Running head: INVENTORY METHODS 1
Inventory Methods: Usages under GAAP and IFRS
Peter Klotzbach
ACCT 301-B01
Liberty University
INVENTORY METHODS 2
Inventory Methods: Usages under GAAP and IFRS
Inventory reporting is a very important aspect of financial statements. Assigning dollar
values to the inventory sold and to the remaining inventory is essential in order to properly
record costs of goods sold for the period. This can be a complicated task because unless
inventory is specifically tracked and tallied as it may be in a small business or with high value
items then inventory flow assumptions must be made. If items can be tracked and specifically
matched to their costs, then specific identification is used. If, as commonly is the case, inventory
moves in large quantities and can be difficult to trace then the three following inventory flow
assumptions are generally used: Average Cost Method, FIFO (First in First Out), or LIFO (Last
in First Out). These are designated as assumptions because even though the inventory flow may
report as one method or the other, the actual flow of goods may not reflect the pattern that is
reported. Each inventory method allows for different benefits or tax advantages and therefore
companies may choose under which method to report inventory as long as they disclose it.
Certain methods work better for specific industries than others and different assumptions are
permitted under GAAP and IFRS.
Specific Identification
Specific identification is the only cost flow method that records inventories actual costs
and actual flow per item. This method is generally utilized by companies that have relatively low
sales volume or valuable inventory items. One popular example of products that follow this cost
flow method is automobiles. Each vehicle is marked with unique serial or VIN numbers that
identify the vehicle. VIN numbers can be used to match the auto to its invoice, maker, as well as
matching parts (Spiceland, Nelson, & Thomas, 2020). Another industry that occasionally uses
specific identification is the fine jewelry industry. For example, diamonds are many times
INVENTORY METHODS 3
engraved by the cutter or specific jeweler that worked the piece and the marking can be used to
identify the jewel as well as its value.
While this method of inventory tracking is highly accurate, it is also very impractical for
most companies (Spiceland, Nelson, & Thomas, 2020). Most companies that push any
significant level of inventory or provide low cost items is likely to utilize one of the inventory
flow assumptions to simplify their inventory recording as well as reduce tracking costs.
Average Cost Method
An opposite of the specific identification method, the average cost flow assumption is
that all goods of a certain type are assumed to be interchangeable and the only difference is their
purchase price. The average cost method operates under the assumption that the cost of goods
sold and ending inventory consist of a mixture of all goods available for sale (Spiceland, Nelson,
& Thomas, 2020). This method assigns costs to inventory by using an average cost weighted by
the number of units acquired at various unit costing points. There are slight differences as to how
you calculate average cost depending on if the periodic or perpetual system is utilized. Under the
periodic system, average cost is calculated by dividing cost of goods available for sale by the
quantity of goods available for sale. Using the average cost method under the perpetual system is
slightly more complicated in that it requires a new weighted average to be calculated for every
instance that new inventory is purchased. This process changes it from a weighted average cost
to a moving average unit cost (Spiceland, Nelson, & Thomas, 2020). After each purchase the
costs of the previous inventory balance are added to the costs of the new purchase, the sum of
that is then divided by the number of units on hand available for sale. Because of this difference,
the average cost method generally produces different allocations for cost of goods sold and
ending inventory under the periodic and perpetual variations.
INVENTORY METHODS 4
FIFO
FIFO stands for first in – first out, meaning that the inventory purchased first will be the
first to be sold and the subsequent purchases will be sold in the order that they were acquired.
This is one of the inventory assumptions that most closely follows the actual flow of inventories
across most industries. This is commonly the method by which grocery stores and manufacturing
industries manage their inventory. In a grocery store it makes logical sense to sell the inventory
acquired first in order to prevent food from expiring past its shelf life. In a manufacturing
industry, it would also make sense that the first goods finished would be sold first and that the
goods still in production would be sold later. Under both the periodic and perpetual variations of
this inventory flow assumption method, cost of goods sold and ending inventory will be the same
(Spiceland, Nelson, & Thomas, 2020). This is because the same units and costs will be acquired
and sold in the same order regardless if the amounts are determined after each sale or at the end
of each period as a residual amount.
