Subject 2. Inventory Valuation Methods

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.

Weighted Average Cost

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

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

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.

User Contributed Comments 9

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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

LIFO
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.