This is “The Necessity of Adopting a Cost Flow Assumption”, section 9.1 from the book Business Accounting (v. 2.0). For details on it (including licensing), click here.

For more information on the source of this book, or why it is available for free, please see the project's home page. You can browse or download additional books there. You may also download a PDF copy of this book (20 MB) or just this chapter (1 MB), suitable for printing or most e-readers, or a .zip file containing this book's HTML files (for use in a web browser offline).

Has this book helped you? Consider passing it on:
Creative Commons supports free culture from music to education. Their licenses helped make this book available to you.
DonorsChoose.org helps people like you help teachers fund their classroom projects, from art supplies to books to calculators.

9.1 The Necessity of Adopting a Cost Flow Assumption

Learning Objectives

At the end of this section, students should be able to meet the following objectives:

  1. Understand that accounting rules tend to be standardized so that companies must often report events according to one set method.
  2. Know that the selection of a particular cost flow assumption is necessary when inventory items are bought at more than one cost.
  3. Apply each of the following cost flow assumptions to determine reported balances for ending inventory and cost of goods sold: specific identification, FIFO, LIFO, and averaging.

Accounting for Inventory When Costs Vary Over Time

Question: In the coverage of financial accounting to this point, general standardization has been evident. Most transactions are reported in an identical fashion by all companies. This defined structure (created by U.S. GAAP or IFRS) helps ensure understandable communication. It also enhances the ability of decision makers to compare results from one year to the next and from one company to another. For example, inventory—except in unusual circumstances—appears on a balance sheet at historical cost unless its value is lower. Consequently, experienced decision makers should be well aware of the normal meaning of a reported inventory figure.

However, an examination of the notes to financial statements for several well-known businesses shows an interesting inconsistency in the reporting of inventory (emphasis added).

Mitsui & Co. (U.S.A.)—as of March 31, 2011: “Commodities and materials for resale are stated at the lower of cost or market. Cost is determined using the specific identification method or average cost.”

Johnson & Johnson—as of January 2, 2011: “Inventories are stated at the lower of cost or market determined by the first-in, first-out method.”

Safeway Inc.—as of January 1, 2011: “Merchandise inventory of $1,685 million at year-end 2010 and $1,629 million at year-end 2009 is valued at the lower of cost on a last-in, first-out (“LIFO”) basis or market value.”

Bristol-Myers Squibb—as of December 31, 2010: “Inventories are stated at the lower of average cost or market.”

“Specific-identification method,” “first-in, first-out method,” “last-in, first-out basis,” “average cost”—these are cost flow assumptions. What information do these terms provide about reported inventory balances? Why are such methods necessary? Why are all four of these businesses using different cost flow assumptions? In the financial reporting of inventory, what is the significance of disclosing that a company applies “first-in, first-out,” “last-in, first-out,” or the like?

 

Answer: In the previous chapter, the cost of all inventory items was kept constant over time. The first bicycle cost $260 and every bicycle purchased thereafter also had a cost of $260. This consistency helped simplify the introductory presentation of accounting issues in the coverage of inventory. However, such stability is hardly a realistic assumption. For example, the retail price of gasoline has moved up and down like a yo-yo in recent years. The costs of some commodities, such as bread and soft drinks, have increased gradually for many decades. In other industries, prices actually tend to fall over time. New technology products often start with a high price that drops as the manufacturing process ramps up and becomes more efficient. Several years ago, personal computers cost tens of thousands of dollars and now sell for hundreds.

A key event in accounting for inventory is the transfer of cost from the inventory T-account to cost of goods sold as the result of a sale. The inventory balance is reduced and the related expense is increased. For large organizations, such transactions take place thousands of times each day. If each item has an identical cost, no problem exists. This established amount is reclassified from asset to expense to reflect the sale (either at the time of sale in a perpetual system or when financial statements are produced in a periodic system).

