Inventory Cost Flow Methods Overview
The use of different cost flow assumptions in inventory accounting, such as FIFO, LIFO, average cost, and specific identification. Learn about the impact on cost of goods sold and ending inventory, along with simplifying LIFO methods like inventory pools and Dollar-Value LIFO.
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Presentation Transcript
Inventories: Measurement (Part 2) INTERMEDIATE ACCOUNTING I CHAPTER 8
COST FLOW ASSUMPTIONS COST FLOW ASSUMPTIONS The first-in, first-out (FIFO) method assumes that items sold are those that were acquired first. Ending inventory consists of the most recently acquired items. Cost of goods sold/ending inventory will be the same under FIFO regardless of whether the periodic or perpetual inventory system is used. The last-in, first-out (LIFO) method assumes that items sold are those that were most recently acquired. Ending inventory consists of the items acquired first. In a perpetual inventory system, a rolling amount is used for the latest layer of inventory . The average cost method assumes that items sold and items in ending inventory come from a mixture of all the goods available for sale. In a perpetual inventory system, a rolling weighted average is used when determining average cost. The specific identification method matches the actual cost to each item sold and assigns this cost to cost of goods sold. Specific identification is not feasible for most companies and is used by businesses who sell a low volume of high-priced, easily identifiable inventory items.
CHOICE OF COST FLOW METHOD CHOICE OF COST FLOW METHOD Companies are not required to choose an inventory method to approximate the actual physical flow of merchandise sold. During periods of generally rising costs FIFO cost of goods sold results in a lower cost of goods sold than LIFO. LIFO cost of goods sold will include the more recent higher unit cost purchases. FIFO ending inventory includes the most recent higher cost purchases which results in a higher ending inventory than LIFO. Under the LIFO Conformity Rule, if a company uses LIFO to measure its taxable income, IRS regulations require that LIFO also be used when reporting income. http://www.inc.com/jeff-haden/how-to-choose-between-lifo-and-fifo-accounting.html
SIMPLIFYING LIFO SIMPLIFYING LIFO Unit LIFO can be costly to implement and can lead to LIFO liquidations. LIFO can be simplified by Using LIFO Inventory Pools Applying Dollar-Value LIFO LIFO Inventory Pools The objective of using LIFO inventory pools are to (1) simplify recordkeeping by grouping inventory units into pools based on physical similarities and (2) to reduce the risk of LIFO layer liquidation. The average cost for all of the pool purchases during the period is applied to the current year's LIFO layer.
Dollar-Value LIFO (DVL) Inventory is viewed as a quantity of value instead of a physical quantity of goods. The DVL inventory pool is viewed as comprising layers of dollar value from different years. An inventory pool is identified in terms of economic similarity rather than physical similarity (subject to the same cost change pressures). DVL simplifies the recordkeeping procedures because no information is needed about unit flows. DVL minimizes the probability of the liquidation of LIFO inventory layers, through the aggregation of many types of inventory into larger pools.
COST INDEXES COST INDEXES Under unit LIFO we determine whether a new LIFO layer was added by comparing the ending quantity with the beginning quantity. Under DVL we determine whether a new LIFO layer was added by comparing the ending dollar amount with the beginning dollar amount. Under DVL, if the cost level has changed, we need a way to determine whether an increase observed is a real increase or one caused by an increase in costs. So before we compare the beginning and ending inventory amounts, we need to deflate the ending inventory amount by any increase in costs so that both the beginning and ending amounts are based on the same level of costs. We accomplish this by using cost indexes. A cost index for a particular layer year is determined as follows: Cost in Layer Year Cost Index in Layer Year = Cost in Base Year The cost index for the base year (the year DVL is initially adopted) is set at 100.
DVL ILLUSTRATION Hanes Company adopted the dollar-value LIFO method on January 1, 2013, when the inventory value was $400,000. The 2013 ending inventory valued at year-end costs is $441,000, and the cost index for the year is 105. Step 1: Convert ending inventory valued at year-end cost to base year cost. $441,000 Ending inventory at baseyear cost = ------------------ = $420,000 1.05
DVL ILLUSTRATION (continued) Step 2: Identify the layers of ending inventory. $420,000 400,000 $ 20,000 Ending inventory at base year cost Beginning inventory, also at base year cost Real increase in inventory quantity (new layer)
DVL ILLUSTRATION (continued) Step 3: Convert each layer sbase year cost to layer year cost using the cost index for the year it was acquired. Date 1/1/13 12/31/13 Totals Ending Inventory at Base Year Cost x Index = at DVL Cost $400,000 1.00 20,000 1.05 $420,000 Cost Ending Inventory $400,000 21,000 $421,000
Inventories: Measurement (Part 2) INTERMEDIATE ACCOUNTING I - CHAPTER 8 END OF PRESENTATION
