Inventory and Cost of Goods Sold - Comparison of Cost Flow Assumptions

 

Perpetual FIFO

Under the perpetual system the Inventory account is constantly (or perpetually) changing. When a retailer purchases merchandise, the retailer debits its Inventory account for the cost; when the retailer sells the merchandise to its customers its Inventory account is credited and its Cost of Goods Sold account is debited for the cost of the goods sold. Rather than staying dormant as it does with the periodic method, the Inventory account balance is continuously updated.

Under the perpetual system, two transactions are recorded when merchandise is sold: (1) the sales amount is debited to Accounts Receivable or Cash and is credited to Sales, and (2) the cost of the merchandise sold is debited to Cost of Goods Sold and is credited to Inventory. (Note: Under the periodic system the second entry is not made.)

With perpetual FIFO, the first (or oldest) costs are the first moved from the Inventory account and debited to the Cost of Goods Sold account. The end result under perpetual FIFO is the same as under periodic FIFO. In other words, the first costs are the same whether you move the cost out of inventory with each sale (perpetual) or whether you wait until the year is over (periodic).

Perpetual LIFO

With perpetual LIFO, the last costs available at the time of the sale are the first to be removed from the Inventory account and debited to the Cost of Goods Sold account. Since this is the perpetual system we cannot wait until the end of the year to determine the last cost—an entry must be recorded at the time of the sale in order to reduce the Inventory account and to increase the Cost of Goods Sold account.

If costs continue to rise throughout the entire year, perpetual LIFO will yield a lower cost of goods sold and a higher net income than periodic LIFO. Generally this means that periodic LIFO will result in less income taxes than perpetual LIFO. (If you wish to minimize the amount paid in income taxes during periods of inflation, you should discuss LIFO with your tax adviser.)

 

 

 

Let's assume that after Corner Shelf makes its second purchase in June 2015, Corner Shelf sells one book. This means the last cost at the time of the sale was $89. Under perpetual LIFO the following entry must be made at the time of the sale: $89 will be credited to Inventory and $89 will be debited to Cost of Goods Sold. If that was the only book sold during the year, at the end of the year the Cost of Goods Sold account will have a balance of $89 and the cost in the Inventory account will be $351 ($85 + $87 + $89 + $90).

If the bookstore sells the textbook for $110, its gross profit under perpetual LIFO will be $21 ($110 - $89). Note that this is different than the gross profit of $20 under periodic LIFO.

 

 

Perpetual Average

Under the perpetual system, "average" means the average cost of the items in inventory as of the date of the sale. This average cost is multiplied by the number of units sold and is removed from the Inventory account and debited to the Cost of Goods Sold account. We use the average as of the time of the sale because this is a perpetual method. (Note: Under the periodic system we wait until the year is over before computing the average cost.)

Let's use the same example again for the Corner Shelf Bookstore:

Let's assume that after Corner Shelf makes its second purchase, Corner Shelf sells one book. This means the average cost at the time of the sale was $87.50 ([$85 + $87 + $89 + $89] ÷ 4]). Because this is a perpetual average, a journal entry must be made at the time of the sale for $87.50. The $87.50 (the average cost at the time of the sale) is credited to Inventory and is debited to Cost of Goods Sold. After the sale of one unit, three units remain in inventory and the balance in the Inventory account will be $262.50 (3 books at an average cost of $87.50).

After Corner Shelf makes its third purchase, the average cost per unit will change to $88.125 ([$262.50 + $90] ÷ 4). As you can see, the average cost moved from $87.50 to $88.125—this is why the perpetual average method is sometimes referred to as the moving average method. The Inventory balance is $352.50 (4 books with an average cost of $88.125 each).

Below is a recap of the varying amounts for the cost of goods sold, gross profit, and ending inventory that were calculated above.

The example assumes that costs were continually increasing. The results would be different if costs were decreasing or increasing at a slower rate. Consult with your tax advisor concerning the election of cost flow assumption.

