Specific Identification Method: Definition, Example, and FAQs
The specific identification method is an accounting principles approach used to assign costs to specific units of inventory when they are sold or remain on hand. Within the broader category of inventory costing methods, this technique involves individually tracking the exact cost of each item, making it particularly suitable for businesses dealing with unique, high-value, or non-interchangeable goods. When an item is sold, its actual cost is matched directly to the revenue generated from its sale, impacting the calculation of cost of goods sold and ultimately a company's gross profit. The specific identification method provides precise cost matching, reflecting the true flow of specific items into and out of a business's possession.
History and Origin
The concept behind the specific identification method is perhaps the most intuitive and foundational of all inventory costing approaches, predating more complex methods designed for mass production. In early commerce, when merchants dealt with a limited number of distinct, often high-value goods like livestock, ships, or rare spices, it was natural to track the exact cost of each individual item. As accounting evolved, this direct matching principle remained relevant for businesses where individual units are clearly distinguishable and possess unique cost attributes. Generally Accepted Accounting Principles (GAAP) recognize specific identification as a valid method, particularly when it accurately reflects the physical flow of goods. It is one of four primary inventory costing methods widely taught in financial accounting, alongside First-In, First-Out (FIFO), Last-In, First-Out (LIFO), and weighted-average cost.5
Key Takeaways
- The specific identification method tracks the exact cost of each individual item in inventory.
- It is typically used for unique, high-value items, such as luxury cars, custom-made furniture, or fine jewelry.
- This method accurately matches specific costs with specific revenues, providing a precise gross profit for each sale.
- It can offer potential tax implications advantages by allowing for strategic selection of units sold.
- The specific identification method requires detailed record-keeping and is not practical for large volumes of undifferentiated goods.
Interpreting the Specific Identification Method
Interpreting the results obtained using the specific identification method is straightforward: the cost of goods sold directly represents the cost of the exact items that were sold, and the remaining inventory on the balance sheet reflects the actual cost of the specific units still on hand. This method provides the most accurate reflection of a company's financial performance by ensuring that the actual costs incurred for specific goods are aligned with the revenues those goods generate. For items where costs fluctuate significantly and individual tracking is feasible, the specific identification method can provide a clear picture of profitability per unit. However, its detailed nature means it's less commonly seen for businesses with high volumes of identical items where the precise cost of each unit is less critical or practical to track.4
Hypothetical Example
Consider "Artisan Guitars," a boutique store specializing in unique, handcrafted musical instruments. Artisan Guitars uses the specific identification method for its inventory.
On March 1, the store purchases a custom-built acoustic guitar, "Guitar A," for $2,500.
On March 15, they purchase another custom electric guitar, "Guitar B," for $3,000.
On March 20, they purchase a limited-edition bass guitar, "Guitar C," for $3,500.
Suppose on March 25, Artisan Guitars sells "Guitar C" for $5,000.
Under the specific identification method, the exact cost of "Guitar C" ($3,500) is recognized as the cost of goods sold for that sale.
Calculation:
Revenue from sale of Guitar C: $5,000
Cost of Guitar C (specifically identified): $3,500
Gross Profit from Guitar C: $5,000 - $3,500 = $1,500
The remaining inventory on hand would be "Guitar A" (cost $2,500) and "Guitar B" (cost $3,000), totaling $5,500 in ending inventory, reflecting their actual purchase prices. This allows Artisan Guitars to know the precise profit margin on each unique instrument sold.
Practical Applications
The specific identification method is primarily applied in industries and situations where individual items are unique, have a high market value, and are not easily interchangeable. Examples include:
- Automobile Dealerships: Each car has a unique Vehicle Identification Number (VIN) and a distinct cost. When a specific car is sold, its exact cost is matched to the sale.
- Jewelry Stores: Individual pieces of jewelry, especially those with unique gemstones or designs, are often tracked using this method due to their high value and distinct characteristics.
- Art Galleries: Artworks are inherently unique, and their costs are meticulously tracked individually.
- Real Estate: Each property has a specific acquisition cost and is sold individually.
