Depending on the method your audit client uses for value ending inventory, the amount transferred from the balance sheet inventory account to the income statement cost of goods sold can vary wildly. Your first question for your client in this stage of the audit is how it values ending inventory. You need this information when recalculating your client’s inventory valuation.
The three common accounting methods for inventory are used; depending on which you use, the same inventory items can result in different ending dollar amounts.
First-in, first-out (FIFO): Using the FIFO method, your client assumes that the oldest items in its inventory are the ones first sold. Consider buying milk in a grocery store. The cartons or bottles with the most current expiration date are pushed ahead of the cartons that have more time before they go bad. The oldest cartons of milk may not always be the first ones sold (because some people dig around looking for later expiration dates), but a client using the FIFO method bases its numbers on the oldest items being sold first.
If you haven’t taken cost accounting, you may be having a ‘huh?’ moment. Think about it this way: accounting and auditing sometimes are strictly reduced to sets of rules. In this case, the inventory cost flow assumption is the official rule. The inventory cost flow assumption states that under FIFO, the oldest units are presumed to be sold first, regardless of whether they actually are.
Last-in, first-out (LIFO): Under this method, the client assumes that its newest items (the ones most recently purchased) are the first ones sold. Imagine a big jar of nails in a hardware store. Every time a customer wants to buy a nail, he takes one off the top (because digging around to the bottom of the jar would be quite painful). As the jar empties, more nails are added on top of the old ones instead of redistributing the old nails so they move to the top of the jar. Therefore, the newest nails are consistently sold to customers rather than the older ones.
When a company uses the LIFO method, it may have to include a LIFO reserve amount in its notes to the financial statements. This reserve amount is the inventory cost difference between using FIFO and LIFO.
Weighted average: When a client uses this method, inventory and the cost of goods sold are based on the average cost of all units purchased during the period. This method is generally used when inventory is substantially the same, such as grains and fuel.
When a business uses or sells inventory, the cost moves from the inventory asset account to the income statement cost of goods sold expense account using the particular method the company has selected for its business. It’s impossible to determine whether these accounts are reflected on the financial statements in a materially correct fashion if you don’t know which method your client uses. You find this information in a continuing client’s prior year audit working papers. For a new client, you secure this information during your interview.