Financial Accounting: In an Economic Context

SELLING INVENTORY: WHICH COST FLOW ASSUMPTION?

Perhaps the most important and difficult question of inventory accounting involves how to allocate the capitalized inventory cost between the cost of goods sold and ending inventory. The examples so far have assumed that the cost of the sold inventory is known, but such situations are relatively unusual. In most cases, companies are unable to determine exactly which items are sold and which items remain in ending inventory. When this occurs, an assumption must be made about the cost flow of the inventory items. The assumption chosen can significantly affect net income, current assets, working capital, and the current ratio because it determines the relative costs allocated to the cost of goods sold and ending inventory.

This section first discusses the specific identification method, which is used when the cost of the sold inventory items can be determined. We then cover three cost flow assumptions that are used extensively in practice: averaging; first-in, first-out (FIFO); and last-in, first-out (LIFO).

Under IFRS, the last-in, first-out (LIFO) inventory cost flow assumption is prohibited. The cost of inventory generally is determined using the first-in, first-out (FIFO) or averaging assumption.

Specific Identification

In some cases, especially with relatively infrequent sales of large-ticket items (e.g., jewelry, furniture, automobiles, ...