Specific Identification Accounting Explained
Discover how assigning an actual cost to each inventory item provides a precise valuation and gives a business direct control over its reported profit.
The specific identification method is an inventory costing approach where the actual cost associated with each individual inventory item is tracked. This process follows an item from the moment it is acquired until it is sold. Unlike other common inventory methods that group similar items, this technique treats every product as a distinct financial entity. It is most suitable for businesses dealing with unique, high-value goods, including items that are not interchangeable.
The Mechanics of Specific Identification
Every item in stock is treated as a distinct, traceable unit, which requires a system to individually mark and follow each product. Businesses that deal with items that have unique characteristics find this method particularly applicable. For example, an art gallery selling one-of-a-kind paintings, a jeweler crafting custom pieces, or a dealership selling automobiles with a specific Vehicle Identification Number (VIN) would use this approach. To implement this, businesses use serial numbers, barcodes, or Radio Frequency Identification (RFID) tags to link a physical item to its specific purchase cost in an inventory management system.
Calculating Cost of Goods Sold and Ending Inventory
The calculation process under specific identification directly uses the tracked costs of individual items. When an item is sold, its exact cost is transferred from the inventory account to the Cost of Goods Sold (COGS) account. This provides a precise matching of costs with revenues, as the actual cost of the specific item sold is recorded, rather than an averaged or assumed cost.
Consider an art gallery that purchases three distinct sculptures. The first sculpture costs $1,000, the second costs $1,200, and the third is acquired for $1,500. If a customer purchases the second sculpture, the one that cost $1,200, the gallery’s COGS for that sale is exactly $1,200. Following the sale, the value of the ending inventory is determined by summing the costs of the items that remain unsold. In the gallery example, the ending inventory balance would be $2,500 ($1,000 + $1,500).
Record-Keeping Requirements
To use the specific identification method, a business must maintain detailed records to substantiate financial statements and tax filings. The system must be capable of tracking each inventory item individually from its purchase to its sale. Documentation includes original purchase invoices that clearly show the cost of each specific item acquired. A business must maintain a perpetual inventory log detailing each item, its unique identifier, its specific cost, and its purchase date. The Internal Revenue Service (IRS) requires taxpayers using this method to demonstrate that they can identify the specific cost of each item sold.
Financial Statement and Tax Implications
The use of the specific identification method has direct consequences for a company’s financial statements. The COGS figure on the income statement is a direct reflection of the actual costs of the specific items sold, which in turn affects the calculation of gross profit and net income. On the balance sheet, the ending inventory value is reported at the sum of the actual costs of the unsold items.
A significant implication of this method is the ability it affords management to influence reported earnings. For instance, if a company holds several identical items purchased at different costs, it can strategically choose which item to sell. Selling an older, lower-cost item will result in a lower COGS and a higher net income. Conversely, management could choose to sell a newer, higher-cost item. This action would increase the COGS, leading to a lower reported profit and a lower taxable income.