Specific identification is a method of finding out ending inventory cost that requires a detailed physical count. The merchandise inventory figure used by accountants depends on the quantity of inventory items and the cost of the items. There are four accepted methods of costing the items: 1 specific identification; 2 first-in, first-out FIFO ; 3 last-in, first-out LIFO ; and 4 weighted-average.
Specific identification is a method of finding out ending inventory cost. It requires a detailed physical count, so that the company knows exactly how many of each goods brought on specific dates remained at year-end inventory.
When this information is found, the amount of goods is multiplied by their purchase cost at their purchase date, to get a number for the ending inventory cost. In theory, this method is the best method because it relates the ending inventory goods directly to the specific price they were bought for. However, this method allows management to easily manipulate ending inventory cost, since they can choose to report that the cheaper goods were sold first, therefore increasing ending inventory cost and lowering cost of goods sold.
This will increase the income. Alternatively, management can choose to report lower income, to reduce the taxes they needed to pay. This method is also a very hard to use on interchangeable goods. For example, it is hard to relate shipping and storage costs to a specific inventory item. To illustrate, assume that the company in can identify the 20 units on hand at year-end as 10 units from the August 12 purchase and 10 units from the December 21 purchase.
The company computes the ending inventory as shown in; it subtracts the USD ending inventory cost from the USD cost of goods available for sale to obtain the USD cost of goods sold.
Note that you can also determine the cost of goods sold for the year by recording the cost of each unit sold. The USD cost of goods sold is an expense on the income statement, and the USD ending inventory is a current asset on the balance sheet. The specific identification costing method attaches cost to an identifiable unit of inventory.
The method does not involve any assumptions about the flow of the costs as in the other inventory costing methods. Conceptually, the method matches the cost to the physical flow of the inventory and eliminates the emphasis on the timing of the cost determination.
Therefore, periodic and perpetual inventory procedures produce the same results for the specific identification method. Specific Identification : Determining ending inventory under specific identification. Inventory cost flow assumptions e. Inventory cost flow assumptions are necessary to determine the cost of goods sold and ending inventory.
Companies make certain assumptions about which goods are sold and which goods remain in inventory resulting in different accounting methodologies.
This is for financial reporting and tax purposes only and does not have to agree with the actual movement of goods companies typically choose a method because of its particular benefits, such as lower taxes. The only requirement, regardless of method is that: The total cost of goods sold plus the cost of the goods remaining in the ending inventory for financial and tax purposes is equal to the actual cost of goods available. LIFO and weighted average cost flow assumptions may yield different end inventories and COGS in a perpetual inventory system than in a periodic inventory system due to the timing of the calculations.
In the perpetual system, some of the oldest units calculated in the periodic units-on-hand ending inventory may get expended during a near inventory exhausting individual sale. In the LIFO system, the weighted average system, and the perpetual system, each sale moves the weighted average, so it is a moving weighted average for each sale. In contrast, in the periodic system, it is only the weighted average of the cost of the beginning inventory, the sum cost of all the purchases, less than the cost of the inventory, divided by the sum of the beginning units and the total units purchased.
Under the Average Cost Method, It is assumed that the cost of inventory is based on the average cost of the goods available for sale during the period. Under the average cost method, it is assumed that the cost of inventory is based on the average cost of the goods available for sale during the period.
The average cost is computed by dividing the total cost of goods available for sale by the total units available for sale. This gives a weighted-average unit cost that is applied to the units in the ending inventory.
From them, the Cost per Unit of Beginning Inventory can be calculated. During the year, multiple purchases are made. Also during the year, multiple sales happen. This deducted amount is added to Cost of Goods Sold. At the end of the year, the last Cost per Unit on Goods, along with a physical count, is used to determine ending inventory cost.
The Weighted-Average Method of inventory costing is a means of costing ending inventory using a weighted-average unit cost. Companies most often use the Weighted-Average Method to determine a cost for units that are basically the same, such as identical games in a toy store or identical electrical tools in a hardware store. Under periodic inventory procedure, a company determines the average cost at the end of the accounting period by dividing the total units purchased plus those in beginning inventory into total cost of goods available for sale.
The ending inventory is carried at this per unit cost. Weighted-average costing takes a middle-of-the-road approach. A company can manipulate income under the weighted-average costing method by buying or failing to buy goods near year-end.
However, the averaging process reduces the effects of buying or not buying. Determining ending inventory : Determining ending inventory under weighted-average method using periodic inventory procedure. FIFO and LIFO methods are accounting techniques used in managing inventory and financial matters involving the amount of money a company has tied up within inventory of produced goods, raw materials, parts, components, or feed stocks.
These methods are used to manage assumptions of cost flows related to inventory, stock repurchases if purchased at different prices , and various other accounting purposes. Because a company using FIFO assumes the older units are sold first and the newer units are still on hand, the ending inventory consists of the most recent purchases. When using periodic inventory procedure to determine the cost of the ending inventory at the end of the period under FIFO, you would begin by listing the cost of the most recent purchase.
If the ending inventory contains more units than acquired in the most recent purchase, it also includes units from the next-to-the-latest purchase at the unit cost incurred, and so on. You would list these units from the latest purchases until that number agrees with the units in the ending inventory.
Different accounting methods produce different results, because their flow of costs are based upon different assumptions. The FIFO method bases its cost flow on the chronological order purchases are made, while the LIFO method bases it cost flow in a reverse chronological order.
The average cost method produces a cost flow based on a weighted average of unit costs. Keep in mind the FIFO assumption: Costs of the first goods purchased are those charged to cost of goods sold when the company actually sells goods.
