Introduction to Inventory Cost Flow Assumptions Financial Accounting

Introduction to Inventory Cost Flow Assumptions Financial Accounting

inventory cost flow assumptions address accounting issues when

Assigns actual cost to each item, ensuring precise cost matching to revenues, ideal for unique, high-value items. Known as the ______ Average Cost method, it is ideal for businesses with ______ inventory items and assumes all items are identical. For example, in the U.S. the LIFO cost flow can be used even ifthe oldest goods are shipped to the buyer.

Module 8: Inventory Valuation Methods

inventory cost flow assumptions address accounting issues when

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. It is not possible to use specific identification when inventory consists of a large number of similar, inexpensive items that cannot be easily differentiated. 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. Determining the cost of each unit of inventory, and thus the total cost of ending inventory on the balance sheet, can be challenging.

Understanding Inventory Cost Flow Methods

  • LIFO charges newest inventory costs to COGS, leading to higher COGS and lower profits during inflation, which can reduce tax liability.
  • This is the number of units on hand according to the accounting records.
  • 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.
  • The average cost flow assumption eliminates the need to track each individual item, which can come in handy, particularly when there are large volumes of similar goods moving through inventory.
  • During the year 2023, the publisher increased the price of the books due to a paper shortage.

Our original example using units assumed there was no opening inventory at June 1, 2023 and that purchases were made as follows. Using the same information, we now apply the FIFO cost flow assumption as shown in Figure 6.9. Calculates consistent unit cost by dividing total inventory cost by total units available. LIFO assumes last acquired inventory is sold first, affecting cost of goods sold and net income. Average Cost divides total cost of goods available by total units available, smoothing out price fluctuations in COGS.

  • 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.
  • For some types of inventory, such as automobiles held by a car dealer, specific identification is relatively easy to apply.
  • Liquidity is the ability to convert assets, such as merchandise inventory, into cash.
  • As we will see in the next sections, the cost of sales may also vary depending on when sales occur.
  • 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.
  • This relationship will always be true for each of specific identification, FIFO, and weighted average.

Strategic Decision-Making

Last-In-First-Out results in higher COGS, lower profits, reducing taxes in inflationary periods. Estimating ending inventory requires an understanding of the relationship of ending inventory with cost of goods sold. An error in ending inventory is offset in the next year because one year’s ending inventory becomes the next year’s opening inventory. This process can be illustrated by comparing gross profits for 2022 and 2023 in the above example.

inventory cost flow assumptions address accounting issues when

Under the average cost flow assumption, all of the costs are added together, then divided by the total number of units that were purchased. The number of units sold can be multiplied by the average price per unit to establish COGS and the ending inventory — the value of goods still available for sale and held by a company at the end of an accounting period. The first-in, first-out method (FIFO) records costs relating to a sale as if the earliest purchased item would be sold first.

inventory cost flow assumptions address accounting issues when

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. 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 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.

What are the main inventory cost flow assumptions and how do they affect a company’s financials?

  • The last cost incurred in buying two blue shirts was $70 so that amount is reclassified to expense at the time of the first sale.
  • The resulting gross profit can then be subtracted from sales, leaving an estimated cost of goods sold.
  • FIFO (first-in first-out) allocates cost to units sold by assuming the units sold were the oldest units in inventory.
  • 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.
  • Based on this, opening inventory, purchases, and cost of goods available can be restated at retail.

Comparing the various costing methods for the sale of one unit in this simple example reveals a significant difference that the choice of cost allocation method can make. Note that the sales price is not affected by the cost assumptions; inventory accounting only the cost amount varies, depending on which method is chosen. Figure 10.4 depicts the different outcomes that the four methods produced. However, it can be a more complicated system to implement especially if costs change frequently.

inventory cost flow assumptions address accounting issues when

The retail inventory method is another way to estimate cost of goods sold and ending inventory. It can be used when items are consistently valued at a known percentage of cost, known as a mark-up. For example, if an inventory item had a retail value of $12 and a cost of $10, then it was marked up to 120% (12/10 x 100). The sum of cost of goods sold and ending inventory is always equal to cost of goods available for sale. Knowing any two of these amounts enables the third amount to be calculated.

BUS103: Introduction to Financial Accounting

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