Inventories Are Linked to the COGS Line of the Income Statement
Recall that Cost of Goods Sold (COGS) refers to the direct cost of buying raw materials and converting them into finished products or services.
Before these costs become part of COGS (on the income statement) and are matched to the revenues they help generate (under the matching principle of accrual accounting), they are part of the company’s inventories (on the balance sheet), such that:
Problem: Cost of office supplies changes: You bought a stapler for $2 that has been sitting in inventories; 6 months later you buy a stapler for your inventories for $2.50. What value do we assign to COGS (the stapler you have recently sold), and what value should ending inventories hold?
Three different methods of inventory accounting have been established to answer this question:
First In, First Out (FIFO). The items first purchased (first in) are the first to be sold (COGS—first out). Therefore, the cost of inventory first acquired (beginning inventory—first in) is assigned to COGS (first out). Ending inventory reflects the cost of the most recently purchased inventories.
Last In, First Out (LIFO). The items purchased last (last in) are the first to be sold (COGS—first out). Therefore, the cost of inventory most recently acquired (ending inventory—last in) is assigned to COGS (first out). Ending inventory reflects the cost of the first purchased inventories.
Average Cost. COGS and ending inventory are calculated as COGS divided by total number of goods.
IFRS Perspective: LIFO Inventory Accounting
IFRS prohibits the use of the LIFO inventory accounting method.
