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INVENTORY ACCOUNTING

Perpetual inventory systemcebookTwitterPrintEmailMore71

Explanation

Perpetual inventory system provides a running balance of cost of goods available for sale and cost of
goods sold. Under this system, no purchases account is maintained because inventory account is directly
debited with each purchase of merchandise. The expenses that are incurred to obtain merchandise inventory
increase the cost of merchandise available for sale. These expenses are, therefore, also debited to inventory
account. Examples of such expenses are freight-in and insurances etc. Each time the merchandise is sold,
the related cost is transferred from inventory account to cost of goods sold account by debiting cost of
goods sold and crediting inventory account.

The balance in inventory account at the end of an accounting period shows the cost of inventory in hand.
The accuracy of this balance is periodically assured by a physical count usually once a year. If a
difference is found between the balance in inventory account and a physical count, it is corrected by
making a suitable journal entry. The common reasons of such difference include inaccurate record keeping,
normal shrinkage, and shoplifting etc.

Both merchandising and manufacturing companies use perpetual inventory system. Merchandising
companies use this system to maintain the record of merchandising inventory and manufacturing
companies use to account for purchase and issue of direct materials.
Traditionally, the perpetual inventory system is used by companies that buy and sell easily identifiable
inventories such as jewelry, clothing and appliances etc. but advanced computer software packages have
made its use easy for almost all business situations.
Journal entries in a perpetual inventory system:
(1). When goods are purchased:

(2). When expenses such as freight-in, insurance etc. are incurred:

(3). When goods are returned to supplier:

(4). When goods are sold to customers:

(5). When goods are returned by customers:


(6). When a difference between the balance of inventory account and physical count of inventory is
found:

For further explanation of the concept of perpetual inventory system, consider the following example:

Example:

(1). On 1st April 2013, Metro company purchases 15 washing machines at $500 per machine on account.
The supplier allows a discount of 5% if payment is made within 10 days of purchase. The Metro company
uses net price method to record the purchase of inventory.

The following journal entry would be made in the books of Metro company to record the purchase of
merchandise:

*Net of discount: ($500 15) $25 discount


(2). On the same day, Metro company pays $320 for freight and $100 for insurance.
The following journal entry would be made to record the payment of freight-in and insurance expenses:

(3). On April 07, Metro company returns 5 washing machines to the supplier.

The return of washing machines to the supplier decreases the cost of inventory and accounts payable. The
following entry would be made to record this decrease:

(4). On April 9, Metro sends the payment via online banking system and takes the advantage of the
discount offered by the supplier.
As the payment is made within 10 days, the Metro company is entitled to receive discount. The following
entry would be made to record the payment:

*($7,125 $2,375)
(5). On April 15, Metro company sells 4 washing machines at $750 per machine. The Metro company does
not allow any discount to customers.

The sale of 4 washing machines transfers the cost of inventory from inventory account to cost of goods
sold account. Two journal entries would be made; one for the sale of 4 washing machines and one for the
transfer of cost from inventory account to cost of goods sold account:

*Cost of 4 machines sold:

[($475 10 machines) + $420 expenses]/10 = $517 per machine


$517 4 machines = $2,068

To summarize the events of increase and decrease in the cost of inventory, Inventory T-account of Metro
company is given below:

Periodic inventory systemcebookTwitterPrintEmailMore54

Explanation

Under periodic inventory system inventory account is not updated for each purchase and each sale. All
purchases are debited to purchases account. At the end of the period, the total in purchases account is added
to the beginning balance of the inventory to compute cost of goods available for sale. The ending inventory
is determined at the end of the period by a physical count and subtracted from the cost of goods available
for sale to compute the cost of goods sold.

The general formula to compute cost of goods sold under periodic inventory system is given below:

Cost of goods sold (COGS) = Beginning inventory + Purchases Closing inventory

Example

The following information belongs to John company, a retailer of high-end fashion products:
Inventory balance on January 1, 2016: $600,000
Purchases made during the year 2016: $1,200,000
Inventory balance on December 31, 2016: $500,000

Required: Compute cost of goods sold for the year 2016 assuming the company uses a periodic inventory
system.

Solution:

Cost of goods sold (COGS) = Beginning inventory + Purchases Closing inventory


= $600,000 + $1,200,000 $500,000
= $1,300,000

Journal entries in a periodic inventory system:

(1). When goods are purchased from supplier:

(2) When expenses are incurred to obtain goods for sale freight-in, insurance etc:

(3). When goods are returned to supplier:

(4). When payment is made to supplier:

(5). When goods are sold to customers:

(6). When goods are returned by customers:


(7). When cash is collected from customers:

(8). At the end of the period:

Example:

The following information belongs to Paradise Hardware Store:

Beginning inventory: 200 units at $12 = $2,400


Purchases made during the period: 1800 units at $12 = $21,600
Sales made during the period: 1200 units at $24 = $28,800
Ending inventory: 800 units at $12 = $9,600

Required: Make journal entries to record above transactions assuming a periodic inventory system is used
by Paradise Hardware Store.