FIFO has always been a commonly practiced and accepted method of inventory valuation
because of its consistency with actual flows of inventory. FIFO benefits are fairly obvious due to
its logical reporting of inventory. FIFO prevents inventory form aging, rotting, becoming
obsolete, or forgotten. It was not until the shift of importance from balance sheets to income
statements that this assumption method began to come under scrutiny (Herzig, 1976). Income
statements were being recognized as better estimates of performance. They also displayed the
effect that income tax had on inventory valuation. Under periods of normal product inflation,
FIFO actually leaves the company with the recently acquired and more expense inventory in its
stock therefore increasing the company’s valuation and subjecting it to higher tax liability. This
INVENTORY METHODS 5
prompted corporations to look to methods increasingly used across the ocean in Great Britain in
order to reduce income valuation and reduce exposure to taxes. The answer that emerged was the
LIFO inventory flow assumption.
LIFO
LIFO stands for last in – first out meaning that the inventory acquired last will be the first
to be sold and the sale pattern will follow chronologically reversed (Inventory Cost Flow
Assumptions, 2020). This inventory flow assumption is essentially the opposite of the FIFO
method. While almost no companies actually manage their inventory like this method would
indicate, it is permitted for reporting purposes only. Unlike in FIFO, cost of goods sold and
inventory amounts calculated are different under the periodic and perpetual inventory methods
under LIFO. If inventory cost rise throughout the year, as they are expected due to inflation,
periodic LIFO will generally result in a lower cost of ending inventory and a higher cost of
goods sold. It is for this reason that companies utilizing LIFO will almost never use the perpetual
method.
While LIFO is now a commonly utilized method of reporting now in the United States it
was not permitted until the Revenue Act of 1938 was passed. It was not widely used until well
into the 1970’s (Herzig, 1976). The primary factor influencing the popularity of LIFO is its
ability to report a lower ending inventory valuation than the other assumption methods. This
attribute shields companies from being taxed at higher rates. However, this benefit is dependent
on the assumption that tax inventory prices will increase in the coming periods. This is not
always the case, as witnessed in the electronics industry. For example, look at the price of
computers over the years. According to USA Today writer Evan Comen, when the first personal
computers were released, an HP 3000 went for $95,000 in 1972. That is the equivalent of slightly
INVENTORY METHODS 6
over half a million in today’s dollars (2018). Far more advanced personal computers can now be
purchased for under $300. Electronics and other industries that experience depreciation at such a
high rate because of the immense competition and ongoing advancements in the field would
benefit from composing statements under FIFO. This only applies to period of decrease costs and
since the majority of industries operate with inventory affected by inflation LIFO is generally
found to produce the lowest ending inventory and therefore the smallest tax liability.
Regulations
While these inventory flow assumption methods provide certain benefits or are better
suited for certain industries or inventory types, they are subject to the regulatory accounting and
tax principles in place in the areas where they conduct business. For multinational corporations,
this can be complicating as different sovereignties may operate under different methods or even
restrict some. Ongoing convergence efforts between the United States’ Generally Accepted
Accounting Principles (GAAP) and the International Financial Reporting Standards (IFRS) are
simplifying these efforts, but some major differences still exist and the convergence costs can be
quite high.
US GAAP
The United States’ generally accepted accounting principles (US GAAP) offers quite a bit
of leniency when it comes to how companies must report their inventory. Under GAAP the
specific identification, average costing, FIFO, and LIFO methods are all permissible (Spiceland,
Nelson, & Thomas, 2020). Companies can even use different methods for their various inventory
sectors. This enables corporations to pick and choose which reporting style
will benefit them more and help emphasize their objectives to shareholders. Although there is
leniency in choice of methods there are certain changes that do require approval from US
INVENTORY METHODS 7
agencies. For example, the Internal Revenue Service does not require permission to switch from
FIFO to LIFO as long as annual earnings data for the year of the change have not been reported.
However, a change from LIFO to FIFO requires permission from the Treasury Department
(Herzig, 1976).
