LIFO
The cost must be easily associated with a number or other identifying feature of the item so that it can be directly connected to that item. Likewise, the item must be easily tracked, found, and available when the promise of sale is made. method requires a business to identify each unit of merchandise with the unit’s cost and retain that identification until the inventory is sold.
Now, it may seem counterintuitive for a company to underreport profits. However, by using LIFO, the cost of goods sold is reported at a higher amount, resulting in a lower profit and thus a lower tax. Since LIFO expenses the newest costs, there is excellent matching on the income statement. The revenue from the sale of inventory is matched with the cost of the more recent inventory cost.
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. LIFO companies frequently augment their reports with supplemental data about what inventory cost would be if FIFO were used instead. This does not mean that changes cannot occur; however, changes should only be made if financial reporting is deemed to be improved.
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Using Last-In First-Out, there are more costs expensed and less costs in inventory. As discussed below, it creates several implications on a company’s financial statements. Notice that the goods available for sale are “allocated” to ending inventory and cost of goods sold. But, in a company’s accounting records, this flow must be translated into units of money.
Example of Last-In, First-Out (LIFO)
The company purchases another 100 units of calculators at a higher unit cost of $10 due to the scarcity of materials used to manufacture the calculators. If the company made a sale of 50 units of calculators, under the LIFO method, the most recent calculator costs would be matched with the revenue generated from the sale. It would provide excellent matching of revenue and cost of goods sold on the income statement. Accounting theorists may argue that financial statement presentations are enhanced by LIFO because it matches recently incurred costs with the recently generated revenues.
Amid the ongoing LIFO vs. FIFO debate in accounting, deciding which method to use is not always easy. LIFO and FIFO are the two most common techniques used in valuing the cost of goods sold and inventory.
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. In many countries LIFO is not permitted for tax or accounting purposes, and there is discussion about the U.S. perhaps adopting this global approach.
The accuracy and accountability offered by the specific identification method is its most prized feature. The fact is especially true for startups and smaller businesses with a much lower inventory and sales volume. Under the specific identification method, it’s also necessary that the cost of each purchased item can be determined on an individual basis.
The cost of goods sold could be verified by summing up the individual cost for each unit sold. This means that inventory cost would include the invoice price, freight-in, and similar items relating to the general rule. Likewise, freight-out and sales commissions would be expensed as a selling cost rather than being included with inventory.
For example, consider a company with a beginning inventory of two snowmobiles at a unit cost of $50,000. For the sale of one snowmobile, the company will expense the cost of the newer snowmobile – $75,000.
- The specific identification method is useful and usable when a company is able to identify, mark, and track each item or unit in its inventory.
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In other words, each unit of inventory will not have the exact same cost, and an assumption must be implemented to maintain a systematic approach to assigning costs to units on hand (and to units sold). Cost of Goods Manufactured, also known to as COGM, is a term used in managerial accounting that refers to a schedule or statement that shows the total production costs for a company during a specific period of time. In other words, the cost of goods purchased last (last-in) is first to be expensed (first-out). Under LIFO, the company reported a lower gross profit even though the sales price was the same.
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.
Therefore, it will provide lower-quality information on the balance sheet compared to other inventory valuation methods as the cost of the older snowmobile is an outdated cost compared to current snowmobile costs. Once the unit cost of inventory is determined via the preceding logic, specific costing methods must be adopted.
Once a specific inventory item is sold, the cost of the unit is assigned to cost of goods sold. and the amount received for the sale of the item – must be able to be attached to a specific item with some form of a unique identifier that singles it out. The process is incredibly difficult for larger businesses – such as big box stores – to achieve because of the sheer volume that such companies move on a daily basis. For example, consider a company with a beginning inventory of 100 calculators at a unit cost of $5.
How do you find the specific identification method?
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.
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. During the year, 100 additional cars are acquired at an aggregate cost of $3,000,000.
Sometimes, the process can be done simply by an employee laying eyes on the items and marking them down on a piece of paper. In an age where technology and computer programs seem to run everything, the specific identification method is used in a similar way; however, inventory counts are recorded in a spreadsheet. Inventory valuation refers to the practice of accounting for the value of a business’ inventory. Business inventories refer to all the supplies that a business requires to operate, and that are either utilized in the production process or sold off to customers. Therefore, we can see that the financial statements for COGS and inventory depend on the inventory valuation method used.
Understanding the Specific Identification Method
The specific identification method is useful and usable when a company is able to identify, mark, and track each item or unit in its inventory. It is an issue that smaller businesses don’t generally face, which is why such companies are the ones that commonly utilize the specific identification method. The chances of losing or misplacing inventory under such a system are almost obliterated because of the accuracy that it provides.
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. If that aggregated to $225,000, then ending inventory would be reported at that amount. One may further assume that the cost of the units sold is $2,900,000, which can be calculated as cost of goods available for sale minus ending inventory.