Inventories are goods held for sale as part of a company’s normal business operations. With the exception of certain service organizations, inventories are essential and important assets of companies. We scrutinize inventories because they are a major component of operating assets and directly affect determination of income.
The importance of costing methods for inventory valuation is due to their impact on net income and asset valuation. Inventory costing methods are used to allocate cost of goods available for sale (beginning inventory plus net purchases) between either cost of goods sold (an income deduction) or ending inventory (a current asset). Accordingly, assigning costs to inventory affects both income and asset measurements. The inventory equation is useful in understanding inventory flows. For a merchandising company:
Beginning inventories Net purchases Cost of goods sold Ending inventories
This equation highlights the flow of costs within the company. It can be expressed alternatively as shown in the graphic on the next page
The costs of inventories are initially recorded on the balance sheet. As the inventories are sold, these costs are removed from the balance sheet and flow into the income statement as cost of goods sold (COGS). Costs cannot be in two places at the same time; either they remain on the balance sheet (as a future expense) or are recognized currently in the income statement and reduce profitability to match against sales revenue. An important concept in inventory accounting is the flow of costs. If all inventories acquired or manufactured during the period are sold, then COGS is equal to the cost of the goods purchased or manufactured. When inventories remain at the end of the accounting period, however, it is important to determine which inventories have been sold and which costs remain on the balance sheet. GAAP allows companies several options to determine the order in which costs are removed from the balance sheet and recognized as COGS in the income statement.
The importance of costing methods for inventory valuation is due to their impact on net income and asset valuation. Inventory costing methods are used to allocate cost of goods available for sale (beginning inventory plus net purchases) between either cost of goods sold (an income deduction) or ending inventory (a current asset). Accordingly, assigning costs to inventory affects both income and asset measurements. The inventory equation is useful in understanding inventory flows. For a merchandising company:
Beginning inventories Net purchases Cost of goods sold Ending inventories
This equation highlights the flow of costs within the company. It can be expressed alternatively as shown in the graphic on the next page
The costs of inventories are initially recorded on the balance sheet. As the inventories are sold, these costs are removed from the balance sheet and flow into the income statement as cost of goods sold (COGS). Costs cannot be in two places at the same time; either they remain on the balance sheet (as a future expense) or are recognized currently in the income statement and reduce profitability to match against sales revenue. An important concept in inventory accounting is the flow of costs. If all inventories acquired or manufactured during the period are sold, then COGS is equal to the cost of the goods purchased or manufactured. When inventories remain at the end of the accounting period, however, it is important to determine which inventories have been sold and which costs remain on the balance sheet. GAAP allows companies several options to determine the order in which costs are removed from the balance sheet and recognized as COGS in the income statement.
Inventory Cost Flows
To illustrate the available cost-flow assumptions, assume that the following reflects the inventory records of a company:
To illustrate the available cost-flow assumptions, assume that the following reflects the inventory records of a company:
Now, assume that 30 units are sold during the year at $800 each for total sales revenue of $24,000. GAAP allows companies three options in determining which costs to match against sales:
First-In, First-Out
First-In, First-Out
This method assumes that the first units purchased are the first units sold. In this case, these units are the units on hand at the beginning of the period. Under FIFO, the company’s gross profit is as follows:
Also, because $15,000 of inventory cost has been removed, the remaining inventory cost to be reported on the balance sheet at the end of the period is $41,000.
Last-In, First-Out
Last-In, First-Out
Under the LIFO inventory costing assumption, the last units purchased are the first to be sold. Gross profit is, therefore, computed as
And because $18,000 of inventory cost has been removed from the balance sheet and reflected in COGS, $38,000 remains on the balance sheet to be reported as inventories. It is important to note that LIFO is not allowed in many countries of the world. The primary reason for this is that use of LIFO can reduce or delay tax payments, which is unpopular with governments. Partly because of this, LIFO is not allowed under IFRS as a method for valuing inventories.
Average Cost
Average Cost
This method assumes that the units are sold without regard to the order in which they are purchased and computes COGS and ending inventories as a simple weighted average as follows:
COGS is computed as a weighted average of the total cost of goods available for sale divided by the number of units available for sale ($56,000/100 = $560). Ending units reported on the balance sheet are $39,200 (70 units x $560 per unit).
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