IFRS
IFRS is the international standard for accounting and financial statements and stands for
the International Financial Reporting Standards. Since European Union’s adoption of IFRS in
2005, more than 144 jurisdictions require the use of IFRS and 12 others permit it (Spiceland,
Nelson, & Thomas, 2020). Even the independent standards of two of the largest and fastest
growing economies, China and India, are modeled after the IFRS and are mostly compatible with
the system (US GAAP vs IFRS, 2020). Unlike the United States generally accepted accounting
principles which allow usage of specific identification and all three assumption methods, IFRS
only allows FIFO and average costing. IAS No.2 specifically singles out LIFO as not permitted
(Spiceland, Nelson, & Thomas, 2020). In order to get around this barrier many U.S. firms that
operate internationally will use LIFO for their domestic inventories and FIFO or average costs
for its foreign operations. This allows the companies to benefit from LIFO’s tax shield attributes
in the US while still complying with the IFRS’ regulations. This dual method of reporting can
create confusion and therefore it is generally mandated that this information be disclosed in a
note on the annual report.
This is a dual reporting allowance has become a topic of concern for corporations that
operate in this manner as they fear the increasing convergence between the US GAAP and the
IFRS will result in the repeal of the LIFO conformity rule (Sander & Hughes 2007). If this
occurs and companies are taxed on the difference between LIFO and their comparable reports
INVENTORY METHODS 8
using FIFO, American corporations stand to lose billions in taxes and convergence fees. The US
government estimates that the repeal of LIFO could increase federal tax revenues by $76 billion
over ten years. While this would seemingly help the US government, it has yet to occur because
it has the potential to devastate American corporations and therefore have a major effect on the
overall economy and lead to unemployment.
Conclusion
Depending on whether a corporation operates under the United States generally accepted
accounting principles or the international financial reporting standards, companies can have quite
a few options when it comes to reporting and valuing inventory. Each method of inventory
valuation has its benefits and disadvantages and therefore it is important to evaluate which
selection will best benefit the company, its managements objectives, satisfy its shareholders, and
comply with the regulatory agency.
Specific identification is ideal for valuable inventories with relatively small inventories.
Average costing on the other hand is great for multinational companies as it is permitted under
IFRS. Yet because average costing does not provide as big tax shield as LIFO or follow the
actual flow inventories as FIFO does, it is not as popular a choice. The two most popular
assumption methods are LIFO and FIFO and many factors will go into determining which will
be used. Both LIFO and FIFO may be an advantage or disadvantage depending upon what
management’s objectives are and what is and what trends the industry’s prices and inventory
flows follow. LIFO should be used when reducing expenses and tax liability is important, prices
are rising or subject to inflation, and inventory is constant or increasing. FIFO should be used
when profit maximization is important and prices are subject to increases and inflation. In
reversed circumstances and conserving cash is important, prices experience a decrease, and
INVENTORY METHODS 9
inventory is constant or increasing, FIFO should be used. Profit maximization under the reversed
circumstances is also achieved via LIFO (Herzig, 1976). It is important to also review which will
provide the best method of reporting for the companies operating sovereignties and comply with
the governing agencies. LIFO is highly restricted under the IFRS and usage of multiple methods
may result in convergence costs that offset the benefit of using LIFO domestically. It is essential
for corporations to seek a method that will best satisfy all its objectives while reducing or
maintaining minimal costs. With convergence between IFRS and GAAP on the horizon, it is wise
for corporations to prepare for possible exposures if the LIFO conformity rule is repealed
(Spiceland, Nelson, & Thomas, 2020).
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References
Comen, E. (2018). Check out how much a computer cost the year you were born. USA TODAY.
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of-a-computer-the-year-you-were-born/36156373/
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deflation". Graduate Student Theses, Dissertations, & Professional Papers. 2842.
https://scholarworks.umt.edu/etd/2842.
Inventory Cost Flow Assumptions. (2020). Retrieved 2 March 2020, from
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Sander and Hughes (2007). "A U.S. Manager's Guide to Differences Between IFRS and U.S.
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https://digitalcommons.butler.edu/cob_papers/69.
Spiceland, D., Nelson, M., & Thomas, W. (2020). Intermediate accounting (10th ed., pp. 9-12).
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Zehna, P. W. (1968). A clarification in LIFO vs. FIFO. Management Science (Pre-1986), 14(11),
734. Retrieved from http://ezproxy.liberty.edu/login?url=https://search-proquest-
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