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Subject 2. Expense Recognition - Inventory PDF Download

The matching principle states that operating performance can be measured only if related revenues and expenses are accounted for during the same period ("let the expense follow the revenues"). Expenses are recognized not when wages are paid, when the work is performed, or when a product is produced, but when the work (service) or the product actually makes its contribution to revenue. Thus, expense recognition is tied to revenue recognition.

Expenses incurred to generate revenues must be matched against those revenues in the time periods when the revenues are recognized.

  • If the revenues are recognized in the current period, the associated expenses should be recognized in the current period and appear in the income statement.
  • If revenues are expected to be recognized in future periods, the associated expenses are capitalized (appearing on the balance sheet of the current period as an asset). When the revenues are recognized in future periods, the asset is converted to expenses in those periods.

The problem of expense recognition is as complex as that of revenue recognition. For costs that are not directly related to revenues, accountants must develop a "rational and systematic" allocation policy that will approximate the matching principle. However, matching permits certain costs to be deferred and treated as assets on the balance sheet when in fact these costs may not have future benefits. If abused, this principle permits the balance sheet to become a "dumping ground" for unmatched costs.

Costs of Inventories

In some cases, it's possible to specifically identify which inventory items have been sold and which remain. Using 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. In most cases, companies may be unable to determine exactly which items are sold and which items remain in ending inventory.

The remaining three methods are referred to as cost flow assumptions under GAAP and cost formulas under IFRS. They should be applied only to an inventory of homogeneous items. The cost flow assumption may or may not reflect the physical flow of inventory.

Using the weighted 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.

  • Average cost = (beginning inventory + purchases) / units available for sale
  • Ending inventory = average cost x units of ending inventory
  • COGS = cost of goods available for sale - ending inventory

FIFO 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 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.

LIFO is not allowed under IFRS. In the U.S., however, LIFO is used by approximately 36 percent of U.S. companies because of potential income tax savings.

Comparison of Inventory Accounting Methods

Inventory data is useful if it reflects the current cost of replacing the inventory. COGS data is useful if it reflects the current cost of replacing the inventory items to continue operations.

During periods of stable prices, all three methods will generate the same results for inventory, COGS, and earnings.

During periods of rising prices and stable or growing inventories, FIFO measures assets better (the most useful inventory data) but LIFO measures income better.

  • Under LIFO, the cost of ending inventory is based on the earliest purchase prices, and thus is well below current replacement cost. For many firms using LIFO, the cost of inventory may be decades old and almost useless for analysis purposes. However, the cost of goods sold is based on the most recent purchase prices, and thus closely reflects current replacement costs. As a result, LIFO provides a better measurement of current income and future profitability.

  • Under FIFO, the cost of ending inventory is based on the most recent purchase prices, and thus closely reflects current replacement cost. However, costs of goods sold are based on the earliest purchase prices, and this is well below the current replacement costs. The gain is actually holding gain or inventory profit. It is debatable whether this should be considered income; at least, analysts can say the underestimated COGS leads to inflated net income.

In an environment of declining inventory unit costs and constant or increasing inventory quantities, the opposite is true.

The usefulness of inventory data reported using the average-cost method lies between LIFO and FIFO.

Doubtful Accounts

Account receivables arise from sales to customers who do not immediately pay cash. There are always some customers who cannot or will not pay their debts. The accounts owed by these customers are called uncollected accounts. Therefore, accounts receivables are valued and reported at net realizable value - the net amount expected to be received in cash, which is not necessarily the amount legally receivable. The chief problem in recording uncollectible accounts receivable is establishing the time at which to record the loss.

Under the direct write-off method, uncollectible accounts are charged to expense in the period that they are determined to be worthless. No entry is made until a specific account has definitely been established as uncollectible. This method is easy and convenient to apply. However, it usually does not match costs with revenues of the period, nor does it result in receivables being stated at estimated realizable value on the balance sheet.

Advocates of the allowance method believe that bad debt expense should be recorded in the same period as the sale to obtain a proper matching of expenses and revenues and to achieve a proper carrying value for accounts receivable. In practice, the estimate of bad debt is made either on the percentage-of-sales basis (income statement approach) or outstanding-receivables basis (balance sheet approach).


Warranty costs are a classic example of a loss contingency. Although the future cost amount, due date, and customer are not known for certain, a liability is probable and should be recognized if it can be reasonably estimated.

User Contributed Comments 9

User Comment
kalps debt to equity ratio should be enhanced by the LIFO reserve
bahodir What do you mean by
"Cash Flows. The choice of LIFO vs. FIFO has no effect on pretax cash flows. The pretax cash flow is determined by the cash inflow from sales and cash outflow for purchases, neither of which is affected by the method of inventory accounting."?

Isn't cash outflow for purchases affected by the method of inventory accounting? After all, LIFO COGS differ from that of FIFO.
kevinf12 Bahodir,

Cash paid for inventory is the same under either method, so cash outflow is not affect (pretax). Look up in the notes and notice, Purchases are the same regardless of the accounting convention. COGS are accounting based, and DONT necessarily equal what cash was paid for inventory.
geok Kevinf12, where can i find the notes and notice?
geok Kevin, pls ignore my question. found the pros and cons using LIFO and FIFO in the part 3 of this chapter.
hit81 FIFO
Inventory --> |6 5 4 3 2 1|
1 sold first, 2 next, 3 next ---> COGS on income statement
4,5,6 ---> Ending Inventory/Inventory on Balance Sheet

Inventory | 6 5 4 3 2 1|
6 sold first, 5 next, 4 next ---> COGS on Income statement
3,2,1 -- Ending Inventory/Inventory on Balance Sheet
pranubal how debt to equity ratio will get enhanced by LIFO reserve @Kalps
sonicskat @ pranubal
If using LIFO, COGS increases, Inventory decreases, total assets decreases, A-L=E, therefore shareolder equity decreases, and D/E increases
zhefuli LIFO and FIFO are also basic concepts in data types. LIFO is a stack and FIFO is a queue.
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I am using your study notes and I know of at least 5 other friends of mine who used it and passed the exam last Dec. Keep up your great work!


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