Solution:
* (21,600 + 2,400) 9,600

Periodic inventory system is usually used by companies that buy and sell a wide variety of inexpensive
products.

A disadvantage of periodic inventory system is that overages and shortages of inventory are buried in cost
of goods sold because no accounting record is available against which to compare physical count of
inventory.

First-in, first-out (FIFO) method in perpetual inventory system

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The first-in, first-out (FIFO) method is a widely used inventory valuation method that assumes that the
goods are sold (by merchandising companies) or materials are issued to production department (by
manufacturing companies) in the order in which they are purchased. In other words, the costs to acquire
merchandise or materials are charged against revenues in the order in which they are incurred.

Under first-in, first-out method, the ending balance of inventory represents the most recent costs incurred
to purchase merchandise or materials.

The use of FIFO method is very common to compute cost of goods sold and the ending balance of
inventory under both perpetual and periodic inventory systems. The example given below explains the use
of FIFO method in a perpetual inventory system. If you want to understand its use in a periodic inventory
system, read first-in, first-out (FIFO) method in periodic inventory system article.

Example:

The Fine Electronics company uses perpetual inventory system to account for acquisition and sale of
inventory and first-in, first-out (FIFO) method to compute cost of goods sold and for the valuation of
ending inventory. The company has made the following purchases and sales during the month of January
2016.

Jan. 01: Inventory at the beginning of the month; 24 units @ $1,000 per unit.
Jan. 04: Sales: 16 units.
Jan. 07: Purchases; 12 units @ $1,020 per unit.
Jan. 10: Purchases; 10 units @ $1,050 per unit.
Jan. 14: Sales; 16 units.
Jan. 23: Sales; 12 units.
Jan. 24: Purchases; 12 units @ $1,060 per unit.
Jan. 27: Purchases; 4 units @ $1,080 per unit.
Jan. 29: Sales; 6 units.

During the month, all sales have been made @ $1600 per unit.

Required:

1. Prepare journal entries to record the above transactions under perpetual inventory system.
2. Prepare a FIFO perpetual inventory card.
3. Compute the cost of goods sold and the cost of inventory in hand at the end of the month of January
2012.

Solution:

(1). Journal entries:

January 4:
The Fine electronics company has sold 16 units for $25,600 (16 units $1,600) on January 4, 2016. On
this date, 24 units in the beginning inventory are the only units available for sale. The cost of goods sold is,
therefore, $16,000 (16 $1,000). Since the company uses perpetual inventory system, two journal entries
would be made for the sale of inventory one to reduce the inventory account by the cost of 16 units and
one to record the sale of 16 units. These two journal entries are given below:

January 7:
The following entry would be made to record the purchase of 12 units @ $1,020 per unit on January 7:

January 10:
The following entry would be made to record the purchase of 10 units @ $1,060 per unit on January 10:

January 14:
According to FIFO assumption, first costs incurred are first costs expensed, the cost of 16 units sold on 14
January would, therefore, be computed as follows:
Cost of 8 units (from beginning inventory): 8 units $1,000 = $8,000
Cost of 8 units (from units purchased on January 7): 8 units $1,020 = $8,160
Total cost of 16 units sold on January 14: $8,000 + $8,160 = $16,160
The journal entries for the above sales would be made as follows:

January 23:
According to first-in, first-out (FIFO) method, the cost of 12 units sold on 23 January is computed below:

Cost of 4 units (from units purchased on January 7): 4 units $1,020 = $4,080
Cost of 8 units (from units purchased on January 10): 8 units $1,050 = $8,400
Total cost of 12 units sold on 23 January: $4,080 + $8,400 = $12,480
The journal entries for the above sales would be made as follows:

January 24:
On January 24, the following entry would be made to record the purchase of 12 units @ $1,060 per unit.

January 27:
On January 27, the following entry would be made to record the purchase of 4 units @ $1,080 per unit.

January 29:
According to first-in, first-out (FIFO) method, the cost of 6 units sold on 29 January is computed below:

Cost of 2 units (from units purchased on January 10): 2 units $1,050 = $2,100
Cost of 4 units (from units purchased on January 29): 4 units $1,060 = $4,240
Total cost of 6 units sold on 29 January: $2,100 + $4,240 = $6,340
The journal entries for the above sales would be made as follows:
(2). FIFO perpetual inventory card:

Companies using perpetual inventory system prepare an inventory card to continuously track the quantity
and dollar amount of inventory purchased, sold and in hand. This card is known as perpetual inventory
card. A separate perpetual inventory card is prepared for each inventory item. This card has separate
columns to record purchases, sales and balance of inventory in both units and dollars. The quantity and
dollar information in these columns are updated in real time i.e., after each purchase and each sale. At any
point in time, the perpetual inventory card can, therefore, provide information about purchases, cost of
sales and the balance in inventory to date.

The perpetual inventory card of Fine Electronics company is prepared below using FIFO method:

(3). Cost of goods sold (COGS) and ending inventory:

With the help of the above inventory card, we can easily compute the cost of goods sold and ending
inventory.

