3. Inventory Systems Two accounting recording systems Perpetual Inventory System The inventory account is continuously updated as purchases and sales are made. Periodic Inventory System The inventory account is adjusted at the end of a reporting cycle.
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11. If the Periodic Inventory System Is Used …. Cost of goods sold must be calculated after the physical inventory count at the end of the period.
14. Expenditures Included in Inventory Invoice Price Freight-in on Purchases + Purchase Returns and Allowances Purchase Discounts
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35. Dollar-Value LIFO (DVL) pages 421-422 Example The replacement inventory differs from the old inventory on hand. We just create a new layer. DVL inventory pools are viewed as layers of value , rather than layers of similar units. DVL simplifies LIFO record-keeping. DVL minimizes the probability of layer liquidation. At the end of the period, we determine if a new inventory layer was added by comparing ending inventory to beginning inventory.
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38. Supplemental LIFO Disclosures Many companies use LIFO for external reporting and income tax purposes but maintain internal records using FIFO or average cost. The conversion from FIFO or average cost to LIFO takes place at the end of the period. The conversion may look like this:
Chapter 8: Inventories: Measurement In this chapter we continue our study of assets by investigating the measurement and reporting inventories and the related expense – cost of goods sold. Inventory refers to the assets a company (1) intends to sell in the normal course of business, (2) has in production for future sale, or (3) uses currently in the production of goods to be sold.
We will look at inventory for two classes of businesses. Wholesale and retail companies purchase goods that are primarily in finished form. These companies are intermediaries in the process of moving goods from the manufacturer to the end-user. The cost of merchandise inventory includes the purchase price plus any other costs necessary to get the goods in condition and location for sale. In manufacturing, companies actually produce the goods they sell to the wholesaler, retailer or other manufacturers. These companies normally have three inventories. The first is raw materials, which makes up the items that will be used in the production process. The second inventory is work-in-process that consists of items being worked on, but not yet complete. Work-in-process inventory includes the cost of raw materials used, the cost of labor that can be directly traced to the goods in process, and the allocated portion of other manufacturing costs, called manufacturing overhead. Overhead costs include electricity and other utility costs, depreciation of manufacturing equipment, and many other manufacturing costs that cannot be directly linked to the production of specific goods. Finished goods inventory consists of items that are available for sale.
We have two inventory systems available to record inventory transactions. The most common system is the perpetual inventory system, which is used by the majority of companies. In the perpetual inventory system, inventory is continuously updated every time we have a purchase of an item for resale and every time we have a sale to a customer. An important feature of a perpetual system is that it is designed to track inventory quantities from their acquisition to their sale. In the periodic inventory system, we don’t determine cost of goods sold until the end of the accounting cycle which is usually at the end of the month or the end of the year. In the perpetual inventory system, cost of goods sold are recorded each time a sale is made to a customer.
The periodic inventory system is not designed to track either the quantity or cost of merchandise inventory. Cost of goods sold is calculated after the physical inventory count at the end of the accounting period. Merchandise purchases, purchase returns, purchase discounts, and freight-in (purchases plus freight-in less returns and discounts equals net purchases) are recorded in temporary accounts. The period’s cost of goods sold is determined at the end of the period by combining the temporary accounts with the inventory account. In the periodic inventory system, we use an equation to determine cost of goods sold. We take a beginning inventory, and add net purchases, to arrive at cost of goods available for sale. We subtract ending inventory from cost of goods available for sale to determine cost of goods sold. The cost of goods sold equation assumes that all inventory quantities not on hand at the end of the period were sold. This may or may not be the case if some inventory items were either damaged or stolen.
This chart summarizes all the differences between periodic and perpetual inventory systems, and will certainly help you understand the differences between the two methods.
As a general rule, inventory should include all costs necessary to purchase the inventory item and get it to its intended location. All goods owned by the company should be included in inventory. There is a problem with goods in transit (goods that are en route from the supplier to our company). Technically, ownership of the goods depends upon whether they are shipped FOB shipping point or FOB destination. When goods are shipped FOB shipping point, title to the goods transfers when the goods are given to the common carrier and are owned by the buyer. When goods are shipped FOB destination, the goods are owned by the seller until received by the buyer. Our company may have inventory out on consignment with another company. The consigned inventory still is owned by us and should be included in inventory.
An item of inventory should include its invoice price plus any freight for transportation to our business. We reduce the cost of the inventory items by any purchase returns and allowances or purchase discounts.
In the first-in, first-out inventory method we assume that the first units in our inventory are the first units sold. Beginning inventory is sold first, followed by purchases during the period in the chronological order of their acquisition. When we use this method the cost of the oldest inventory items are assigned to cost of goods sold, and the cost of the newest inventory items remain in ending inventory.
Under the last-in, first-out inventory method, we assume that the last goods placed in our inventory will be the first goods sold out of our inventory. The newest inventory costs are associated with cost of goods sold, and the oldest inventory cost remained in inventory.
Under the FIFO system, inventory is valued at approximate replacement cost. Under LIFO, inventory is valued at oldest costs. In a period of rising prices FIFO results in higher taxable income, and LIFO results in lower taxable income.
LIFO is an important issue for U.S. multinational companies. Unless the U.S. Congress repeals the LIFO conformity rule, in inability to use LIFO under IFRS will impose a serious impediment to convergence. From the perspective of the FASB, LIFO is permitted and used by U.S. Companies. If used for income tax reporting, the company must use LIFO for financial reporting. Conformity with IAS No. 2 would cause many U.S. companies to lose a valuable tax shelter. However, IAS No. 2, Inventories, does not permit the use of LIFO. Because of this restriction, many U.S. companies use LIFO only for domestic inventories.
LIFO inventory liquidation usually happens in periods of rising prices when the inventory is on the balance sheet at lower prices. So, when inventory is reduced (liquidated) the cost of goods sold would be at older lower prices creating increase profits. We know that LIFO inventories contain old costs and these old costs really do not reflect replacement cost of the item in inventory. If inventories physically decline, these older, or out of date, costs may be charged against current earnings resulting in what we refer to as “LIFO liquidation profit.” A material effect on net income of LIFO layer liquidation must be disclosed in a note to the financial statements.
DVL extends the concept of inventory pools by allowing a company to combine a large variety of goods into one pool. Physical units are not used in calculating ending inventory. The technique helps companies simplify LIFO record-keeping, it also minimizes the probability of layer liquidation. At the end of the period, we determine if a new inventory layer was added by comparing ending inventory to beginning inventory. When using DVL we think in terms of inventory layers rather than inventory pools.
Many companies that use LIFO for external and income tax purposes maintain FIFO or average cost inventory amounts on their internal records. In 1981, the LIFO conformity rule was liberalized to permit LIFO users to present designated supplemental disclosures, allowing a company to report in a note the effect of using another method on inventory valuation rather than LIFO.
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