- Investment Portfolios: For investors, the specific identification method can be used when selling shares of stock. Instead of assuming a first-in, first-out (FIFO) or average cost basis, an investor can choose to sell specific lots of shares purchased at different prices. This can be advantageous for tax implications, allowing investors to manage capital gains or losses by selecting shares with a higher or lower cost basis. For instance, IRS Publication 550 discusses how taxpayers can identify specific shares sold to determine their basis and subsequent capital gain or loss.3 This selective approach directly impacts an investor's financial reporting and overall profitability.
This method provides precise inventory valuation and financial statements, but its feasibility decreases with a high volume of identical or low-cost items.
Limitations and Criticisms
While highly accurate, the specific identification method has significant limitations. Its primary drawback is the impracticality and high cost of tracking individual units for businesses with large volumes of inventory or items that are essentially identical. For example, a grocery store selling thousands of cans of beans would find it impossible to track the specific cost of each can.2
Other criticisms include:
- Administrative Burden: The detailed record-keeping required can be time-consuming and expensive, especially without sophisticated inventory management systems. Each purchase and sale event necessitates recording the unique identifier and cost of the specific item.
- Potential for Income Manipulation: When a company holds identical items purchased at different costs, management could selectively choose which specific units to sell to influence the cost of goods sold and, consequently, the reported net income. For instance, if prices have been rising, selling the higher-cost units would lead to a lower reported profit, while selling lower-cost units would boost profits. This subjectivity could undermine the objectivity of financial reporting. The Journal of Accountancy has discussed how different inventory costing methods, including specific identification, can impact reported profitability and require careful consideration of their application.1
- Not Representative of Physical Flow: For many businesses, the physical flow of goods does not naturally follow a specific identification pattern. Items are often stored and retrieved without regard to their individual purchase costs.
Due to these limitations, the specific identification method is largely confined to industries dealing with distinct, high-value, and low-volume asset types.
Specific Identification Method vs. FIFO
The specific identification method and the FIFO (First-In, First-Out) method are both inventory costing approaches, but they differ fundamentally in how they assign costs.
The specific identification method directly tracks the actual cost of each individual item. When an item is sold, its precise purchase cost is used to calculate the cost of goods sold. This method is used when items are unique and distinguishable, such as custom-made furniture or luxury vehicles. It provides the most accurate reflection of the cost flow for those particular items.
In contrast, the FIFO method is a cost flow assumption that presumes the first items purchased are the first ones sold, regardless of their actual physical movement. This means that the costs associated with the oldest inventory are expensed first, leaving the most recently acquired costs in the ending inventory on the balance sheet. FIFO is widely used because it generally aligns with the physical flow of many goods (especially perishable items) and can result in a higher reported profitability during periods of rising prices. However, unlike specific identification, FIFO does not aim to match the exact cost of a specific item sold, but rather applies a cost-flow assumption.
The key distinction lies in accuracy versus assumption: specific identification is precise but often impractical for mass goods, while FIFO is an assumption that simplifies inventory accounting for interchangeable items.
FAQs
What types of businesses commonly use the specific identification method?
Businesses that deal with unique, high-value, and non-interchangeable items commonly use the specific identification method. Examples include art galleries, jewelry stores, car dealerships, and companies selling custom-made products. Investors also use this method for tracking the cost basis of specific blocks of securities.
Why is the specific identification method not suitable for all businesses?
It is not suitable for businesses dealing with large volumes of identical, low-value, or undifferentiated goods, such as a supermarket or a hardware store. The administrative burden and cost of tracking each individual item would be prohibitive and impractical.
Can using the specific identification method affect a company's taxes?
Yes, especially for investments. When selling securities, an investor using the specific identification method can choose which specific shares (e.g., those purchased at a higher or lower price) to sell, which can strategically impact their reported capital gains or losses and, consequently, their tax implications.
Does the specific identification method accurately reflect the physical flow of goods?
For unique, identifiable items, the specific identification method accurately reflects the physical flow of goods. However, for interchangeable goods, the physical flow might not necessarily align with how their costs are assigned under other methods like FIFO or LIFO.
Is the specific identification method allowed under GAAP?
Yes, the specific identification method is allowed under Generally Accepted Accounting Principles. It is considered appropriate when individual units of inventory are distinguishable and can be specifically identified with their acquisition costs.