*Cost of goods sold: $16,000 + $8,000 + $8,160 + $4,080 + $8,400 + $2,100 + $4,240 = $50,980
**Ending inventory: $8,480 + $4,320 = $12,800

* The total of sales column of perpetual inventory card.


** The balance at 29 January at the end of balance column.

First-in, first-out (FIFO) method in periodic inventory system


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Under first-in, first-out (FIFO) method, the costs are chronologically charged to cost of goods sold (COGS)
i.e., the first costs incurred are first costs charged to cost of goods sold (COGS). This article explains the
use of first-in, first-out (FIFO) method in a periodic inventory system. If you want to read about its use in
a perpetual inventory system, read first-in, first-out (FIFO) method in perpetual inventory system article.

In a periodic inventory system when a sale is made, the entry to record the cost of goods sold is not made.
At the end of accounting period, the quantity of inventory on hand (ending inventory) is found by a
physical count and if the FIFO method is used to compute the cost of ending inventory, the cost of most
recent purchases are used. Once the cost of ending inventory has been computed, the cost of goods sold can
be computed easily using the following simple formula:

Cost of goods sold (COGS) = Beginning inventory + Purchases Ending inventory

The following example illustrates the use of FIFO method in a periodic inventory system:

Example:

The Sunshine company uses periodic inventory system. The company makes a physical count at the end of
each accounting period to find the number of units in ending inventory. The company then applies first-in,
first-out (FIFO) method to compute the cost of ending inventory.

The information about the inventory balance at the beginning and purchases made during the year 2016 are
given below:

Mar. 01: Beginning balance; 400 units @ $18 per unit.


Mar. 12: Purchases; 600 units @ $20 per unit.
Oct. 17: Purchases; 800 units @ $22 per unit.
Dec. 15: Purchases; 200 units @ $24 per unit.

On 31st December 2016, 600 units are on hand according to physical count.

Required: Compute the following using first-in, first-out (FIFO) method:

1. Cost of ending inventory at 31 December 2016.


2. Cost of goods sold during the year 2016.

Solution:

(1). Cost of ending inventory FIFO method:

If FIFO method is used, the units remaining in the inventory represent the most recent costs incurred to
purchase the inventory. The cost of 600 units on 31 December would, therefore, be computed as follows:

(2). Cost of goods sold FIFO method

Cost of goods sold can be computed by using either periodic inventory formula method or earliest cost
method.

a. Formula method: Under formula method, the cost of goods sold would be computed as follows:
Cost of goods sold = Cost of units in beginning inventory + Cost of units purchased during the period
Cost of units in ending inventory

b. Earliest cost method: Under earliest cost method, we would find the total number of units sold during
the period and then we would calculate the cost of these units using earliest costs.

Number of units sold = Beginning inventory + Purchases Ending inventory

= 400 units + 1,600* units 600 units

= 1,400 units

*600 + 800 + 200

The 1,400 units sold during the year would be costed using earliest costs as follows:

The periodic inventory and FIFO concepts can also be applied for recording and valuing direct materials in
manufacturing companies. To understand their use in a manufacturing company, consider the following
example:

Example:

The Galaxy manufacturing company has provided the following information about beginning balance and
purchases of direct material for the year 2016:

01 Jan: Beginning balance; 2,800 units @ $9.20 per units.


15 Apr: Purchases; 2,000 units @ $9.50 per units.
20 Aug: Purchases; 2,500 units @ $9.80 per units.
15 Nov: Purchases; 1,000 units @ $10.20 per units.

At the end of the year 2016, the company makes a physical measure of material and finds that 1,700 units
of material is on hand.

Required:

1. Compute the cost of materials on hand at the end of the year.


2. Also compute the cost of materials issued to production during the year.

(1). Cost of materials on hand at the end of the year FIFO method:

(2). Cost of materials issued for production during the year FIFO method:

a. Formula method:

b. Earliest cost method:

Number of units issued = Units in beginning inventory + Units purchased during the period Units in
ending inventory

= 2,800 units + 5,500* units 1,700 units

= 6,600 units

*2,000 + 2,500 + 1,000


Last-in, first-out (LIFO) method in a perpetual inventory system

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In contrast to first-in, first-out (FIFO) method, the last-in, first-out (LIFO) method of inventory valuation
assumes that the last costs incurred to purchase merchandise or direct materials are first costs charged
against revenues. In other words, it assumes that the cost of merchandise sold (in a merchandising
company) or the cost of materials issued to production department (in a manufacturing company) is the
cost of most recent purchases.

Like first-in, first-out (FIFO), last-in, first-out (LIFO) method can be used in both perpetual inventory
system and periodic inventory system. The following example explains the use of LIFO method for
computing cost of goods sold and the cost of ending inventory in a perpetual inventory system.

Example LIFO perpetual inventory system in a merchandising company:

BZU uses perpetual inventory system to record purchases and sales and LIFO method to valuate its
inventories. The company has provided the following information about commodity DX-13C and wants
your assistance in computing the cost of commodity DX-13C sold and the cost of ending inventory of
commodity DX-13C.