Exercise-8 (FIFO and LIFO under periodic and perpetual system)

Posted in: Inventory costing methods exercises

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The Breeze trading company discloses the following information for the month of August 2013.

Aug. 01	Beginning inventory:	600 units @ $5 each
Aug. 10	Sales:	400 units @ $12 each
Aug. 11	Purchases:	1,600 units @ $6
Aug. 15	Sales:	1000 units @ 12.50
Aug. 20	Purchases:	1000 units @ $6.50
Aug. 27	Sales:	600 units @ $13.50

 

 

 

 

Required:

1.           Assume the Breeze trading company uses periodic inventory system, compute cost of goods sold (COGS), ending inventory and gross profit under:
(a). FIFO
(b). LIFO

2.          Assume the Breeze company uses perpetual inventory system, compute cost of goods sold (COGS), ending inventory and gross profit under:
(a). FIFO
(b). LIFO

3.          Explain the reason of higher gross profit under FIFO than LIFO?

Solution:

(1) If Breeze trading company uses periodic inventory method:

Ending inventory in units = Beginning inventory + Purchases – Sales
= 600 units + 2,600 units – 2,000 units
= 3,200 units – 2,000 units
= 1,200 units

Ending inventory in dollars:
1000 units @ 6.50 each	$6,500
200 units @ 6.00 each	$1,200
	———-
Ending inventory under periodic-FIFO	$7,700
	———-
Cost of goods sold (COGS):
600 units @ $5.00 each	$3,000
1,400 units @ $6.00 each	$8,400
	———-
Cost of goods sold (COGS) under periodic-FIFO	$11,400
	———-
Gross profit (G.P)
Sales (400 × 12.00) + (1,000 × 12.50) + (600 × 13.50)	$25,400
Less cost of goods sold (computed above)	$11,400
	———-
Gross profit under periodic-FIFO	$14,000
	———-

 (b). Periodic-LIFO

Ending inventory in dollars:	$3,000
600 units @ $5.00 each	$3,600
600 units @ $6.00 each	———-
Ending inventory under periodic-LIFO	$6,600
	———-
Cost of goods sold (COGS):
1,000 units @ $6.50 each	$6,500
1,000 units @ $6.00 each	$6,000
	———-
Cost of goods sold (COGS) under periodic-LIFO	$12,500
	———-
Gross profit:
Sales (400 × 12.00) + (1,000 × 12.50) + (600 × 13.50)	$25,400
Cost of goods sold	$12,500
	———-
Gross profit under periodic-LIFO	$12,900
	———-

(2) If Breeze trading company uses perpetual inventory method:

(a). Perpetual-FIFO:

Date	Purchases	Sales	Balance
Aug. 01	Beginning inventory		600 × $5.00 = $3,000
Aug. 10		400 × $5.00 = $2,000	200 × $5.00 = $1,000
Aug. 11	1,600 × $6.00 = $9,600		200 × $5.00 = $1,000 1,600 × $6.00 = $9,600
Aug. 15		200 × $5.00 = $1,000 800 × $6.00 = $4,800 $5,800	800 × $6.00 = $4,800
Aug. 20	1,000 × $6.50 = $6,500		800 × $6.00 = $4,800 1,000 × $6.50 = $6,500
Aug. 27		600 × $6.00 = $3,600	200 × $6.00 = $1,200 1,000 × $6.50 = $6,500

 

Ending inventory in dollars:
= $1,200 + $6,500
= $7,700
Cost of goods sold (COGS):
= $2,000 + $5,800 + $3,600
= $11,400
Gross profit:
Sales	$25,400
Less cost of goods sold (COGS)	$11,400
	———-
Gross profit	$14,000
	———-

(b). Perpetual-LIFO:

Date	Purchases	Sales	Balance
Aug. 01	Beginning inventory		600 × $5.00 = $3,000
Aug. 10		400 × $5.00 = $2,000	200 × $5.00 = $1,000
Aug. 11	1,600 × $6.00 = $9,600		200 × $5.00 = $1,000 1,600 × $6.00 = $9,600
Aug. 15		1,000× $6.00 = $6,000	200 × $5.00 = $1,000 600 × $6.00 = $3,600
Aug. 20	1,000 × $6.50 = $6,500		200 × $5.00 = $1,000 600 × $6.00 = $3,600 1,000 × $6.50 = $6,500
Aug. 27		600 × $6.50 = $3,900	200 × $5.00 = $1,000 600 × $6.00 = $3,600 400 × $6.50 = $2,600

 

Ending inventory in dollars:
= $1,000 + $3,600 + $2,600
= $7,200
Cost of goods sold (COGS):
= $2,000 + $6,000 + $3,900
= $11,900
Gross profit:
Sales	$25,400
Less cost of goods sold (COGS)	$11,900
	———-
Gross profit	$13,500
	———-

3. The reason of higher gross profit under FIFO than LIFO:

Under LIFO cost flow assumption, the most recent costs are matched against revenues, whereas under FIFO cost flow assumption, the oldest costs are matched against revenues. In inflationary environment (an economic situation where prices continuously rise), the FIFO produces higher gross profit than LIFO. The reverse is true in a deflationary environment (an economic situation where prices continuously decrease).

In this exercise, the prices are rising therefore, the FIFO produces higher gross profit than LIFO

 

 

LIFO periodic vs LIFO perpetual inventory system

Posted in: Inventory costing methods

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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 second month of operations:

Date	Purchases	Sales
July  01	10,000 units @ $10.00 per unit	—
”   05	15,000 units @ $10.20 per unit	—
”   10	—	12,000 units
”   15	5,000 units @ $10.50 per unit	—
”   20	—	6,000 units
”   25	10,000 units @ $10. 75 per unit	—
”   30	—	5,000 units

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

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

1.           LIFO periodic system.

2.          LIFO perpetual system.

Solution:

(1). LIFO periodic:

Number of units purchased during the month	*40,000 units
Less number of units sold during the month	**23,000 units
	—————
Ending inventory	17,000 units
	—————
From 01 July purchases 10,000 units × $10.00	$100,000
From 05 July purchases 7,000 Units × $10.20	$71,400
	—————
Cost of ending inventory	$171,400
	—————
Cost of units available for sale during the month	***$413,000
Less ending inventory	$171,400
	—————
Cost of goods sold (COGS) during the month	241,600
	—————

* 10,000 units + 15,000 units + 5,000 units + 10,000 units
= 40,000 units

**12,000 units + 6,000 units + 5,000 units
= 23,000 units

***[(10,000 units × $10) + (15,000 units × $10.20) + (5,000 units × $10.50)+ (10,000 units × $10.75)]
= [$100,000 + $153,000 + $52,500 + $107,500]
= $413,000

 (2). LIFO perpetual:

Date	Purchases	Sales	Balance
July. 01	10,000 × $10.00 = $100,000		10,000 × $10.00 = $100,000
July. 05	15,000 × $10.20 = $153,000		10,000 × $10.00 = $100,000 15,000 × $10.20 = $153,000 $253,000
July. 10		12,000 × $10.20 = $122,400	10,000 × $10.00 = $100,000 3,000 × $10.20 = $30,600 $130,600
July. 15	5,000 × $10.50 = $52,500		10,000 × $10.00 = $100,000 3,000 × $10.20 = $30,600 5,000 × $10.50 = $52,500 $183,100
July. 20		5,000 × $10.50 = $52,500 1,000 × $10.20 = $10,200 $62,700	10,000 × $10.00 = $100,000 2,000 × $10.20 = $20,400 $120,400
July. 30	10,000 × $10.75 = 107,500		10,000 × $10.00 = $100,000 2,000 × $10.20 = $20,400 10,000 × $10.75 = $107,500 $227,900
		5,000 × $10.75 = $53,750	10,000 × $10.00 = $100,000 2000 × 10.20 = $20,400 5,000 × $10.75 = $53,750 $174,150
Total	$413,000	$238,850	$174,150

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.