LIFO stands for last-in, first-out, meaning that the most recently produced items are recorded as sold first.
A merchandising company can prepare an accurate income statement, statements of retained earnings, and balance sheets only if its inventory is correctly valued. On the income statement, a company using periodic inventory procedure takes a physical inventory to determine the cost of goods sold.
The weighted-average method relies on average unit cost to calculate cost of units sold and ending inventory. Average cost is determined by dividing total cost of goods available for sale by total units available for sale. Examine each of the following comparative illustrations noting how the cost of beginning inventory and purchases flow to ending inventory and cost of goods sold.
The actual physical flow of the inventory may or may not bear a resemblance to the adopted cost flow assumption.
Purchases and sales are shown in the schedule. Assume that Gonzales conducted a physical count of inventory and confirmed that 5, units were actually on hand at the end of the year. The dollar amount of sales will be reported in the income statement, along with cost of goods sold and gross profit. How much is cost of goods sold and gross profit? The answer will depend on the cost flow assumption. If Gonzales uses FIFO , ending inventory, cost of goods sold, and the resulting financial statements are as follows:.
If Gonzales uses LIFO , ending inventory, cost of goods sold, and the resulting financial statements are as follows:. If Gonzales uses the weighted-average method , ending inventory and cost of goods sold calculations are as follows:. These calculations support the following financial statement components. The following table reveals that the amount of gross profit and ending inventory can appear quite different, depending on the inventory method selected:. The preceding results are consistent with a general rule that LIFO produces the lowest income assuming rising prices, as was evident in the Gonzales example , FIFO the highest, and weighted average an amount in between.
Because LIFO tends to depress profits, one may wonder why a company would select this option; the answer is sometimes driven by income tax considerations. Lower income produces a lower tax bill, thus companies will tend to prefer the LIFO choice.
Usually, financial accounting methods do not have to conform to methods chosen for tax purposes. However, in the U. In many countries LIFO is not permitted for tax or accounting purposes, and there is discussion about the U.
Accounting theorists may argue that financial statement presentations are enhanced by LIFO because it matches recently incurred costs with the recently generated revenues. Others maintain that FIFO is better because recent costs are reported in inventory on the balance sheet. Whichever method is used, it is important to note that the inventory method must be clearly communicated in the financial statements and related notes.
Consistency in method of application should be maintained. This does not mean that changes cannot occur; however, changes should only be made if financial reporting is deemed to be improved. Once a specific inventory item is sold, the cost of the unit is assigned to cost of goods sold. Specific identification requires tedious record keeping and is typically only used for inventories of uniquely identifiable goods that have a fairly high per-unit cost e.
To illustrate, assume Classic Cars began the year with 5 units in stock. Classic has a detailed list, by serial number, of each car and its cost. Each car is unique and had a different unit cost.
The year ended with only 3 cars in inventory. Under specific identification, it would be necessary to examine the 3 cars, determine their serial numbers, and find the exact cost for each of those units. The cost of goods sold could be verified by summing up the individual cost for each unit sold. Necessary cookies are absolutely essential for the website to function properly. These cookies ensure basic functionalities and security features of the website, anonymously.
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Reasons of using LIFO method The only reason for using LIFO is when companies assume that inventory costing methods and the higher inventory cost themselves will increase over time providing a higher value, which means prices will inflate. Through LIFO, the main advantage lies in reporting lower profits, getting around financial analysis. It is more apt for cash accounting, inventory purchase, matching cost revenue figures and allowing a complete recovery of material cost.
It helps to validate the published financials and the income statement. LIFO is simple to understand, easy to operate among these inventory management systems. By moving high-cost inventories to cost of goods sold, businesses can lower their reported profit levels and defer income tax recognition for the total purchases.
It is more difficult and complex to maintain inventory cost accounting in this method. If most recent purchased inventories are always used as cost of goods sold, it creates older and outdated inventories, which can never be sold. Therefore, it is quite unrealistic in rising price environments. LIFO calculations are more complicated, especially when current costs keeps fluctuating. It might also cause a problem if there is an unusual increase in prices. Clerical work and inventory cost accounting is more in LIFO procedure.
This might cause delays for financial accounting purposes. March 1 Beginning Inventory 60 units Rs. The theory is based on the logic of selling those inventories which are first purchased. Therefore, companies issue materials and utilize the goods that are set at higher price first. During inflation, FIFO has the potential to enhance the value of remaining inventory and bring higher net income.
Showing more assets and income helps businesses to fish in potential investors and lenders. Since closing stock comprises of more recent purchases, therefore closing stock of materials are valued at market price. Total Units Rs. Total Jan 1 5 50 5 50 Jan 5 2 50 3 50 Jan 10 1 50 50 2 50 Jan 15 5 70 5 70 Jan 15 7 Jan 25 2 50 1 70 70 4 70 Under FIFO technique, cost of inventory is related to the cost of latest purchases, that is Rs.
When prices double or triple and accountants still use costs, dating back to months or perhaps years; there will be lot of cost issues that finance managers will fail to understand. There is no tax advantage, like LIFO. Companies incur huge expenses as income tax, which reduces financial benefit.
FIFO inventory valuation results in higher amount of taxes, which further lower down cash flow and potential growth opportunities of any business. If consignments are frequently received that too at fluctuating prices at the time of material purchase, there are higher chances of clerical errors.
It becomes tough for the ledger clerks to ensure the accurate price to be charged. Check Other Interesting Posts. April 27, Leave a Reply Cancel reply. We write only in-depth, original content with an intention to help business owners grow. Over 50, self-made business owners love it.
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