Aug. 01: Beginning inventory; 20 units @ $40 per unit.


Aug. 07: Sales; 14 units.
Aug. 12: Purchases; 16 units @ $42 per unit.
Aug. 17: Sales; 8 units.
Aug. 23: Sales; 4 units.
Aug. 27: Purchases; 8 units @ $44 per unit.
Aug. 30: Sales; 10 units.

Required:

1. Prepare a LIFO perpetual inventory card.


2. Compute cost of goods sold and the cost of ending inventory using LIFO method.

Solution:

(1). LIFO perpetual inventory card:


(2). Cost of goods sold (COGS) and ending inventory:

LIFO perpetual inventory card (prepared above) can help compute cost of goods sold and ending inventory.

a. Cost of goods sold (COGS): $560 + $336 + $168 + $436 = $1,500

b. Ending inventory: [$240 + $84] = $324

When LIFO method is used in a perpetual inventory system, it is typically known as LIFO perpetual
system.

The above example explains the use of LIFO perpetual system in a merchandising company. In
manufacturing companies, it is used to compute the cost of materials issued to production and cost of
ending inventory of raw materials (also known as direct materials). Consider the following example:

Example LIFO perpetual system in a manufacturing company:

The Three Star company manufactures product X. Material K5 is used to manufacture product X. The
information about the acquisition and issuance of material K5 for the month of June is given below:

Jun. 01: Beginning inventory; 50 kgs @ $4.80/kg and 100 kg @ $5.00/kg.


Jun. 05: 10 kgs of material K5 were returned to supplier.
Jun. 09: 35 kgs of material K5 were issued to factory.
Jun. 12: 70 kgs of material K5 were purchased @ $5.10/kg.
Jun. 17: 50 kgs of material K5 were issued to factory.
Jun. 19: 25 kgs of material K5 were issued to factory.
Jun. 23: 50 kgs of material K5 were purchased @ $5.20/kg
Jun. 26: 60 kgs of material K5 were issued to factory.
Jun. 30: 5 kgs of material K5 were returned from factory to store room.

A perpetual inventory system is used to account for acquisition and issuance of direct materials.

Required: Compute the cost of material K5 issued to factory and the cost of material K5 at the end of June
using last-in, first-out (LIFO) method.

Solution:
As the company uses perpetual inventory system, a materials ledger card would be prepared to compute the
cost of materials issued to factory and the cost of materials on hand at the end of the month. Materials
ledger card is similar to inventory card prepared above. Materials ledger card of Three Star company is
give below:

(1). LIFO perpetual material card:

* Materials returned from store room to supplier is usually recorded in purchases column and materials
returned from factory to store room is usually written in issues column. The returns are normally written in
red ink to differentiate them from normal purchases and issues.

(2). Cost of material issued to factory:

= $175 + $255 + $102 + $25 + $260 + $50 $25*

= $842

*Material returned from factory to store room

(3). Cost of inventory on hand on June 30th:

= $240 + $225

= $465

Last-in, first-out (LIFO) method in a periodic inventory system

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Under last-in, first-out (LIFO) method, the costs are charged against revenues in reverse chronological
order i.e., the last costs incurred are first costs expensed. In other words, it assumes that the merchandise
sold to customers or materials issued to factory has come from the most recent purchases. The ending
inventory under LIFO would, therefore, consist of the oldest costs incurred to purchase merchandise or
materials inventory.

LIFO is extensively used in periodic as well as perpetual inventory system. In this article, the use of LIFO
method in periodic inventory system is explained with the help of examples. To understand the use of LIFO
in a perpetual inventory system, read last-in, first-out (LIFO) method in a perpetual inventory system
article.

Example LIFO periodic system in a merchandising company:

A trading company has provided the following data about purchases and sales of a commodity made during
the year 2016.

Jan. 01: Beginning inventory; 1,000 units @ $16 per unit.


Feb. 15: Purchased; 1,800 units @ $18 per unit.
Apr. 15: Purchased; 1,000 units @ $20 per unit.
Jul. 10: Purchased; 2,000 units @ $22 per unit.
Oct. 20: Purchased; 1,500 units @ $24 per unit

According to a physical count, 1,300 units were found in inventory on December 31, 2016. The company
uses a periodic inventory system to account for sales and purchases of inventory.

Required: Assuming a last-in, first-out (LIFO) cost flow assumption is used, compute:

1. the cost of inventory on December 31, 2016.


2. the cost of goods sold for the year 2016.

Solution:

(1). Cost of ending inventory :

Since the company is using LIFO periodic system, the 1,300 units in ending inventory would be costed
using the earliest purchasing costs. The computations are given below:

Cost of goods sold for 2016

The cost of goods sold is equal to the cost of units sold during the year. It can be computed using one of the
two methods given below:

Formula method: Under formula method, we would compute the cost of goods sold by deducting the cost
of ending inventory (computed above) from the total cost of units available for sale during the period. The
total cost of units available for sale is equal to cost of beginning inventory plus cost of all units purchased
during the year. It can be expressed in the form of the following formulas or equations.