However, if inventory items are acquired at different costs, a problem is created: Which of these costs is moved from asset to expense to reflect a sale? To resolve that question, a cost flow assumption must be selected by company officials to identify the cost that remains in inventory and the cost that moves to cost of goods sold. This choice can have a significant and ongoing impact on both income statement and balance sheet figures. Investors and creditors cannot properly analyze the reported net income and inventory balance of a company such as ExxonMobil without knowing the cost flow assumption that has been utilized.

Applying Cost Flow Assumptions

Question: To illustrate, assume a men’s retail clothing store holds $120 in cash. Numbers will be kept artificially low in this example so that the impact of the various cost flow assumptions is easier to visualize. On December 2, Year One, one blue dress shirt is bought for $50 in cash and added to inventory. Later, near the end of the year, this style of shirt suddenly becomes especially popular and prices skyrocket. On December 29, Year One, the store manager buys a second shirt exactly like the first but this time at a cost of $70. Cash on hand has been depleted ($120 less $50 and $70), but the company holds two shirts in its inventory.

On December 31, Year One, a customer buys one of these two shirts by paying cash of $110. Regardless of the cost flow assumption, the company retains one blue dress shirt in inventory at the end of the year and cash of $110. It also reports sales revenue of $110. Those facts are not in dispute.

From an accounting perspective, only two questions must be resolved: (1) what is the cost of goods sold reported for the one shirt that was sold, and (2) what is the cost remaining in inventory for the one item still on hand?

Should the $50 or $70 cost be reclassified to cost of goods sold? Should the $50 or $70 cost remain in ending inventory? In financial accounting, the importance of the answers to those questions cannot be overemphasized. If the shirts are truly identical, answers cannot be determined by any type of inspection; thus, a cost flow assumption is necessary. What are the various cost flow assumptions, and how are they applied to inventory?

 

Answer:

Specific Identification. In a literal sense, specific identificationInventory cost flow method in which a company physically identifies both its remaining inventory and the inventory that was sold to customers. is not a cost flow assumption. Companies that use this method are not making an assumption because they know which item was sold. In some way, the inventory conveyed to the customer can be identified so that the actual cost is reclassified to expense to reflect the sale.

For some types of inventory, such as automobiles held by a car dealer, specific identification is relatively easy to apply. Each vehicle tends to be somewhat unique and can be tracked through identification numbers. Unfortunately, for many other types of inventory, no practical method exists for determining the physical flow of specific goods from seller to buyer.

Thus, if the men’s retail store maintains a system where individual shirts are coded when acquired, it will be possible to know whether the $50 shirt or the $70 shirt was actually conveyed to the first customer. That cost can then be moved from inventory to cost of goods sold.

However, for identical items like shirts, cans of tuna fish, bags of coffee beans, hammers, packs of notebook paper and the like, the idea of maintaining such precise records is ludicrous. What informational benefit could be gained by knowing whether the first blue shirt was sold or the second? In most cases, unless merchandise items are both expensive and unique, the cost of creating such a meticulous record-keeping system far outweighs any potential advantages.

First-in, first-out (FIFO). The FIFOInventory cost flow assumption based on the oldest costs being transferred first from inventory to cost of goods sold so that the most recent costs remain in ending inventory. cost flow assumption is based on the premise that selling the oldest item first is most likely to mirror reality. Stores do not want inventory to lose freshness. The oldest items are often displayed on top in hopes that they will sell before becoming stale or damaged. 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 moved from inventory to cost of goods sold when a sale occurs.

Note that it is not the oldest item that is necessarily sold but rather the oldest cost that is reclassified first. No attempt is made to determine which shirt was purchased by the customer. Consequently, an assumption is necessary.

Here, because the first shirt cost $50, the entry in Figure 9.1 "Journal Entry—Reclassification of the Cost of One Piece of Inventory Using FIFO" is made to reduce the inventory and record the expense.

Figure 9.1 Journal Entry—Reclassification of the Cost of One Piece of Inventory Using FIFO

After the sale is recorded, the following financial information is reported by the retail story but only if FIFO is applied. Two shirts were bought for ($50 and $70), and one shirt was sold for $110.

