Inventory Methods Principles of Accounting The specific identification method requires companies to keep records of the original cost of each inventory item. Bar coding, electronic product codes, and radio frequency identification make it possible to do this for nearly any product. This practice is still rare today, as most companies use cost flow assumptions about which units were sold. 1. FIFO (first in, first out) 2. LIFO (last in, first out) 3. Average cost There is no accounting requirement that the cost flow assumption be consistant with the physical movement of goods. Cost of Goods Sold Cost of Goods Sold=Beginning Inventory+Cost of Goods Purchased−Ending Inven First In, First Out Assumes that the earlist goods purchased are the first to be sold. - The costs of the earlier goods purchased are the first to be recognized in determining cost of goods sold. - This does not necessarily mean that the oldest units are sold first, but that the costs of the oldest units are recognized first. Note: Sequencing of the Allocation: (1) compute ending inventory; (2) determine cost of goods sold. Last In, First Out Assumes that the latest goods purchased are the first to be sold. This seldom coincides with the actual flow of inventory (except goods stored in piles e.g., coal and hay). - The costs of the latest goods purchased are the first to be recognized in determining the cost of goods sold. - Companies obtain the cost of the ending inventory by taking the unit cost of the earliest goods available for sale and working forward until all units of inventory have been costed. Under a periodic system, all goods purchased during the period are assumed to be Good Test available for the first sale, regardless of the date of purchase. Question Specific Identification Average Cost Allocates the cost of goods avaiable for sale using weighted averages. Cost of Goods Available for Sale Total Units Available for Sale The reasons companies adopt different inventory cost flow methods are varies, but they usually involve income statement effects, balance sheet effects, or tax effects. Weighted AverageUnit Cost = Financial Statement and Tax Effects of Cost Flow Methods Income Statement Effects  Example (Price Changes) In a period of inflation, FIFO produces higher net income (lower unit costs). In a period of inflation, LIFO produces a lower net income. If prices are falling, the results are reversed. FIFO is low; LIFO is high. Regardless of prices, avg. cost produces net income between FIFO, LIFO. Balance Sheet Effects - During inflation, the costs allocated to ending inventory will approximate their current cost if using FIFO. - During inflation, the costs allocated to ending inventory may be significantly understated in term of current cost if using LIFO. Consistency Example: Cost Flow Methods Tax Effects - LIFO results in lower income taxes because of lower net income during times of rising prices. Whatever method a company chooses, it should be consistant from one period to another. This makes it easier to compare over time.  Example: Note the following accounting records: Beginning inventory 4000 units at $3 Purchases 6000 units at $4 Sales 7000 units at $12 Cost of Goods Available for Sale: $ 3(4000)+ $ 4 (6000)=$ 36,000 Ending Inventory: 10,000−7000 =3000 units QUESTION: Calculate the cost of goods sold during the period under a periodic inventory system using the different inventory methods. FIFO: $ 36,000−$ 4 (3000)= $ 24,000 LIFO: $ 36,000−$ 3(3000)=$ 27,000 Average Cost: $ 3( 4000)+$ 4( 6000) =$ 3.60 10,000 Then, calculcate the average cost: $ 36,000−$ 3.6 ( 3000 )=$ 25,200 First, find the average cost per unit: