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    Inventory Accounting Methods: Specific Identification Method

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    Vidhya Churi
    This document discusses different inventory accounting methods: 1. Specific Identification Method - tracks the cost of each individual inventory item, but is too cumbersome for large inventories. 2. Weighted Average Method - calculates the weighted average cost of inventory and applies it evenly. Used for undifferentiated items. 3. FIFO Method - assumes oldest inventory is sold first, matching cash flows but maximizing taxes in inflation. 4. LIFO Method - assumes newest inventory is sold first, minimizing taxes but undervaluing inventory on the balance sheet. Most companies use FIFO or LIFO.

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    Inventory Accounting Methods: Specific Identification Method

    Uploaded by

    Vidhya Churi
    38 views9 pages
    This document discusses different inventory accounting methods: 1. Specific Identification Method - tracks the cost of each individual inventory item, but is too cumbersome for large inventories. 2. Weighted Average Method - calculates the weighted average cost of inventory and applies it evenly. Used for undifferentiated items. 3. FIFO Method - assumes oldest inventory is sold first, matching cash flows but maximizing taxes in inflation. 4. LIFO Method - assumes newest inventory is sold first, minimizing taxes but undervaluing inventory on the balance sheet. Most companies use FIFO or LIFO.

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    This document discusses different inventory accounting methods: 1. Specific Identification Method - tracks the cost of each individual inventory item, but is too cumbersome for large inventories. 2. Weighted Average Method - calculates the weighted average cost of inventory and applies it evenly. Used for undifferentiated items. 3. FIFO Method - assumes oldest inventory is sold first, matching cash flows but maximizing taxes in inflation. 4. LIFO Method - assumes newest inventory is sold first, minimizing taxes but undervaluing inventory on the balance sheet. Most companies use FIFO or LIFO.

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    Download as docx, pdf, or txt
    38 views9 pages

    Inventory Accounting Methods: Specific Identification Method

    Uploaded by

    Vidhya Churi
    This document discusses different inventory accounting methods: 1. Specific Identification Method - tracks the cost of each individual inventory item, but is too cumbersome for large inventories. 2. Weighted Average Method - calculates the weighted average cost of inventory and applies it evenly. Used for undifferentiated items. 3. FIFO Method - assumes oldest inventory is sold first, matching cash flows but maximizing taxes in inflation. 4. LIFO Method - assumes newest inventory is sold first, minimizing taxes but undervaluing inventory on the balance sheet. Most companies use FIFO or LIFO.

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    of 9

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    INVENTORY ACCOUNTING METHODS

    SPECIFIC IDENTIFICATION METHOD.

    Inventory pricing also becomes complicated when unit prices for inventory items
    fluctuate during an accounting period. Nevertheless the basic idea of inventory pricing is
    uncomplicated: a retailer should determine the value of its inventory by figuring out
    what it cost to acquire that inventory. When an inventory item is sold, the inventory
    account should be reduced (credited) and cost of goods sold should be increased
    (debited) for the amount paid for each inventory item. This method works if a company
    is operating under the Specific Identification Method. That is, a company knows the cost
    of every individual item that is sold. This method works well when the amount of
    inventory a company has is limited, the value of its inventory items is high, and each
    inventory item is relatively unique. Companies that use this method include car
    dealerships, jewelers, and art galleries.

    Problems arise when a company has a large inventory and each specific inventory item
    is relatively indistinguishable from other items. Some retailers, for example, sell only
    one line of products, such as blue jeans. Such a retailer may have an inventory that
    includes various styles and sizes, but the inventory on the whole is similar. Suppose this
    retailer buys the inventory from a wholesaler or manufacturer and pays $3,000 for 300
    pairs of jeans. Hence, the cost per pair is $10. If the cost never changes, then inventory
    costing is simple. Every pair of jeans costs the exact same amount. Because of inflation
    as well as discounts and sales, however, prices tend to fluctuate. For instance, this
    retailer might buy 100 pairs of jeans on Monday for $1,000 ($10 per pair), and 200
    pairs of jeans on Friday for $2,150 ($10.75 per pair). Under the Specific Identification
    Method, the retailer would have to mark or code every pair of jeans, to determine which
    purchase a particular pair of jeans came from. This method is far too cumbersome for
    companies with large and even medium-sized inventories, although it is the most
    precise way of determining inventory prices. As a result, other inventory valuation
    methods have been developed.

    0EIGHTED AVERAGE METHOD.

