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6.3: Financial Statement Impact of Different Inventory Cost Flows

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    • Contributed by Henry Dauderis and David Annand
    • Athabasca University
    • Sourced from Lyryx Learning

    Learning objective

    LO2 – Explain the impact of inventory cost flows and errors.

    When purchase costs are increasing, as in a period of inflation (or decreasing, as in a period of deflation), each cost flow assumption results in a different value for cost of goods sold and the resulting ending inventory, gross profit, and net income.

    Using information from the preceding comprehensive example, the effects of each cost flow assumption on net income and ending inventory are shown in Figure 6.3.1.

    Spec. Ident. FIFO Wtd. Avg.
    Sales $40.00 $40.00 $40.00
    Cost of goods sold 11.00 10.00 10.88
    Gross profit and net income $29.00 $30.00 $29.12
    Ending inventory (on the balance sheet) $4.00 $5.00 $4.12

    Figure \(\PageIndex{1}\): Effects of Different Cost Flow Assumptions

    FIFO maximizes net income and ending inventory amounts when costs are rising. FIFO minimizes net income and ending inventory amounts when purchase costs are decreasing.

    Because different cost flow assumptions can affect the financial statements, GAAP requires that the assumption adopted by a company be disclosed in its financial statements (full disclosure principle). Additionally, GAAP requires that once a method is adopted, it be used every accounting period thereafter (consistency principle) unless there is a justifiable reason to change. A business that has a variety of inventory items may choose a different cost flow assumption for each item. For example, Walmart might use weighted average to account for its sporting goods items and specific identification for each of its various major appliances.

    Effect of Inventory Errors on the Financial Statements

    There are two components necessary to determine the inventory value disclosed on a corporation's balance sheet. The first component involves calculating the quantity of inventory on hand at the end of an accounting period by performing a physical inventory count. The second requirement involves assigning the most appropriate cost to this quantity of inventory.

    An error in calculating either the quantity or the cost of ending inventory will misstate reported income for two time periods. Assume merchandise inventory at December 31, 2019, 2020, and 2021 was reported as $2,000 and that merchandise purchases during each of 2020 and 2021 were $20,000. There were no other expenditures. Assume further that sales each year amounted to $30,000 with cost of goods sold of $20,000 resulting in gross profit of $10,000. These transactions are summarized below.


    Figure \(\PageIndex{2}\)

    Assume now that ending inventory was misstated at December 31, 2020. Instead of the $2,000 that was reported, the correct value should have been $1,000. The effect of this error was to understate cost of goods sold on the income statement — cost of goods sold should have been $21,000 in 2020 as shown below instead of $20,000 as originally reported above. Because of the 2020 error, the 2021 beginning inventory was incorrectly reported above as $2,000 and should have been $1,000 as shown below. This caused the 2021 gross profit to be understated by $1,000 — cost of goods sold in 2021 should have been $19,000 as illustrated below but was originally reported above as $20,000.


    Figure \(\PageIndex{3}\)

    As can be seen, income is misstated in both 2020 and 2021 because cost of goods sold in both years is affected by the adjustment to ending inventory needed at the end of 2020 and 2021. The opposite effects occur when inventory is understated at the end of an accounting period.

    An error in ending inventory is offset in the next year because one year's ending inventory becomes the next year's opening inventory. This process can be illustrated by comparing gross profits for 2020 and 2021 in the above example. The sum of both years' gross profits is the same.

    Overstated Inventory Correct Inventory
    Gross profit for 2020 $10,000 $ 9,000
    Gross profit for 2021 10,000 11,000