FIFO
Cost of Goods Sold (one unit sold—the cost of the first one) $50
Gross Profit ($110 sales price less $50 cost) $60
Ending Inventory (one unit remains—the cost of the last one) $70

In a period of rising prices, the earliest (cheapest) cost moves to cost of goods sold and the latest (more expensive) cost remains in ending inventory. For this reason, in inflationary times, FIFO is associated with a higher reported net income as well as a higher reported inventory total on the company’s balance sheet. Not surprisingly, these characteristics help make FIFO a popular choice.

Test Yourself

Question:

A hardware store buys a lawn mower on Monday for $120, another identical model on Tuesday for $125, another on Wednesday for $132, and a final one on Thursday for $135. One is then sold on Friday for $180 in cash. The company uses the FIFO cost flow assumption for inventory. Because an identification number was left on the lawn mower bought on Tuesday, company officials know that this lawn mower was actually the one sold to the customer. In the accounting system, that specific cost is moved from inventory to cost of goods sold. Which of the following is true?

  1. Reported inventory is too high by $5.
  2. Gross profit is too high by $5.
  3. Working capital is too low by $5.
  4. Net income is correctly stated.

Answer:

The correct answer is choice c: Working capital is too low by $5.

Explanation:

Because FIFO is applied, the first cost ($120) should be moved from inventory to cost of goods sold instead of $125 (the cost of the Tuesday purchase). Cost of goods sold is too high by $5 and inventory is too low by the same amount. Working capital (current assets less current liabilities) is understated because the inventory balance within the current assets is too low. Because the expense is too high, both gross profit and net income are understated (too low).

Last-in, first-out (LIFO). LIFOInventory cost flow assumption based on the most recent costs being transferred first from inventory to cost of goods sold so that the oldest costs remain in ending inventory. is the opposite of FIFO: The most recent costs are moved to expense as sales are made.

Theoretically, the LIFO assumption is often justified as more in line with the matching principle. Shirt One was bought on December 2 whereas Shirt Two was not acquired until December 29. The sales revenue was generated on December 31. Proponents of LIFO argue that matching the December 29 cost with the December 31 revenue is more appropriate than using a cost incurred several weeks earlier. 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.

The difference in reported figures is especially apparent in periods of high inflation which makes this accounting decision even more important. “By matching current costs against current sales, LIFO produces a truer picture of income; that is, the quality of income produced by the use of LIFO is higher because it more nearly approximates disposable income.”Clayton T. Rumble, “So You Still Have Not Adopted LIFO,” Management Accountant, October 1983, 50. Note 1 to the 2010 financial statements for ConocoPhillips reiterates that point: “LIFO is used to better match current inventory costs with current revenues.”

The last cost incurred in buying blue shirts was $70 so this amount is reclassified to expense at the time of the first sale as shown in Figure 9.2 "Journal Entry—Reclassification of the Cost of One Piece of Inventory Using LIFO".

Figure 9.2 Journal Entry—Reclassification of the Cost of One Piece of Inventory Using LIFO

Although the physical results of these transaction are the same (one unit was sold, one unit was retained, and the company holds $110 in cash), the financial picture painted using the LIFO cost flow assumption is quite different from that shown previously in the FIFO example.

LIFO
Cost of Goods Sold (one unit sold—the cost of the last one) $70
Gross Profit ($110 sales price less $70 cost) $40
Ending Inventory (one unit remains—the cost of the first one) $50

Characteristics commonly associated with LIFO can be seen in this example. When prices rise, LIFO companies report lower net income (the most recent and, thus, the most costly purchases are moved to expense) and a lower inventory account on the balance sheet (the earlier, cheaper costs remain in the inventory T-account). As will be discussed in a subsequent section, LIFO is popular in the United States because it helps reduce the amount many companies must pay in income taxes.