    Under the Weighted Average Method, a company would determine the weighted
    average cost of the inventory. In the example above, the weighted average cost would be
    $3,150 / 300 pairs which equals $10.50 per pair of jeans. Therefore, every pair of jeans
    would have the inventory price of $10.50, regardless of whether they were actually
    bought in the $10 purchase or the $10.75 purchase. This weighted average would remain
    unchanged until the next purchase occurs, which would result in a new weighted
    average cost to be calculated. This inventory accounting method is used primarily by
    companies that maintain a large supply of undifferentiated inventory items such as fuels
    and grains.

    FIFO METHOD.

    Another method used by companies is called the FIFO Method (first-in, first-out).
    Under FIFO, it is assumed that the oldest inventory²i.e., the inventory first purchased²
    is always sold first. Therefore, the inventory that remains is from the most recent
    purchases. So for the given example, the first 100 jeans that are sold will reduce
    inventory and increase cost of goods sold at a rate of $10 per pair. The next 200 sold will
    have an inventory price of $10.75 per pair. It is irrelevant whether customers actually
    buy the older pairs of jean first. Under FIFO, a company always assumes that it sells its
    oldest inventory first and that ending inventories include more recently purchased
    merchandise. Companies selling perishable goods such as food and drugs tend to use
    this method, because cash flow closely resembles goods flow with this method.
    ·IFO METHOD.

    The final method that a company can use is the LIFO Method (last-in, first-out). Under
    LIFO, it is assumed that the most recent purchase is always sold first. Therefore, the
    inventory that remains is always the oldest inventory. So for the given example, the first
    200 jeans that are sold will reduce inventory and increase cost of goods sold at a rate of
    $10.75 per pair. Again, It does not matter if customers actually buy the newer pair of
    jeans first. Under LIFO, a company always assumes that it sells its newest inventory
    first. Nevertheless, this method represents the true flow of goods for very few
    companies.

    COMPARISON OF THE METHODS

    These different methods will affect cash flow, the actual or assumed association of
    inventory unit costs with goods sold or in stock²not goods flow, the actual movement of
    goods. Therefore, gross profits will vary among the different methods. The example of
    250 pairs of jeans sold at $15 each in Table 2 demonstrates this phenomenon. Suppose
    that 80 pairs of jeans remain unsold during this period, making up the ending
    inventory, and apply the inventory prices supplied above for each method: the first 100
    pairs of jeans were bought for $10 and the next 200 for $10.75²or $3,150.
    Table 2
    Differences in Gross Profit on Sales
    for Each Pricing Method
    Specific Identification Avg. FIFO ·IFO
    Sales250/$15 $3,750 $3,750 $3,750 $3,750
    Beginning Inventory 500
    500 500 500 500
    500
    Purchases 3,150 3,150 3,150 3,150 3,150 3,150
    Goods for Sale* 3,650 3,650 3,650 3,650 3,650
    Ending Inv. 837.50 840 837.50 840 860 820
    Cost of Goods 2,812.50
    2,812.50 2,810 2,790 2,830
    2,810
    Gross Profit $ 937.50 $ 940 $ 960 $ 920
    * Goods available for sale include the beginning inventory aswell as
    additional purchases within the accounting period.

    The differences in value of the ending inventory stem from the different ways each
    method calculates the ending inventory²by determining whether newer or older jeans
    were left, determining the weighted average for the two purchases, assuming the
    remaining 80 pairs are newer pairs, or assuming the remaining pairs are older pairs,
    respectively. Consequently, the differences in gross profit shown in Table 2 reflect the
    assumptions made about cash flow using the various inventory pricing methods, not the
    actual goods flow.
    Of these four inventory methods, the most popular methods used are FIFO and LIFO.
    Even though LIFO does not reflect the actual flow of goods in most cases, approximately
    50 percent of major companies use this method. The FIFO Method may come the closest
    to matching the actual physical flow of inventory. Since FIFO assumes that the oldest
    inventory is always sold first, the valuation of inventory still on hand is at the most
    recent price. Assuming inflation, this will mean that cost of goods sold will be at its
    lowest possible amount. Therefore, a major advantage of FIFO is that it has the effect of
    maximizing net income within an inflationary environment. The downside of that effect
    is that income taxes will be the greatest.

