Tax Accounting:
Valuation of Inventories: A Cost
Basis Approach under GAAP
Adopted in part from Kieso, Weygandt, and Warfield’s
Intermediate Accounting and
Originally prepared by
Jep Robertson and Renae Clark
New Mexico State University
(altered by Thomas M. Brinker, Jr. for Tax Accounting)
Flow of Costs through
Manufacturing and
Merchandising Companies
Inventory Control
Inventory control is important for:
1. Ensuring availability of inventory items
2. Preventing excessive accumulation of inventory
items
The perpetual system maintains a
continuous record of inventory changes
The periodic system updates inventory
records only periodically
Inventory Systems
Perpetual Method
Periodic Method
• Purchases are debited
to Inventory account
• Freight-in, Purch. R &
A and Purch. Disc. are
recorded in Inventory
account.
• Debit COGS and credit
Inventory account for
each sale.
• Purchases are debited
to Purchases account.
• Freight-in, Purch. R &
A and Purch. Disc. are
recorded in their
respective accounts.
• COGS is computed only
periodically:
COGAS
- Ending Inventory
COGS
Guidelines for Determining
Inventory Ownership
Effect of Inventory Errors
Error in
Ending
Inventory
Effect on
Income
Items
Effect on
Balance sheet
Items
Understated
COGS (over)
Net income (under)
Inventory (under)
Retained Earn (under)
Overstated
COGS (under)
Net income (over)
Inventory (over)
Retained Earn (over)
Costs Included in Inventory
Generally accounted for on a cost
basis.
• Product costs (DM, DL, O/H) are
“inventoriable” costs, whereas
• Period costs (S,G, & A) are not
inventoriable costs
Cost Flow Assumptions
The objective is to most clearly reflect
periodic income.
Cost flow assumptions need not be
consistent with physical flow of goods.
The cost flow assumptions are:
1
2
3
4
Specific Identification
Weighted Average Cost
First-in, First-out (FIFO) and
Last-in, First-out (LIFO)
Cost Flow Assumptions: Example
Susieworld reports the following transactions for
2004:
Date
Purchases
Purchase Cost
May 12
100 units
$1,000
Aug 14
200 units
2,200
Sep 18
120 units
1,800
420 units
$5,000
On December 31, the company had 20 units on hand
and uses the periodic inventory system.
What are the cost of goods sold and the cost of
ending inventory?
Weighted Average Method
Given Data:
Date
May 12
Aug 14
Sep 18
Purchases
100 units
200 units
120 units
420 units
Cost
$1,000
$2,200
$1,800
$5,000
Steps:
1. Calculate per unit average cost: $5,000/420 = $11.905
2. Apply this per unit average cost to units sold to get COGS:
400 x $11.905 = $4,762
3. Apply the per unit average cost to units remaining in
inventory to determine Ending Inventory: 20 x $11.91 = $238
First-In, First-Out (FIFO) Method
Given data:
Date
Purchases
May 12 100 units @ $10
Aug 14 200 units @ $11
Sep 18 120 units @ $15
420
Cost
$1,000
$2,200
$1,800
$5,000
Cost of goods sold (FIFO)
$1,000 (100 sold)
$2,200 (200 sold)
$1,500 (100 sold; 20 end inv)
$4,700
Cost of goods
available
Cost of Goods Sold
$4,700
$5,000
Ending Inventory
20 * $15 = $300
Last-In, First-Out (LIFO) Method
Given data:
Date
Purchases
May 12 100 units @ $10
Aug 14 200 units @ $11
Sep 18 120 units @ $15
420
Cost
$1,000
$2,200
$1,800
$5,000
Cost of goods sold (LIFO)
$ 800 (80 sold; 20, end inv)
$2,200 (200 sold)
$1,800 (120 sold)
$4,800
Cost of goods
available
Cost of Goods Sold
$4,800
$5,000
Ending Inventory
20 * $10 = $200
Cost Flow Assumptions: Notes
• The ending inventory in units is the same in
all three methods: the cost is different.
• The cost of goods sold and the cost of
ending inventory are different, but
• The cost of goods available is the same in
all three methods.
• LIFO would result in the smallest reported
net income (with rising prices).
Advantages of LIFO Method
• LIFO matches more recent costs with
current revenues.
• With increasing prices, LIFO yields the
lowest taxable income (assuming inventory
does not decrease).
• With reduced taxes, cash flow is improved.
• Under LIFO, the need to write down
inventory to market is lower.
Disadvantages of LIFO Method
• LIFO does not approximate the physical
flow of goods except in special situations.
• LIFO yields the lowest net income and
therefore reduced earnings (when prices
rise).
• Under LIFO, the ending inventory is
understated relative to current costs.
• LIFO involuntary liquidation may result in
income that is detrimental from a tax view.
• LIFO Conformity rule for GAAP
• LCM does not apply for tax purposes