What Is Specific Identification?
Specific identification is an inventory costing and asset valuation method used in accounting where the actual cost of each individual item of inventory or securities sold is tracked and matched with its revenue. Unlike other valuation methods that make assumptions about the flow of goods, specific identification precisely links a specific cost to a specific item. This method is particularly useful for businesses that deal with a small volume of high-value, unique, or easily distinguishable items, such as automobiles, custom-made jewelry, or fine art.
History and Origin
The concept of matching specific costs to specific items dates back to the early days of commerce, predating formalized accounting standards. When merchants dealt with a limited number of distinct goods, it was straightforward to know the exact purchase price of each item and apply that cost when the item was sold. As businesses grew and dealt with large volumes of undifferentiated goods, the practicalities of specific identification became challenging, leading to the development of alternative inventory valuation methods like First-In, First-Out (FIFO) and Last-In, First-Out (LIFO).
However, specific identification remains a fundamental principle, especially when dealing with identifiable assets where precise cost tracking is both feasible and desirable for financial reporting and tax implications. For instance, U.S. tax regulations, such as those detailed in 26 CFR ยง 1.471-1, explicitly allow for specific identification as a method for allocating inventory costs for certain taxpayers.
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Key Takeaways
- Specific identification directly matches the actual cost of an item sold to its revenue.
- It is most suitable for businesses handling unique, high-value, or easily distinguishable goods.
- This method provides the most accurate reflection of the flow of costs.
- It offers significant flexibility in managing reported gross profit and net income for tax planning purposes.
- Extensive record-keeping is required for its proper application.
Interpreting the Specific Identification Method
When applying the specific identification method, a business precisely tracks the cost basis of each individual asset it holds, whether it's inventory or investment securities. Upon the sale of one of these assets, the exact cost associated with that specific item is used to calculate the cost of goods sold (for inventory) or the gain/loss (for investments). This direct linkage means that the reported financial results, such as gross profit, truly reflect the actual cost of the particular item that left the business. This method offers transparency, as there is no assumption about the order in which items were acquired or sold.
Hypothetical Example
Imagine "Elite Art Gallery" purchases three unique sculptures:
- Sculpture A: purchased for $10,000 on January 10
- Sculpture B: purchased for $12,000 on February 15
- Sculpture C: purchased for $11,000 on March 20
On April 5, Elite Art Gallery sells Sculpture B for $18,000.
Using the specific identification method, the gallery would record the exact cost of Sculpture B, which is $12,000, as its cost of sale. The gross profit from this sale would be calculated as:
Sales Price โ Cost of Sculpture B = Gross Profit
$18,000 โ $12,000 = $6,000
The remaining inventory would consist of Sculpture A (cost $10,000) and Sculpture C (cost $11,000), precisely reflecting their acquisition costs. This contrasts with other inventory methods that might assume a different cost flow.
Practical Applications
Specific identification is primarily applied in two key areas:
- Inventory Management for Unique Goods: Businesses that sell distinct, high-value items such as custom machinery, real estate properties, luxury vehicles, or unique artwork often use specific identification to accurately determine their cost of goods sold. This ensures that financial records precisely match the physical flow and value of their specialized inventory. The method is allowed by the Internal Revenue Service (IRS) for determining inventory costs.
- 4Investment Cost Basis for Securities: Individual investors and financial institutions can utilize specific identification when selling shares of stock or other investments purchased at different prices and times. By specifically identifying which shares are being sold, investors can strategically manage their capital gains or losses for tax purposes. For example, an investor might choose to sell shares with a higher cost basis to minimize taxable gains or to realize losses for tax-loss harvesting, as explained by financial services firms. This3 method offers the most control over the realized gain or loss.
2Limitations and Criticisms
While specific identification offers precise cost matching, it comes with practical limitations and potential criticisms:
- Complexity and Record-Keeping: For businesses with a large volume of similar, undifferentiated items (e.g., a grocery store, a hardware store), tracking each individual item's cost would be impractical and extremely burdensome. The method requires meticulous record-keeping for each unit, including its acquisition cost and date, which can be administratively intensive.
- 1Potential for Income Manipulation: When a company possesses identical items acquired at different costs, specific identification allows management to choose which specific unit to report as sold. This flexibility can be used to manipulate reported gross profit and, consequently, net income. For example, if prices are rising, a company could choose to sell the lowest-cost items to show higher profits or the highest-cost items to show lower profits and reduce tax implications. This raises concerns about the comparability and transparency of financial statements if not managed ethically.
- Not Suitable for All Industries: Due to its high administrative cost and the nature of inventory, it is generally unsuitable for industries dealing with high volumes of low-cost, fungible goods.
Specific Identification vs. First-In, First-Out (FIFO)
Specific identification and First-In, First-Out (FIFO) are both methods used for inventory valuation and asset costing, but they differ fundamentally in their assumptions about cost flow.
Feature | Specific Identification | First-In, First-Out (FIFO) |
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Cost Flow Assumption | Matches the actual cost of the specific item sold. | Assumes that the first items purchased are the first ones sold, regardless of the physical flow of goods. |
Applicability | Best for unique, high-value, or easily identifiable items (e.g., cars, art, specific stock lots). | Suitable for most businesses, especially those with perishable goods or those where selling older inventory first is logical. |
Accuracy | Provides the most accurate reflection of actual costs. | Generally reflects the physical flow of goods for many businesses, but assumes rather than precisely identifies. |
Record-Keeping | Requires detailed tracking of each individual item's cost. | Less intensive; tracks costs on a batch or group basis. |
Tax Planning | Offers maximum flexibility to manage capital gains and losses for tax purposes by selecting specific lots. | Less flexibility; applies a consistent assumption about which costs are expensed, potentially leading to higher taxable income in periods of rising costs. |
The key confusion arises because both methods can lead to different reported profits and inventory values, especially in periods of fluctuating costs. While specific identification aims for absolute factual accuracy for each item, FIFO aims for a logical and consistent assumption about the flow of costs through the business.
FAQs
When is specific identification typically used?
Specific identification is typically used for businesses that deal with a small number of distinct, high-value items that can be individually identified, such as real estate, fine jewelry, automobiles, or specific lots of securities. It allows for precise matching of an item's actual cost with its sale.
Does specific identification affect a company's taxes?
Yes, specific identification can significantly affect a company's or an investor's tax implications. By choosing to sell specific items or shares with particular cost basis, businesses or individuals can manage their reported gross profit or capital gains, thereby influencing their taxable income.
Is specific identification allowed by accounting standards?
Yes, specific identification is an accepted inventory costing method under major accounting standards, provided it is practical and accurately reflects the physical flow of goods. However, due to its complexity and the potential for manipulation, it is generally reserved for unique, high-value items rather than large volumes of fungible goods.
What are the disadvantages of specific identification?
The main disadvantages include the extensive record-keeping required for each individual item, which can be burdensome for companies with high volumes of inventory. Additionally, the ability to choose which specific item to "sell" from identical items acquired at different costs could allow for manipulation of reported profits if not applied transparently.