Why do companies use cost flow assumptions to cost their inventories?

Calculate the corrected cost of goods sold, net income, total assets and equity for 2015 and 2016. Opening inventory at January 1 amounted to 4,000 units at $11.90 per unit for Product A and 2,000 units at $13.26 per unit for Product B. An error in ending inventory is offset in the next year because one year’s ending inventory becomes the next year’s opening inventory. https://accounting-services.net/ This process can be illustrated by comparing gross profits for 2020 and 2021 in the above example. Each of these three methodologies relies on a different method of calculating both the inventory of goods and the cost of goods sold. The estimated ending inventory at June 30 must be $100—the difference between the cost of goods available for sale and cost of goods sold.

LO2 – Explain the impact on financial statements of inventory cost flows and errors. Figure 5.8 highlights the relationship in which total cost of goods sold plus total cost of ending inventory equals total cost of goods available for sale. This relationship will always be true for each of specific identification, FIFO, and weighted average. There are 12 units in ending inventory at an average cost of $12.09 for a total ending inventory cost of $145.12.

Once those units were sold, there remained 30 more units of beginning inventory. At the time of the second sale of 180 units, the LIFO assumption directs the company to cost out the 180 units from the latest purchased units, which had cost $27 for a total cost on the second sale of $4,860. Thus, after two sales, there remained 30 units of beginning inventory that had cost the company $21 each, plus 45 units of the goods purchased for $27 each. The last transaction was an additional purchase of 210 units for $33 per unit.

Additional Inventory Issues

Some accountants argue that these profits are overstated because, in order to stay in business, a going concern must replace its inventory at current acquisition prices or replacement costs. First-in, First-out (FIFO) could also be called “last in still here.” The first purchases we made are assumed to be the first items sold, so the most recent purchases are the ones left in ending inventory. In this case, https://simple-accounting.org/ we would assume that the 12 bats left in our store at the end of the year were the eight we bought on the 15th of December and four of the bats we bought on the 15th of November. Figure 10.12 shows the gross margin resulting from the weighted-average periodic cost allocations of $8283. The following dataset will be used to demonstrate the application and analysis of the four methods of inventory accounting.

  • A weighted average is a calculation that takes into account the varying degrees of importance of the numbers in a data set.
  • This average cost is then applied to the units that have been sold and the units that are still in the inventory.
  • This amount is then assigned to the units sold in the period and the units remaining in stock.
  • Using a weighted average versus a normal average can convey an entirely different picture.
  • The lowest gross margin and ending inventory and highest cost of goods sold resulted when LIFO was used.

At the end of December, we have 12 bats on hand at an average cost of $12.57. Notice that because beginning inventory of this item was zero, total costs of items sold ($369.15) plus cost of ending inventory ($150.85) is equal to purchases. If we had a beginning inventory, the calculation is still the same, and ending inventory plus COGS would equal purchases plus beginning inventory. These estimates could be needed for interim reports, when physical counts are not taken.

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As you’ve learned, the periodic inventory system is updated at the end of the period to adjust inventory numbers to match the physical count and provide accurate merchandise inventory values for the balance sheet. The adjustment ensures that only the inventory costs that remain on hand are recorded, and the remainder of the goods available for https://online-accounting.net/ sale are expensed on the income statement as cost of goods sold. Here we will demonstrate the mechanics used to calculate the ending inventory values using the four cost allocation methods and the periodic inventory system. The last-in, first-out method (LIFO) of cost allocation assumes that the last units purchased are the first units sold.

Why do different companies use different cost flow assumptions?

For example, a survey may gather enough responses from every age group to be considered statistically valid, but the 18 to 34 age group may have fewer respondents than all others relative to their share of the population. The survey team may weigh the results of the 18 to 34 age group so that their views are represented proportionately. The FIFO method produces the lowest COGS and the highest pretax income when prices are rising. While you may pay more in small business taxes, you’re boosting your asset balance and business income.

Why would businesses use last in, first out (LIFO)?

The method utilized to assign costs to inventory and COGS can have a big bearing on a company’s key financials, reported profitability, and tax obligations. A weighted average calculation can easily take this into account by adjusting weight values to compensate. However, retroactive taxes, such the LIFO transition tax, come with two concerns. A general concern is that sudden changes in federal tax policy make businesses fearful that other arbitrary adjustments may happen in the future, and increase risk and uncertainty, which reduce the willingness to invest. As such, businesses would be required to pay tax on something that really isn’t an asset. This may require some companies to borrow money to pay tax on their reserve.

Weighted-Average Cost (AVG)

As an example, a change in consumer demand may mean that inventories become obsolete and need to be reduced in value below the purchase cost. This often occurs in the electronics industry as new and more popular products are introduced. Using the information above to apply specific identification, the resulting inventory record card appears in Figure 6.6.

Assume the same information as above for Pete’s Products Ltd., except that now every item in the store is marked up to 160% of its purchase price. Based on this, opening inventory, purchases, and cost of goods available can be restated at retail. Cost of goods sold can then be valued at retail, meaning that it will equal sales for the period. From this, ending inventory at retail can be determined and then converted back to cost using the mark-up.

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