Cost Flow Assumption

1. Understand the reason that accounting rules are often standardized so that all companies report many events in the same manner.

2. Know that the selection of a particular cost flow assumption is necessary when inventory is sold.

3. Apply the following cost flow assumptions to determine reported balances for ending inventory and cost of goods sold: specific identification, FIFO, LIFO, and averaging.

Question: In the coverage of financial accounting to this point, general standardization has been evident.

Most transactions are recorded in an identical fashion by all companies. This defined structure helps ensure

understanding. It also enhances the ability of decision makers to compare results from one year to the next or

from one company to another. For example, inventory—except in unusual circumstances—is always reported at

historical cost unless its value is lower. Experienced decision makers should be well aware of that criterion when

they are reviewing the inventory figures reported by a company.

However, an examination of the notes to financial statements for some well-known businesses shows an interesting

inconsistency in the reporting of inventory (emphasis added).

Mitsui & Co. (U.S.A.) Inc.—as of March 31, 2009:

“Inventories, consisting mainly of commodities and materials for resale, are stated at the lower of cost,

principally on the specific-identification basis, or market.”

Johnson & Johnson and Subsidiaries—as of December 28, 2008: “Inventories are stated at the lower-of-cost-or- market determined by the first-in, first-out method.”

Safeway Inc. and Subsidiaries—as of December 31, 2008: “Merchandise inventory of $1,740 million at year-end

2008 and $1,866 million at year-end 2007 is valued at the lower of cost on a last-in, first-out (‘LIFO’) basis or

market value.”

Bristol-Myers Squibb—as of December 31, 2008: “Inventories are generally stated at average cost, not in excess

of market.”

“Specific-identification basis,” “first-in, first-out,” “last-in, first-out,” “average cost”—what information do

these terms provide? Why are all of these companies using different methods?

In the financial reporting of inventory, what is the significance of disclosing that a company applies “first-in,

first-out,” “last-in, first-out,” or the like?

Answer: In the previous chapter, the cost of all inventory items was kept constant over time. Although that helped

simplify the initial presentation of relevant accounting issues, such stability is hardly a realistic assumption.

For example, the retail price of gasoline has moved up and down like a yo-yo in recent years. The cost of

some commodities, such as bread and soft drinks, has increased gradually for many decades. In other industries,

prices actually tend to fall over time. New technology products often start with a high price that drops as the

manufacturing process ramps up and becomes more efficient. Several years ago, personal computers cost tens of

thousands of dollars and now sell for hundreds.