    The LIFO Method is preferred by many companies because it has the effect of reducing a
    company's taxes, thus increasing cash flow. Nevertheless, these attributes of LIFO are
    present only in an inflationary environment. Under LIFO, a company always sells its
    newest inventory items first. Given inflation, these items will also be its most expensive
    items. So cost of goods sold will always be at its greatest amount; therefore, net income
    before taxes will be at its lowest amount, and taxes will be minimized, which is the
    major benefit of LIFO.

    Another advantage of LIFO is that it can have an income smoothing effect. Again,
    assuming inflation and a company that is doing well, one would expect inventory levels
    to expand. Therefore, a company is purchasing inventory, but under LIFO, the majority
    of the cost of these purchases will be on. the income statement as part of cost of
    goods sold. Thus, the most recent and most expensive purchases will increase cost of
    goods sold, thus lowering net income before taxes as well as lowering taxes and net
    income. Net income may still be high, but not as high as it would if FIFO had been used.

    On the other hand, if a company is doing poorly, it will have a tendency to reduce
    inventories. To do so, the company will have to effectively sell more inventory than it
    acquires. Since a company using LIFO assumes it sells its most recent purchases first,
    the inventory that remains is older and less expensive (given inflation). So when a
    company shrinks its inventory, it sells older, less expensive inventory. Therefore, the
    cost of goods sold is lower, net income before taxes is higher, and net income is higher
    than it otherwise would have been.
    A disadvantage of LIFO is the effect it has on the balance sheet. If a company always
    sells its most recent inventory first, then the balance sheet will contain inventory valued
    at the oldest inventory prices. For instance, if a company were to switch from FIFO to
    LIFO in 1955, then unless the inventory was zeroed out at some point in time, there may
    be units of inventory valued at 1955 prices, even though the physical inventory is
    comprised of the most recent units. As a result, the inventory account can be
    dramatically undervalued if a company has adopted LIFO, and if during that time, the
    cost of inventory has increased.

    The LIFO Method is justified based upon the matching principle, as the most recent cost
    of inventory is matched against the current revenue generated from the sale of that
    inventory. FIFO does not, however, distort the valuation of inventory on the balance
    sheet like LIFO can potentially do.

    Companies generally disclose their inventory accounting methods in their financial


    statements, usually as a footnote or a parenthetical note in the relevant sections.
    Therefore, when examining financial statements, it is imperative that the inventory
    notes be read carefully, to determine the method of inventory valuation chosen by a
    company. It is most likely that either FIFO or LIFO would have been chosen. Assuming
    inflation, FIFO will result in higher net income during growth periods and a higher and
    more realistic inventory balance. In periods of growth, LIFO will result in lower net
    income and lower income tax payments, thus enhancing a company's cash flow. During
    periods of contraction, LIFO will result in higher income levels. LIFO also has the
    potential to greatly undervalue inventory over time.

    PERPETUA· INVENTORY PRICING

    The previous discussion and examples applied to periodic inventory accounting where a
    company records the purchases it makes, makes no record of the cost of goods sold at
    the time of sale, and periodically updates its inventory account. Companies that make
    numerous sales of products with relatively small unit costs usually employ the periodic
    accounting method. Such companies include grocery stores, department stores, and
    drug stores. Companies that make fewer sales of products with higher unit costs,
    however, use a perpetual inventory system. The perpetual inventory system is updated
    continuously, not periodically. This systems requires that companies keep track of
    merchandise purchases at the time of acquisition and the cost of goods sold at the time
    of sale. Hence, companies using this system have an account for merchandise
    acquisitions and for the cost of goods sold.

    The same four pricing methods apply to this system. With specific identification, the
    actual cost of the goods sold makes up the cost of goods sold and the value of the
    remaining inventory equals the specific cost of each unsold item. The average method is
    called the moving average in the perpetual system. The average is determined each time
    a new inventory item is purchased. The cost of goods sold for each sale is calculated by
    multiplying the moving average at the time by the number of items sold.

    When using the FIFO method with this system, a company determines the cost of goods
    sold each time a sale is made by multiplying the cost of the oldest goods on hand by the
    number of items sold. Finally, when using the LIFO method, a company computes the
    cost of goods sold each time a sale is made by multiplying the cost of the most recent
    purchases by the number of goods sold.

    The use of the perpetual inventory accounting system requires a company to maintain a
    detailed perpetual record of inventory transactions, either manually or by computer.
    This record must include information on the inflow and outflow of inventory items as
    well as the quantities and prices of items at any given time. While these records are
    updated continuously, companies generally check their accuracy at least once a year by
    physically counting available merchandise.

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