Cost of goods sold = Cost of units available for sale Cost of units in ending inventory

Or
Cost of goods sold = [Cost of units in beginning inventory + Cost of units purchased during the period]
Cost of units in ending inventory

Recent cost method: Under recent cost method, we would compute the total number of units sold during
the year and then we would assign cost to these units using most recent costs incurred to purchase units.
The computations are given below:

Number of units sold during the year = Units in beginning inventory + Units purchased during the year
Units in ending inventory

= 1,000 units + 6,300* units 1,300 units

= 6,000 units

*1800 + 1000 + 2000 + 1500 = 6,300

LIFO periodic system is also extensively used by manufacturing companies for recording and costing
materials. Consider the following example:

Example-LIFO periodic system in a manufacturing company:

The HEC manufacturing company uses periodic inventory system. The physical inventory of materials is
priced using LIFO method. The following data is available for the month of December 2016:

Dec. 01: Beginning inventory; 50 units @ $2.00.


Dec. 12: Purchases; 90 units @ $2.10.
Dec. 19: Purchases; 230 units @ $2.20.
Dec. 25: Purchases; 110 units @ $2.30.
Dec. 29: Purchases; 40 units @ $2.35.

On December 31, 2016, a physical count of inventory was made and 120 units of material were found in
the store room.

Required:

1. Compute the total cost of inventory on December 31, 2016.


2. Compute the total cost of units issued to factory during the month of December.

Solution:

(1). Cost of ending inventory:

In LIFO periodic system, the 120 units in ending inventory would be valued using earliest costs.

(2). Cost of units issued to factory during December

Formula method: Under formula method, the cost of units issued to factory would be computed by
deducting the cost of units in ending inventory from the total cost of units available for use during the
month. The total cost of units available for use is equal to cost of units in beginning inventory plus cost of
units purchased during the month.

Cost of units issued = Cost of units available for use Cost of units in ending inventory

Or

Cost of units issued = [Cost of units in beginning inventory + Cost of units purchased during the period]
Cost of units in ending inventory
Recent cost method: Under this method, the number of units issued to factory would be computed first
and then they would be costed using most recent costs. In our example, the units in ending inventory would
be computed and costed as follows:

Units issued to factory = Units in beginning inventory + Units purchased during the period Units in
ending inventory

= 50 units + 470* units 120 units

= 400 units

*90 + 230 + 110 + 40 = 470

LIFO periodic vs LIFO perpetual inventory system

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The LIFO periodic system and the LIFO perpetual system may generate different cost of goods sold (or
materials issued) and the cost of ending inventory figures. The reason is that under LIFO periodic system,
the total of sales (or issues) is matched with the total of purchases (including beginning inventory, if any) at
the end of the period whereas under LIFO perpetual system, each sale (or issue) is matched with the
immediate preceding purchases.

For better understanding of the concept, we need an example.


Example LIFO periodic vs LIFO perpetual:

The Fine Dealings Inc. has the following transactions for the first month of operations:

The Fine Dealings Inc. uses last-in, first out (LIFO) method for inventory valuation purposes. There was no
inventory in hand at the beginning of the month of July.

Required: Compute the cost of goods sold during the month and inventory in hand at the end of the month
under:

1. LIFO periodic system.


2. LIFO perpetual system.

Solution:

(1). LIFO periodic

a. Cost of goods sold:

Number of units sold during the month: 12,000 units + 6,000 units + 5,000 units = 23,000 units

Under periodic LIFO, the cost of above 23,000 units have been computed below:

b. Cost of ending inventory:

Ending inventory = Beginning inventory + Number of units purchased during the month Number of units
sold during the month

= 0 units + *40,000 units **23,000 units

= 17,000 units

* Units purchased during the month: 10,000 units + 15,000 units + 5,000 units + 10,000 units = 40,000
units

** Units sold during the month: 12,000 units + 6,000 units + 5,000 units = 23,000 units
(2). LIFO perpetual

Cost of goods sold and ending inventory:

*Cost of goods sold (total of sales column)

**Cost of ending inventory (the last row of balance column)

Notice that the cost of goods sold and ending inventory amounts computed under LIFO periodic are
different from the cost of goods sold and ending inventory amounts computed under LIFO perpetual. The
reason is that the LIFO periodic system does not take into account the exact dates involved but LIFO
perpetual does. In above example, LIFO periodic system assumes that all the units purchased on July 30
have been sold and ending inventory is to be valued using earliest costs. But if computations are made on
the basis of LIFO perpetual system, out of 10,000 units purchased on July 30, 5000 units remain unsold
and go to ending inventory at the same cost at which they were purchased.

Average costing method

Under average costing method,the average cost of all similar items in the inventory is computed and used
to assign cost to each unit sold. Like FIFO and LIFO methods, this method can also be used in
both perpetual inventory system and periodic inventory system.

