Inventory cost flow assumption definition

inventory cost flow assumptions address accounting issues when

Using this method, Zapp Electronics assumes that all 100 units in ending inventory were purchased on October 10. Use the final moving average cost per unit to calculate the ending value of inventory and the cost of goods sold. As the chart below indicates, the moving average cost per unit changes from $14.00 to $15.50 after the purchase on April 10 and becomes $16.70 after the purchase inventory accounting on October 10. If Zapp Electronics uses the last‐in, first‐out method with a periodic system, the 100 units remaining at the end of the period are assumed to be the same 100 units in beginning inventory. Let’s assume the Corner Bookstore had one book in inventory at the start of the year 2022 and at different times during 2022 it purchased four additional copies of the same book.

inventory cost flow assumptions address accounting issues when

As well, for goods that are similar and interchangeable, this method may most closely represent the actual physical flow of those goods. However, the costs of the goods in inventory does not have to flow the way the goods flowed. This means the bookstore can remove the oldest copy of its three copies from inventory but remove the cost of its most recently purchased copy. In other words, the goods can flow using first in, first out while the costs flow using last in, first out. This is why accountants refer to the cost flows as cost flow assumptions.

What is the Inventory Cost Flow Assumption?

As a historical note, a further cost flow assumption, last in, first out (LIFO), was once available for use. This method took the most recent purchases and allocated them to the cost of the goods sold first. LIFO is now not allowed in Canada under IFRS or ASPE, but it is still used in the United States. Although this method resulted in the most precise matching on the income statement, tax authorities criticized it as way to reduce taxes during periods of inflation.

inventory cost flow assumptions address accounting issues when

This is
considered acceptable for tax purposes, but not for financial accounting. Each unit that is sold is specifically identified, and the cost for that unit is allocated to cost of goods sold. This method would thus achieve the perfect matching of costs to the revenue generated. First, unless items are easy to physically segregate, it may difficult to identify which items were actually sold. As well, although physical segregation may be possible, this method could be expensive to implement, as a great deal of record keeping is required. The second disadvantage of this method is its susceptibility to earnings-management techniques.

Inventory Holding Cost

As well, it was more easily manipulated by management and did not result in accurate valuations on the balance sheet. Canadian companies that are allowed to report under US GAAP may still use this method, but it is not allowed for tax purposes in Canada. Recall that the order in which costs are removed from inventory (and reported on the income statement as the cost of goods sold) can be different from the order in which the goods are physically removed from inventory. A further consideration would be the effects on the income statement and balance sheet. FIFO results in the inventory reported on the balance being reported at more current costs.

If this stance is adopted by other accounting frameworks in the future, it is possible that the LIFO method may not be available as a cost flow assumption. All of the preceding issues are of less importance if the weighted average method is used. This approach tends to yield average profit levels and average levels of taxable income over time. The cost of goods available for sale equals the beginning value of inventory plus the cost of goods purchased.