Determining the exact quantity of goods in the firm’s ending inventory and then assigning prices to those things are required in order to arrive at the overall cost of the firm’s ending stocks.
At the end of each year is when most businesses do a physical inventory. Whether a company chooses the perpetual or the periodic inventory technique, a physical inventory is necessary.
Assuming a specific cost flow pattern, prices are then assigned to each inventory item after the quantity has been calculated. Price multiplied by quantity equals the cost of stock on hand at the conclusion of the period.
Quantities of Inventory at the Close
In most cases, a physical count is the only reliable way to determine the precise number of items in the closing stockpile. As a result, businesses typically have to shut down while they complete the count, which can take more than a day.
Think of the time and energy required to tally the closing stock of a major department store as an example. Companies, especially those in the retail industry, sometimes resort to estimating methods for these same reasons.
When doing a final inventory count, a company must include everything in its possession, even whether it’s held in a public warehouse or in transit.
Sales on a FOB destination basis and purchases on a FOB shipping basis are both considered to be goods in transit. Sold but unsold inventory shouldn’t be counted.
Expenses Considered for Closing Stock
It is generally understood that inventories should be documented at cost in accordance with generally accepted accounting rules. Here is how the AICPA characterizes expense:
The [cost] of acquiring something is the money or other resources used to do so. In the context of stock, “cost” is understood to be the aggregate of all the money and other resources that went into bringing an item to its current state and position.
Acquisition costs for retailers include the purchase price less any discounts, plus shipping expenses, transit insurance, and any applicable taxes before the item is ready for sale.
However, the effort required to allocate expenditures such as freight and insurance to particular items is typically more than the advantage gained.
Therefore, when assigning a cost to each item in the ending inventory, most businesses simply utilize the net invoice price. These supplementary expenditures are rolled into the final price tag.
Due to the inability to adequately assign them to specific objects, indirect costs like selling and warehousing are not factored into the cost of inventory.
As such, they are deducted from the current period’s income as period costs.
A fundamental accounting issue that has yet to be solved is finding out what to include in the acquisition cost after calculating the ending inventory amount.
What final prices should be set for individual items in the stockpile is a choice that must be made.
In other words, the issue is how an accountant is to ascertain the acquisition cost or price paid for each item in the ending inventory, given that the goods were purchased at various times and at varying prices.
Techniques for Assigning Final Inventory Prices
The initial impression is that it is simple to calculate the acquisition cost of each item sold or the acquisition cost of the ending inventory.
Now think of a company that does exactly the same thing, only they offer molded plastic chairs that they paid varying amounts for.
Or think of a department shop that offers a wide selection of goods in a number of formats and pricing points.
It is difficult, if not impossible, for these enterprises, even with a sophisticated electronic recordkeeping system, to calculate the value of each item in the closing stock.
If everything is bought at once, the cost of the finished stock and the products sold will be easy to calculate.
Since prices tend to fluctuate, accountants have come up with creative ways to assign dollar amounts to stock.
As opposed to physical flow assumptions, these techniques instead rely on cost flow assumptions.
That is to say, the way in which the commodities enter and leave the firm has no bearing on the assumed cost flow pattern, which can take place in any of four possible ways.
These presumptions on cash flow costing are as follows:
“First in, first out”
Liquidity integrity and management by using the “last in, first out”
Specific identification is a type of real flow assumption that can be used under certain conditions.