Average costing method in periodic inventory system:


When average costing method is used in a periodic inventory system, the cost of goods sold and the cost of
ending inventory is computed using weighted average unit cost. Weighted average unit cost is computed
using the following formula:

Weighted average unit cost = Total cost of units available for sale / Number of units available for sale

Example:

The Meta company is a trading company that purchases and sells a single product product X. The
company has the following record of sales and purchases of product X for the month of June 2013.

June 01: Balance on hand at the beginning of the month; 200 units @ $10.15.
June 05: Purchased 800 units @ $10.25.
June 07: Sold 400 units.
June 12: Purchases: 600 units @ $10.40.
June 14: Sales: 500 units
June 20: Purchases: 400 units @ $10.50
June 25: Purchases: 800 units @ $10.70
June 26: Sales: 1,400 units
June 28: Sales: 200 units
June 30: Purchases: 600 units @ $10.85

Required: Compute inventory cost at June 30, 2013 using average cost method assuming the Meta
company uses periodic inventory system.

Solution:

Units available for sale:

Weighted average unit cost = $35,740 / 3,400 units


= $10.51176 per unit

Units in ending inventory = Total units available for sale Total units sold during the period
= 3,400 units (400 units + 500 units + 1,400 units + 200 units)
= 3,400 units 2,500 units
= 900 units

Cost of goods sold: 2,500 units $10.51176 = $26,279.40


Cost of ending inventory: 900 units $10.51176 = $9,460.60

Average costing method in perpetual inventory system:

When average costing method is used in a perpetual inventory system, an average unit cost figure is
computed each time a purchase is made. This average unit cost figure is then used to assign cost to each
unit sold until a new purchase is made. This technique is also referred to as moving average method.

Using the data from above example we can compute the cost of goods sold and the cost of ending inventory
as follows:
Solution:

Cost of goods sold: $4,092 + $5,158 + $14722 + $2,103 = $26,075 (Total of sales column)
Cost of ending inventory: $9,665 (Balance column)

The use of average costing method in perpetual inventory system is not common among companies.

The main advantage of using average costing method is that it is simple and easy to apply. Moreover, the
chances of income manipulation are less under this method than under other inventory valuation methods.

Specific identification method

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Specific identification method can be applied in situations where different purchases can be physically
separated. Under this method, each item sold and each item remaining in the inventory is identified. The
cost of specific items that are sold during a period is included in the cost of goods sold for that period and
the cost of specific items remaining on hand at the end of a period is included in the ending inventory of
that period.

Consider the following example to understand the calculation of the cost of ending inventory and cost of
goods sold under specific identification method:

Example:

A company made the following purchases and sales during the month of April 2013:
The 3,000 units in the inventory on April 30 is composed of 500 units from purchases made on April 01,
1,500 units from purchases made on April 12 and 1,000 units from purchases made on April 30.

Required: Calculate the cost of ending inventory and the cost of goods sold using specific identification
method of inventory valuation.

Solution:

Calculation of ending inventory:

Calculation of cost of goods sold:

This method is ideal in situations where small number of easily distinguishable items (such as jewelry,
automobiles, handicrafts and furniture etc.) are handled.

Advantages and disadvantages:

The main advantage of this method is that, flow of cost corresponds to the physical flow of inventory. In
other words, actual costs are matched against revenues.

The main disadvantage of using specific identification method is that, the net income can be easily
manipulated under this method. For example, if an identical item is purchased early in the year at different
prices, the items from the highest or the lowest priced lot can be selected to be delivered to the customers
with the intention of income manipulation.

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LIFO liquidation occurs when a company, using LIFO inventory valuation method, sells (or issues) the
old stock of merchandise (or raw materials) inventory. In other words, it occurs when a company using
LIFO method sells (or issues) more than it purchases.

LIFO liquidation causes distortion in net operating income and may become a reason of higher tax bill in
current period. When LIFO inventory is liquidated, the old costs are matched with the current revenues and
as a result, financial statements show higher income. The LIFO liquidation, therefore, causes a higher tax
liability in periods of high inflation.

In most of the cases, companies do not liquidate their LIFO inventory voluntarily. A company may have to
liquidate its LIFO inventory due to one or more of the following reasons:
Shortage of merchandise or materials inventory
Higher volume of sales than purchases
A sudden increase in demand for the product
Shortage of funds
Need to move the old inventory immediately due to change in taste or fashion
Need to free up warehouse space etc.

For further explanation of the concept, consider the following example:

Example:

The Delta company uses last-in, first-out (LIFO) cost flow assumption. At the end of the year 2012, the
company has 20,000 meters of copper coil in its inventory. The details are given below:

Notice that the total cost of inventory at the end of 2012 comprises of the costs incurred in 2012, 2011,
2010, 2009 and 2008. These costs are referred to as layers of LIFO inventory or onlyLIFO layers. The
LIFO layers of Delta company are shown below:

Assume that the Delta company needs to use 18,000 meters of copper coil during 2013 but company
experiences a shortage of copper coil and, therefore, needs to liquidate much of its inventory.

