An assumption about the cost flow of inventory is necessary: a only when the flow of goods cannot be determined. b. because it is required by the income tax regulation. c. because prices usually change, and tracking which units have been sold is difficul

However, as the previous statistics point out, this requirement did not prove to be the deterrent that was anticipated. For many companies, the savings in income tax dollars more than outweigh the problem of having to report numbers that make the company look a bit weaker. Explain how the concepts of relevant costs, opportunity costs, strategy, and balanced scorecard relate to decision making. FIFO. The oldest unit costs flow to the cost of goods sold.

• Without any replacement of the inventory, the cost of the gasoline bought in 1972 for $0.42 per gallon is shifted from inventory to cost of goods sold in 2010.
• In the following illustration, assume that Gonzales Chemical Company had a beginning inventory balance that consisted of 4,000 units costing $12 per unit.
• Under the average cost flow assumption, all of the costs are added together, then divided by the total number of units that were purchased.

Assume that Gonzales conducted a physical count of inventory and confirmed that 5,000 units were actually on hand at the end of the year. Some companies prefer the conservatism of lifo, whereas others may feel that it is too conservative and opt for fifo. Others choose to use the average cost method, which provides a balance between fifo and lifo in terms of matching costs with sales revenue. This article compares the effect of different cost flow assumptions—FIFO, average cost, and LIFO—on ending inventory, cost of goods sold, and gross margin for the Cerf Company. If the cost of goods sold varies, net income varies. In times of rising prices, LIFO produces the lowest ending inventory value, the highest cost of goods sold, and the lowest net income.

Why Do Companies Use Cost Flow Assumptions?

Thus, the physical order of sales is not considered. Accountants usually adopt the FIFO, LIFO, or Weighted-Average cost flow assumption. The actual physical flow of the inventory may or may not bear a resemblance to the adopted cost flow assumption. In the following illustration, assume that Gonzales Chemical Company had a beginning inventory balance that consisted of 4,000 units costing $12 per unit.

Specific identification would be a good method if the company were selling snowboards that are one-of-a-kind pieces of art or collectibles from famous athletes. In these cases, tracking the physical flow of the goods is easier than in high-volume retail operations. To calculate the ending inventory in the specific identification method, tally the cost of each item in inventory at the end of the period. The ending inventory valuation is the 575 units remaining multiplied by the weighted average cost. Perpetual inventory has been seen as the wave of the future for many years. It has grown since the 1970s alongside the development of affordable personal computers. These UPC codes identify specific products but are not specific to the particular batch of goods that were produced.

Why do different companies use different cost flow assumptions?

Briefly explain the specific identification approach. Barnes & Noble, for example, reports that its gross margin was 30.9 percent in 2008 and 30.4 percent in 2007. That is certainly one piece of information to be included in a detailed investigation of this company. As can be seen here, periodic and perpetual LIFO do not necessarily produce identical numbers.

Two bathtubs were sold on September 9 but the identity of the specific costs to be transferred depends on the date on which the determination is made. A periodic system views the costs from the perspective of the end of the year, while perpetual does so immediately when a sale is made. Periodic and perpetual FIFO always arrive at the same results.

Ending Inventory, COGS, and Gross Profit for Specific Identification

The six inventory systems shown here for Mayberry Home Improvement Store provide a number of distinct pictures of ending inventory and cost of goods sold. As stated earlier, these numbers are all fairly presented but only in conformity with the specified principles being applied. Third, income tax laws enable the government to assist certain members of society who are viewed as deserving help. For example, taxpayers who encounter high medical costs or casualty losses are entitled to a tax break. Donations conveyed to an approved charity can also reduce a taxpayer’s tax bill. The rules and regulations were designed to provide assistance for specified needs.

At the end of the year, on December 31, a physical inventory is taken that finds that four bathtubs, Model WET-5, are in stock (4 – 3 + 3 – 3 + 3 – 2 + 2). None were stolen, lost, or damaged during the period. In filing income taxes with the United States government, a company must follow the regulations of the Internal Revenue Code. In filing income taxes with the United States government, a company must follow the regulations https://accounting-services.net/ of the Internal Revenue Code1. Those laws have several underlying objectives that influence their development. The last cost incurred in buying two blue shirts was $70 so that amount is reclassified to expense at the time of the first sale. However, for identical items like shirts, cans of tuna fish, bags of coffee beans, hammers, packs of notebook paper and the like, the idea of maintaining such precise records is ludicrous.

A weighted average inventory system determines a single average for the entire period and applies that to both ending inventory and the cost of goods sold. A moving average system computes a new average cost whenever merchandise is acquired. That figure is then reclassified to cost of goods sold at the time of each sale until the next purchase is made. Thus, for this illustration, beginning an assumption about cost flow is used inventory remains $440 (4 units at $110 each) and the number of units purchased is still eight with a cost of $1,048. The reported figure that changes is the cost of the ending inventory. Four bathtubs remain in stock at the end of the year. According to LIFO, the last costs are transferred to cost of goods sold; only the cost of the first four units remains in ending inventory.

However, the impact is only indirect because the number is simply carried over from the previous period. No current computation of beginning inventory is made based on the cost flow assumption in use. New costs always get transferred to cost of goods sold leaving the first costs ($1 per gallon) in inventory.

Under this approach an inventory purchase is made on paper, but the inventory is not actually delivered. The “seller” agrees to repurchase the goods at a slightly higher price after the financial statement date. This is considered acceptable for tax purposes, but not for financial accounting. The specific identification method isn’t a cost flow assumption because you’re perfectly matching your inventory costs with your inventory sales. It’s possible to change cost flow assumptions, but it requires the help of a CPA and a tax attorney to revalue your inventory and quantify the impact on your financial statements.