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.
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.
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.
|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.|