Because the company uses LIFO method, the most recent layer, 2012, would be liquidated first, followed
by 2011 layer and so on. This liquidation would enforce the company to match old low costs with the
current higher sales prices. The income statement of Delta company would, therefore, show much higher
profits that would lead to higher tax bill in the current period.
Use of specific goods pooled LIFO approach:

To overcome the problem of LIFO liquidation, some companies adopt an approach known as specific
goods pooled LIFO approach. Under this approach, a number of similar products are combined and
accounted for together. This combination or group of similar items is referred to as pool. Under this
approach, the liquidation of an item in the pool is usually offset by an increase in another item.

Specific goods pooled LIFO approach is not a perfect solution of LIFO liquidation but can eliminate the
disadvantages of tradition LIFO inventory system to some extent.

Companies frequently change their sales mix as they grow. This approach may be costly and time
consuming for such companies because they have to redefine pools each time a change in mix of their
products is made.

Dollar-value LIFO methodacebookTwitterPrintEmailMore50

Like specific goods pooled LIFO approach, Dollar-value LIFO method is also used to alleviate the
problems of LIFO liquidation. Under this method, goods are combined into pools and all increases and
decreases in a pool are measured in terms of total dollar value. The pools created under this method are,
therefore, known as dollar-value LIFO pools.

This approach is considered more effective than the specific goods pooled LIFO approach (discussed in
LIFO liquidation article) because of the following reasons:

1. As the pools are determined and measured in terms of total dollar value, this method allows
companies to include a broader range of goods in a pool.
2. Under specific goods pooled LIFO approach, an item can be replaced only with an item that is
substantially identical whereas in a dollar-value LIFO pool, an item can be replaced with an item
that is similar in use or interchangeable.

Under this method, it is possible to use a single pool. However, companies can use any number of pools
according to their requirement. The unnecessary employment of a large number of dollar-value LIFO
pools may increase the cost and also reduce the effectiveness of dollar-value LIFO approach.

Who uses dollar-value LIFO method?

The companies that maintain a large number of products and expect significant changes in their product
mix in future, frequently use dollar-value LIFO technique. The use of traditional LIFO approaches is
common among companies that have a few items and expect very little change in their product mix.

Consider the following example to understand how the value of inventory is computed under dollar value
LIFO method:

Example 1:
The Fast company adopted dollar-value LIFO method on December 31, 2011. The inventory on current
prices at the end of 2011 and 2012 was as follows:
December 31, 2011(end of year prices): $40,000
December 31, 2012 (end of year prices): $52,800
The inventory prices were increased by 25% during the year 2012.
Required: Compute the amount of inventory at the end of 2012 using dollar-value LIFO method.

Solution:

First of all, we need to compute the value of ending inventory at base-year-prices. It is computed using the
following formula:

Ending inventory at base-year-prices = $52,800/1.25

= $42,240

Now we can compute the real-dollar quantity increase in inventory:

= ($42,240 $40,000)

= $2,240

The next step is to value this real dollar quantity increase in inventory at year-end-prices:

= $2,240 1.25

= $2,800

The real dollar quantity increase in inventory valued at year-end-prices is usually known as dollar-value
LIFO layer (or layer). If this layer is added to the beginning inventory of the year 2012, we would get the
total inventory at the end of the year 2012. It is shown below:

Hint!
A layer is formed only when ending inventory at base-year-prices exceeds the beginning inventory at base-
year-prices.

Example 2 the use of dollar-value LIFO method in a more complex situation:

The following information belongs to Best Buy company:

Required: Compute the inventory at the end of each year using dollar-value LIFO method.
Solution:

First, we need to add two new columns to the original information given in the example; one to show the
inventory at base-year-prices and one to show the changes in inventory from prior year. It is done as
follows:

Now we can compute the dollar value inventory:

* The price index of 2010 has been used because no layer has been formed during the year 2011. The
ending inventory at base-year-prices ($500,000) is less than the beginning inventory at base-year-prices
($520,000).

LIFO reserveFacebookTwitterPrintEmailMore28

Most of the companies use first-in, first-out (FIFO), average, or standard cost method for internal uses and
last-in, first-out (LIFO) method for external reporting and tax purposes. The LIFO reserve (also known as
the allowance to reduce inventory to LIFO) is an account that represents the difference between the
inventory cost computed for internal reporting purpose using a non-LIFO method and the inventory cost
computed using LIFO method. For example, the LIFO reserve of a company that uses FIFO for internal
reporting and LIFO for external reporting can be expressed in the form of the following equation:
LIFO reserve = FIFO inventory LIFO inventory

The above equation assumes that the FIFO inventory is higher than the LIFO inventory, that is usually
found in an inflationary environment. In a deflationary environment, the LIFO inventory would be higher
than the FIFO inventory and the LIFO reserve could be expressed as follows:

LIFO reserve = LIFO inventory FIFO inventory

LIFO effect:

The change in the balance of LIFO reserve account during the year is referred to as LIFO effect. The
following entry is made at the end of the year to record this change:

A company using a non-LIFO method would deduct the LIFO reserve (allowance to reduce inventory to
LIFO) from the inventory if it needs to state the inventory on LIFO basis.

