Cost Flow Assumptions in Inventory in Financial Accounting

For cost-based inventory valuation methods, it is necessary to select an assumption of the flow of costs to value the inventory and cost of sales systematically. The reason is that the unit cost of items typically varies over time, and a consistent method must be adopted for allocating costs to inventory and cost of sales. As items are accumulated in inventory at different costs, a basis must be established to determine the cost of each item sold. The cost flow does not always match the physical movement of the inventory goods. ARB No. 43 recognizes that several cost flow assumptions are acceptable and that the major objective in selecting a method is to reflect periodic income most clearly. This emphasis on operating results rather than on financial position is contrary to the current direction of the FASB, which has, more recently, emphasized the balance sheet over the income statement in its Concepts Statements and recent pronouncements. ARB No. 43 also states that in some cases it may be “desirable to apply one of the acceptable methods of determining cost to one portion of the inventory or components thereof and another of the acceptable methods to other portions of the inventory.”

Most firms purchase inventory items on an ongoing basis. Usually, these purchases are not made at a uniform price. This poses an accounting problem when inventory is sold: What is the cost of the goods that were sold and what is the cost of the goods that remain on hand?

Some firms find it advantageous to keep a record of the cost of individual inventory items. These situations involve inventory units with a high dollar value and relatively few sales. Car dealerships are good illustrations. When negotiating with a customer over the selling price of a given car, for example, the cost of that particular car is important information for the dealer. Thus, these firms are motivated to keep a record of each car’s cost. Moreover, a dealer’s inventory consists of perhaps no more than 100 cars, and the dealer makes only a few sales per day. Such activity levels do not present a significant record-keeping challenge. The specific identification method maintains accounting records showing the cost of each inventory item.

For most businesses, however, the number of inventory units and the volume of purchases and sales are so large that the specific identification method would be very costly to implement.

Inventory Methods Topics

  • Specific Identification Method
  • Average-Cost method
  • First-in, First-out (or FIFO) method
  • Last-in, First-out (LIFO) inventory method
  • Financial Statement Effects of Inventory Method
Show Buttons
Hide Buttons