increasing inventory quantities, LIFO results in a higher cost of goods sold, a lower reported periodic income, and lower current income taxes than either FIFO or the weighted-average cost-flow assumption.