Consider the following example for more explanation:

Example:

The Fine company uses FIFO method for internal reporting and LIFO method for external reporting. The
inventory on December 31, 2012 is $90,000 under FIFO and $65,000 under LIFO. The LIFO reserve (or
allowance to reduce inventory to LIFO) account showed a credit balance of $15,000 on January 1, 2012.

Required: What is the amount of LIFO reserve and LIFO effect? Prepare a journal entry to adjust the
LIFO reserve at the end of the year.

Solution:

LIFO reserve:

LIFO reserve = FIFO inventory LIFO inventory

= $90,000 $65,000

= $25,000

LIFO effect:

LIFO effect = LIFO reserve Beginning balance

= $25,000 $15,000

= $10,000

Journal entry at the end of the year:

The use of LIFO reserve in ratios analysis:

Ratios analysis is a useful tool to evaluate and compare the liquidity, profitability, and solvency of
companies. Most of the ratios of two companies can be compared only if they use the same inventory
valuation method.
Current ratio is a widely used metric to analyze and compare the liquidity of companies. For example, if
company A uses LIFO method but company B uses FIFO method, the current ratio of the two companies
would not be comparable. However, if LIFO reserve of company A is known, it can be added to LIFO
inventory to convert it to the FIFO inventory. The FIFO inventory of company A would then be comparable
to the FIFO inventory of company B.

FIFO inventory of company A = LIFO inventory of company A + LIFO reserve of company A

To compute the FIFO amount of cost of goods sold of company A, the change in the LIFO reserve account
during the period (LIFO effect) would be subtracted from the LIFO amount of the cost of goods sold of
company A.

FIFO COGS of company A = LIFO COGS of company A change in LIFO reserve during the period

Advantages and disadvantages of last-in, first-out (LIFO) method

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Advantages of last-in first-out (LIFO) method:

The employment of LIFO is very common among companies worldwide because of the following benefits:

(1). LIFO matches most recent costs against current revenues:

The LIFO method provides a better measurement of current earnings by matching most recent costs against
current revenues.

The non-LIFO methods (such as FIFO method) match old costs against current revenues. When old costs
are matched against current revenues in an inflationary environment, the inventory profit (also known as
paper profit or transitory profit) is created. Inventory profit occurs when replacement cost of inventory
is more than the inventory cost matched against revenues. This inventory profit understates cost of goods
sold (COGS) and overstates profit.

The LIFO helps in reducing the inventory profits by matching the most recent costs against revenues. It
results in reduction of understatement of cost of goods sold (COGS) and overstatement of profit. Therefore
the quality and reliability of earnings are improved under LIFO.

(2). Tax benefits and improvement in cash flows:

The major reason of the popularity of last-in, first-out (LIFO) inventory valuation method is its tax benefit.
When LIFO is used in the periods of inflation, the current purchases at higher prices are matched against
revenues that alleviate the overstatement of profit and therefore reduce income tax bill. The reduction in
income tax results in improvement of cash flows of the company.

(3). LIFO minimizes write-downs to market:

The net income of a company that uses LIFO is less likely to be affected by decline in price in future.
Usually, the companies using LIFO method do not have much inventory at current higher prices because,
under this method, most recent inventory purchased at higher price is sold first. So the chances of write-
downs to market in future due to decline in inventory prices are minimized or even eliminated under LIFO.

(4). Physical flow of inventory:

In some situations, the physical flow of inventory corresponds to the LIFO cost flow. For example, in the
case of a coal pile, the most recent coal added to the coal pile is always on the top of the coal pile.
Therefore, the last coal in is always the first coal out.

This benefit is not a reason of the popularity of LIFO method because the situations where physical flow of
inventory corresponds to the LIFO cost flow are very rare to find. The benefit 1, 2 and 3 described above
are the main arguments of the widespread employment of this method.

Disadvantages of last-in, first-out (LIFO) method:

The major drawbacks of using LIFO as inventory costing method are given below:
(1). Reduced earnings in inflationary times:

The LIFO method reduces reported earnings during the periods of inflation. Therefore, many companies
fear that an accounting change to LIFO will have a negative effect on investors and will reduce the price of
companys stock because many investors may not be able to understand the impact of LIFO and inflation
on the reported earnings.

(2). Understatement of inventory:

Under LIFO method, the balance sheet inventory figure is usually understated because it is based on the
oldest costs. Due to understatement of inventory, the working capital position may look worse than it really
is.

(3). Problem of LIFO liquidation:

The LIFO liquidation may inflate the reported income for a given period that results in higher tax payments
for the period. To avoid this problem, a company may purchase goods in large quantities with the intention
to match them against revenues. Therefore, the adoption of LIFO may develop poor buying habits among
companies.

(4). Manipulation of income:

A company using last-in, first-out (LIFO) method can easily manipulate its reported earnings for a period
by changing its purchase pattern at the end of the year.