Understanding Business Accounting For Dummies, 2nd Edition (98 page)

For example, say you own a shop that sells antiques. Every time an item sells, you need to transfer the amount you paid for the item from the stock asset account into the cost of goods sold expense account. At the start of a fiscal period, your cost of goods sold expense is zero, and if you own a medium-sized shop selling medium-quality antiques, your stock asset account may be £20,000. Over the course of the fiscal period, your cost of goods sold expense should increase (hopefully rapidly, as you make many sales).

You probably want your stock asset account to remain fairly static, however. If you paid £200 for a wardrobe that sells during the period, the £200 leaves the stock asset account and finds a new home in the cost of goods sold expense account. However, you probably want to turn around and replace the item you sold, ultimately keeping your stock asset account at around the same level - although more complicated businesses have more complicated strategies for dealing with stock and more perplexing accounting problems.

You have three methods to choose from when you measure cost of goods sold and stock costs: You can follow a first-in, first-out (FIFO) cost sequence, follow a last-in, first-out cost sequence (LIFO), or compromise between the two methods and take the average costs for the period. Other methods are acceptable, but these three are the primary options.
Caution:
Product costs are entered in the stock asset account in the order acquired, but they are not necessarily taken out of the stock asset account in this order. The different methods refer to the order in which product costs are
taken out
of the stock asset account. You may think that only one method is appropriate - that the sequence in should be the sequence out. However, generally accepted accounting principles permit other methods.

In reality, the choice boils down to FIFO versus LIFO; the average cost method runs a distant third in popularity. If you want our opinion, FIFO is better than LIFO for reasons that we explain in the next two sections. You may not agree, and that's your right. For your business, you make the call.

The FIFO method

With the FIFO method, you charge out product costs to cost of goods sold expense in the chronological order in which you acquired the goods. The procedure is that simple. It's like the first people in line to see a film get in the cinema first. The usher collects the tickets in the order in which they were bought.

We think that FIFO is the best method for both the expense and the asset amounts. We hope that you like this method, but also look at the LIFO method before making up your mind. You should make up your mind, you know. Don't just sit on the sidelines. Take a stand.

Suppose that you acquire four units of a product during a period, one unit at a time, with unit costs as follows (in the order in which you acquire the items): £100, £102, £104, and £106. By the end of the period, you have sold three of those units. Using FIFO, you calculate the cost of goods sold expense as follows:

£100 + £102 + £104 = £306


In short, you use the first three units to calculate cost of goods sold expense. (You can see the benefit of having such a standard method if you sell hundreds or thousands of different products.)

The ending stock asset, then, is £106, which is the cost of the most recent acquisition. The £412 total cost of the four units is divided between the £306 cost of goods sold expense for the three units sold and the £106 cost of the one unit in ending stock. The total cost has been taken care of; nothing fell between the cracks.

FIFO works well for two reasons:

In most businesses, products actually move into and out of stock in a first-in, first-out sequence: The earlier acquired products are delivered to customers before the later acquired products are delivered, so the most recently purchased products are the ones still in ending stock to be delivered in the future. Using FIFO, the stock asset reported on the balance sheet at the end of the period reflects the most recent purchase cost and therefore is close to the current
replacement cost
of the product.

When product costs are steadily increasing, many (but not all) businesses follow a first-in, first-out sales price strategy and hold off on raising sales prices as long as possible. They delay raising sales prices until they have sold all lower-cost products. Only when they start selling from the next batch of products, acquired at a higher cost, do they raise sales prices. We strongly favour using the FIFO cost of goods sold expense method when the business follows this basic sales pricing policy because both the expense and the sales revenue are better matched for determining gross margin.

The LIFO method

Remember the cinema usher we mentioned earlier? Think about that usher going to the
back
of the line of people waiting to get into the next showing and letting them in from the rear of the line first. In other words, the later you bought your ticket, the sooner you get into the cinema. This is the LIFO method, which stands for
last-in, first-out
. The people in the front of the queue wouldn't stand for it, of course, but the LIFO method is quite acceptable for determining the cost of goods sold expense for products sold during the period. The main feature of the LIFO method is that it selects the
last
item you purchased first and then works backward until you have the total cost for the total number of units sold during the period. What about the ending stock, the products you haven't sold by the end of the year? Using the LIFO method, you never get back to the cost of the first products acquired (unless you sold out your entire stock); the earliest cost remains in the stock asset account.

Using the same example from the preceding section, assume that the business uses the LIFO method instead of FIFO. The four units, in order of acquisition, had costs of £100, £102, £104, and £106. If you sell three units during the period, LIFO gives you the following cost of goods sold expense:

£106 + £104 + £102 = £312


The ending stock cost of the one unit not sold is £100, which is the oldest cost. The £412 total cost of the four units acquired less the £312 cost of goods sold expense leaves £100 in the stock asset account. Determining which units you actually delivered to customers is irrelevant; when you use the LIFO method, you always count backward from the last unit you acquired.

If you really want to argue in favour of using LIFO - and we have to tell you that we won't back you up on this one - here's what you can say:

Assigning the most recent costs of products purchased to the cost of goods sold expense makes sense because you have to replace your products to stay in business, and the most recent costs are closest to the amount you will have to pay to replace your products. Ideally, you should base your sales prices not on original cost but on the cost of replacing the units sold.

During times of rising costs, the most recent purchase cost maximises the cost of goods sold expense deduction for determining taxable income, and thus minimises the taxable income. In fact, LIFO was invented for income tax purposes. True, the cost of stock on the ending balance sheet is lower than recent acquisition costs, but the profit and loss account effect is more important than the balance sheet effect.