Inventory Valuation: Identified Cost vs FIFO

Identified Cost vs FIFO

  • Both methods identify the same number of units sold and remaining on hand, but cost allocations differ, so COS and Inventory on hand values differ.
  • FIFO (First-In, First-Out): assumes oldest items are sold first.
    • In rising cost environments: COS is lower, Net Profit higher, and Inventory on hand value is higher.
    • Inventory on hand tends to be valued higher because newer, more expensive items remain.
  • Identified Cost (specific identification): assigns exact cost to each item sold; inventory on hand may reflect older cheaper items.
  • In falling cost environments: FIFO yields higher COS, lower Net Profit, and lower Inventory on hand.
  • Impact on financial statements:
    • Cost of Sales and Inventory values depend on the method, even if unit sales are the same.
    • Net Profit and Owner’s equity are affected by the chosen method.
  • Qualitative consideration (Qualitative Characteristics):
    • Both methods provide information that is Relevant and Faithful.
    • Choice should weigh benefits vs. costs of the method for the specific inventory.
    • FIFO remains a Faithful representation because prices are verifiable from source documents, but it biases COS toward older costs and Inventory on hand toward newer costs.

Inventory accounting concepts and terminology

  • Cost of Sales (COS) vs Cost of Goods Sold (COGS):
    • COS is the cost of inventory sold in the period.
    • COGS is the heading used in the Income Statement for all costs incurred to bring inventory into saleable condition (includes COS and related costs such as freight inwards, import duties, packaging, etc.).
    • Costs after inventory is ready for sale that are incurred to deliver the product to customers (e.g., freight outwards) are recorded under Other Expenses, not COGS.
  • Net Sales: ext{Net Sales} = ext{Total Sales} - ext{Sales Returns}
  • Gross Profit: ext{Gross Profit} = ext{Net Sales} - ext{Cost of Sales}
  • Adjusted Gross Profit: adjust Gross Profit for Inventory Loss or Gain captured on the inventory cards and physical count.
    • Inventory Loss → subtract from Gross Profit.
    • Inventory Gain → add to Gross Profit.
  • Net Profit: ext{Net Profit} = ext{Adjusted Gross Profit} - ext{Other Expenses}
  • Inventory records:
    • Cash Journals (CRJ/CPJ) record cash payments for purchases and cash receipts from sales.
    • Inventory Cards record cost price of inventory when purchased (IN) and when sold (OUT).
    • Inventory losses/gains should be reported separately (not included in COS).

Reporting for inventory in the Income Statement (high level)

  • Income Statement structure for a trading business (inventory-focused):
    • Net Sales = Total Sales − Sales Returns
    • Cost of Goods Sold (COS) = sum of costs of inventory sold during the period
    • Gross Profit = Net Sales − COS
    • Inventory Loss/Gain reported separately as part of Adjusted Gross Profit
    • Adjusted Gross Profit = Gross Profit ± Inventory Gain/Loss
    • Other Expenses include costs after inventory is ready for sale (e.g., wages, advertising, rent, delivery to customers)
    • Net Profit = Adjusted Gross Profit − Other Expenses
  • Key note on calculations:
    • COS is derived from the OUT entries in the inventory cards (for sales components only; exclude non-sales removals such as drawings or donations which are not sales).
    • Inventory losses/gains are not included in COS; they are reported separately.

Calculating Gross Profit from cash journals and inventory cards

  • Gross Profit calculation steps:
    • Determine Net Sales from Cash Receipts Journal/Sales Journal: Net Sales = Total Sales − Sales Returns
    • Determine Cost of Sales from Inventory Cards (FIFO): sum of the cost of inventory sold (OUT entries for sales)
    • Gross Profit = Net Sales − Cost of Sales
  • Important notes:
    • Inventory losses/gains are adjusted separately to derive Adjusted Gross Profit.
    • Delivery to customers is treated as an Other Expense, not part of COS.

Formulas to remember (quick recall)

  • Net Sales: ext{Net Sales} = ext{Total Sales} - ext{Sales Returns}
  • Gross Profit: ext{Gross Profit} = ext{Net Sales} - ext{Cost of Sales}
  • Adjusted Gross Profit: ext{Adjusted Gross Profit} = ext{Gross Profit} \u00B1 ext{Inventory Gain/Loss}
  • Net Profit: ext{Net Profit} = ext{Adjusted Gross Profit} - ext{Other Expenses}

Practice exercises (conceptual guidance)

  • Exercise 12.1 (FIFO, November 2030)
    • a) Propose one reason for the 15 November memo (Memo 12).
    • b) Identify another OUT-type transaction that does not contribute to COS.
    • c) Compute Cost of Sales for November 2030.
    • d) Explain why the calculated COS is unlikely to equal the Income Statement COS for Sonics.
  • Exercise 12.3 (Wherelslt Maps)
    • a) Prepare a Cash Flow Statement and an Income Statement for March 2030.
    • b) Explain treatment of GST settlement and buying expenses.

Quick recall tips for exam

  • FIFO vs Identified Cost differences hinge on price changes, not on units sold.
  • COS and Inventory on Hand values change with price levels, affecting Net Profit and Assets.
  • Use Net Sales and COS to derive Gross Profit, then adjust for inventory gains/losses to get Adjusted Gross Profit.
  • Separate inventory-related losses/gains from COS to keep the Income Statement informative for inventory management.