The Necessity of Adopting a Cost Flow Assumption

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.

A key event in accounting for inventory is the transfer of cost from the inventory T-account to cost of goods sold as the result of a sale. The inventory balance is reduced and the related expense is increased. For large organizations, such transactions can take place thousands of times each day. If each item has an identical cost, no problem exists. This standard amount is always reclassified into expense to reflect the sale.

However, if inventory items are acquired at different costs, which cost is moved from asset to expense? At that point, a cost flow assumption must be selected by company officials to guide reporting. That choice can have a significant impact on both the income statement and the balance sheet. It is literally impossible to analyze the reported net income and inventory balance of a company such as ExxonMobil without knowing the cost flow assumption that has been applied.

Question: An example is probably the easiest approach by which to demonstrate cost flow assumptions. Assume a men’s retail clothing store holds $120 in cash. On October 26, Year One, one blue dress shirt is bought for $50 in cash for resell purposes. Later, near the end of the year, this style of shirt becomes especially popular. On December 29, Year One, the store’s manager buys a second shirt exactly like the first but this time at a cost of $70. Cash on hand has been depleted completely ($120 less $50 and $70) but the company now holds two shirts in its inventory.

Then, on December 31, Year One, a customer buys one of these two shirts by paying cash of $110. Regardless of the cost flow assumption, the company retains one blue dress shirt in inventory at the end of the year and cash of $110. It also reports sales revenue of $110. Those facts are not in doubt.

From an accounting perspective, two questions are left to be resolved (1) what is the cost of goods sold reported for the one shirt that was sold and (2) what is the cost remaining in inventory for the one item still on hand?

In simpler terms, should the $50 or $70 be reclassified to cost of goods sold; should the $50 or $70 remain in ending inventory? For financial accounting, the importance of the answers to those questions cannot be overemphasized. What are the various cost flow assumptions and how are they applied to inventory?

Answer: SPECIFIC IDENTIFICATION. In a literal sense, specific identification is not a cost flow assumption. Companies that use this approach are not making an assumption because they know which item was sold. By some technique, they are able to identify the inventory conveyed to the customer and reclassify its cost to expense.

For some types of inventory, such as automobiles held by a car dealer, specific identification is relatively easy to apply. Each vehicle tends to be somewhat unique and can be tracked through identification numbers. Unfortunately, for many other types of inventory, no practical method exists for determining the physical flow of merchandise.

Thus, if the men’s retail store maintains a system where the individual shirts are marked in some way, it will be possible to know whether the $50 shirt or the $70 shirt was actually conveyed to the customer. That cost can be moved from asset to expense.

However, for identical items like shirts, cans of tuna fish, bags of coffee beans, hammers, packs of notebook paper and the like, the idea of maintaining such precise records is ludicrous. What informational benefit could be gained by knowing whether the first blue shirt was sold or the second? In most cases, the cost of creating such a meticulous record-keeping system far outweighs any potential advantages.