Test Yourself

Question:

A hardware store buys a lawn mower on Monday for $120, another identical model on Tuesday for $125, another on Wednesday for $132, and a final one on Thursday for $135. One is sold on Friday for $180 in cash. The company applied FIFO although company officials had originally argued for the use of LIFO. Which of the following statements are true?

  1. If the company had applied LIFO, its net income would have been $10 lower than is being reported.
  2. If the company had applied LIFO, gross profit would have been $15 lower than is being reported.
  3. If the company had applied LIFO, inventory on the balance sheet would have been $15 higher than is being reported.
  4. If the company had applied LIFO, cost of goods sold would have been $10 higher than is being reported.

Answer:

The correct answer is choice b: If the company had applied LIFO, gross profit would have been $15 lower than is being reported.

Explanation:

In FIFO, the $120 cost is removed from inventory and added to cost of goods sold because it is the first cost acquired. Under LIFO, the $135 cost of the last lawn mower would have been reclassified. Thus, in using LIFO, cost of goods sold is $15 higher so that both gross profit and net income are $15 lower. Because the higher (later) cost is removed from inventory, this asset balance will be $15 lower under LIFO.

Averaging. Because the identity of the items conveyed to buyers is unknown, this final cost flow assumption holds that averagingInventory cost flow assumption based on the average cost being transferred from inventory to cost of goods sold so that this same average cost remains in ending inventory. all costs is the most logical solution. Why choose any individual cost if no evidence exists of its validity? The first item received might have been sold or the last. Selecting either is an arbitrary decision. 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).

Figure 9.3 Journal Entry—Reclassification of the Cost of One Piece of Inventory Using Averaging

Although no shirt actually cost $60, this average serves as the basis for reporting both cost of goods sold and the item still on hand. Therefore, all costs are included in arriving at each of these figures.

Averaging
Cost of Goods Sold (one unit sold—the cost of the average one) $60
Gross Profit ($110 sales price less $60 cost) $50
Ending Inventory (one unit remains—the cost of the last one) $60

Averaging has many supporters. However, it can be a rather complicated system to implement especially if inventory costs change frequently. In addition, it does not offer the benefits that make FIFO (higher reported income) and LIFO (lower taxes in the United States) so appealing. Company officials often arrive at practical accounting decisions based more on an evaluation of advantages and disadvantages rather than on theoretical merit.

Test Yourself

Question:

A hardware store buys a lawn mower on Monday for $120, another identical model on Tuesday for $125, another on Wednesday for $132, and a final one on Thursday for $135. One is sold on Friday for $180 in cash. Company officials are trying to decide whether to select FIFO, LIFO, or averaging as the cost flow assumption. Which of the following statements is true?

  1. Gross profit under FIFO is $7 higher than under averaging.
  2. Gross profit under averaging is $7 higher than under LIFO.
  3. Gross profit under averaging is $7 lower than under FIFO.
  4. Gross profit under LIFO is $7 lower than under FIFO.

Answer:

The correct answer is choice b: Gross profit under averaging is $7 higher than under LIFO.

Explanation:

With FIFO, $120 (the first cost) is moved out of inventory and into cost of goods sold. Gross profit is $60 ($180 less $120). For LIFO, $135 (the last cost) is transferred to expense to gross profit is $45 ($180 less $135). In averaging, an average of $128 is calculated ([$120 + $125 + $132 + $135]/4 units). That cost is then reclassified from inventory to cost of goods sold so that gross profit is $52 ($180 less $128). FIFO is $8 higher than averaging; averaging is $7 higher than LIFO.

Key Takeaway

U.S. GAAP tends to apply standard reporting rules to many transactions to make resulting financial statements more easily understood by decision makers. The application of an inventory cost flow assumption is one area where significant variation does exist. A company can choose to use specific identification, first-in, first-out (FIFO), last-in, first-out (LIFO), or averaging. In each of these assumptions, a different cost is moved from inventory to cost of goods sold to reflect the sale of merchandise. 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. In periods of inflation, FIFO reports a higher net income than LIFO and a larger inventory balance. Consequently, LIFO is popular because it is often used to reduce income tax costs.