Chapter Summary

By the specific identification method, the actual costs of the specific units sold are transferred from inventory to the cost of goods sold. (Debit Cost of Goods Sold; credit Inventory.) This method achieves the proper matching of sales revenue and cost of goods sold when the individual units in the inventory are unique. However, the method becomes cumbersome and may produce misleading results if the inventory consists of homogeneous items.

The remaining three methods are flow assumptions, which should be applied only to an inventory of homogeneous items.

By the average-cost method, the average cost of all units in the inventory is computed and used in recording the cost of goods sold. This is the only method in which all units are assigned the same (average) per-unit cost.

FIFO (first-in, first-out) is the assumption that the first units purchased are the first units sold. Thus inventory is assumed to consist of the most recently purchased units. FIFO assigns current costs to inventory but older (and often lower) costs to the cost of goods sold.

LIFO (last-in, first-out) is the assumption that the most recently acquired goods are sold first. This method matches sales revenue with relatively current costs. In a period of inflation, LIFO usually results in lower reported profits and lower income taxes than the other methods. However, the oldest purchase costs are assigned to inventory, which may result in inventory becoming grossly understated in terms of current replacement costs.

In a perpetual inventory system, a physical inventory is taken to adjust the inventory records for shrinkage losses. In a periodic inventory system, the physical inventory is the basis for determining the cost of the ending inventory and for computing cost of goods sold.

Shrinkage losses are recorded by removing from the Inventory account the cost of the missing or damaged units. The offsetting debit may be to Cost of Goods Sold, if the shrinkage is normal in amount, or to a special loss account. If inventory is found to be obsolete or unsalable, it is written down to zero (or its scrap value, if any). If inventory is valued at the lower-of-cost-or-market, it is written down to its current replacement cost, if at year-end this amount is substantially below the cost shown in the inventory records.

The cost of goods sold is determined by combining the beginning inventory with the purchases during the period and subtracting the cost of the ending inventory. Thus the cost assigned to ending inventory also determines the cost of goods sold.

By the specific identification method, the ending inventory is determined by the specific costs associated with the units on hand. By the average-cost method, the ending inventory is determined by multiplying the number of units on hand by the average cost of the units available for sale during the year. By FIFO, the units in inventory are priced using the unit costs from the most recent cost layers. By the LIFO method, inventory is priced using the unit costs in the oldest cost layers.

In the current year, an error in the costs assigned to ending inventory will cause an opposite error in the cost of goods sold and, therefore, a repetition of the original error in the amount of gross profit. For example, understating ending inventory results in an overstatement of the cost of goods sold and an understatement of gross profit.

The error has exactly the opposite effects on the cost of goods sold and the gross profit of the following year, because the error is now in the cost assigned to beginning inventory.

Both the gross profit and retail methods use a cost ratio to estimate the cost of goods sold and ending inventory. The cost of goods sold is estimated by multiplying net sales by this cost ratio; ending inventory then is estimated by subtracting this cost of goods sold from the cost of goods available for sale.

In the gross profit method, the cost ratio is 100% minus the company's historical gross profit rate. In the retail method, the cost ratio is the percentage of cost to the retail prices of merchandise available for sale.

The inventory turnover rate is equal to the cost of goods sold divided by the average inventory. Users of financial statements find the inventory turnover rate useful in evaluating the liquidity of the company's inventory. In addition, managers and independent auditors use this computation to help identify inventory that is not selling well and that may have become obsolete.

A LIFO reserve is the amount by which the current replacement cost of inventory exceeds the LIFO cost shown in the accounting records.

If a company has a large LIFO reserve, neither its inventory nor its cost of goods sold are comparable to those of a company using FIFO. Also, a LIFO reserve may cause earnings to increase dramatically if inventory falls below normal levels. Notes accompanying the financial statements provide the statement users with information useful in evaluating the implications of a LIFO reserve.

In this chapter we have seen that different inventory valuation methods can have significant effects on net income as reported in financial statements and on income tax returns as well. In the following chapter, we will see that a similar situation exists with respect to the alternative methods used in depreciating plant and equipment.