Cost Flow Assumptions Lecture Notes

Introduction

• Definition: Inventory cost flow assumption is an assumption of how inventory costs flow from the balance sheet to the income statement.
• Purpose: To account for the transfer of costs from inventory to cost of goods sold (COGS).
• Flexibility: Companies don't have to choose a method that matches the actual physical flow.

Key Assumptions/Methods

1. FIFO (First In, First Out)

   • Inventory bought first is sold first.
   • Common in real-world scenarios (e.g., grocery stores).
   • Ending inventory consists of the most recent purchases.
   • Provides more relevant ending inventory value but older COGS.

2. LIFO (Last In, First Out)

   • Inventory bought last is sold first.
   • Ending inventory consists of older purchases.
   • Matches recent costs with recent sales, resulting in more accurate gross profit.
   • Results in lower net income and lower taxes when prices are rising.

3. Weighted Average

   • Average cost of inventory is used for both ending inventory and COGS.
   • Can use either Periodic or Perpetual inventory systems.

4. Specific Identification

   • Not discussed in detail but mentioned as a method.

Tracking Inventory Methods

• Periodic Method: Updates inventory and COGS at the end of each period.
• Perpetual Method: Continuously updates inventory and COGS after each purchase/sale.

Example: Adam Inventory Information

• Beginning Inventory: 5000 units at $5 per unit ($25,000 total).
• Purchases:
  • Jan 10: 1000 units at $6
  • Apr 22: 3000 units at $7
  • Nov 15: 3000 units at $7.50
• Available Units for Sale: 12,000 units
• Total Cost of Goods Available for Sale: $74,500
• Sales:
  • Jan 15: 3500 units
  • Apr 27: 1500 units
  • Nov 20: 3000 units
• Units Sold: 8,000 units
• Ending Inventory: 4,000 units

Periodic and Perpetual Inventory Calculations

Weighted Average Cost

• Periodic: Calculate average cost at the end of the period.
  • Average cost = Total cost of goods available for sale / Total units available
  • Example: $74,500 / 12,000 units = $6.20 per unit
• Perpetual: Calculate new average cost after each purchase
  • Example provided with step-by-step calculations.

FIFO Method

• Periodic:
  • Units sold are from the oldest inventory first.
  • Cost of Goods Sold (COGS) and Ending Inventory calculated based on assumptions.
• Perpetual:
  • Inventory layers tracked chronologically.
  • COGS and Ending Inventory updated after each purchase/sale.

LIFO Method

• Periodic:
  • Units sold are from the most recent purchases first.
  • Older purchases remain in ending inventory.
• Perpetual:
  • Inventory layers tracked chronologically with most recent costs sold first.
  • Cost of Goods Sold and Ending Inventory updated after each purchase/sale.

Key Points and Takeaways

• Different methods (FIFO, LIFO, Weighted Average) result in different valuations for COGS and ending inventory.
• Effects of Rising Costs:
  • LIFO provides higher COGS, lower net income, lower taxes.
  • FIFO provides lower COGS, higher net income, higher taxes.
• IRS Regulations: LIFO conformity rule - If LIFO is used for tax purposes, it must also be used for financial statements.

Additional Concepts to Explore

• LIFO Reserve
• LIFO Liquidation
• Dollar Value LIFO
• Specific Identification Method (to be covered separately)

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