As an illustration, note that two bathtubs were sold on September 9 in this example. Perpetual LIFO immediately determines the cost of this sale and reclassifies the amount. On that date, the cost of the last two units ($130 each) came from the June 13 purchase.
Using Different Inventory Valuation Methods
- LIFO is likely to yield a different gross profit under each inventory system.
- FitTees sold 700 units of designer shirts and 900 units of jeans at $39 each.
- Under the FIFO cost flow assumption, the first (oldest) costs are the first costs to leave inventory and be reported as the cost of goods sold on the income statement.
- Abusiness can easily create purchase orders, develop reports forcost of goods sold, manage inventory stock, and update discounts,returns, and allowances.
- Temporary accounts requiring closure are Sales, Sales Discounts, Sales Returns and Allowances, and Cost of Goods Sold.
A purchase return or allowance under perpetual inventory systems updates Merchandise Inventory for any decreased cost. Under periodic inventory systems, a temporary account, Purchase Returns and Allowances, is updated. Purchase Returns and Allowances is a contra account and is used to reduce Purchases. The biggest disadvantages of using the perpetual inventorysystems arise from the resource constraints for cost and time. Thismay prohibit smaller or less established companies from investingin the required technologies.
The Cost of Goods Sold (COGS)
With periodic LIFO the costs of the latest purchases starting with the end of the year are removed first. Since 4 units were sold during the year, the costs removed from inventory and charged to the cost of goods sold will be the last cost of 4 units, which is $11 each. This means the cost of its December 31 inventory using periodic LIFO will be $31 (1 unit at $11 plus 2 units at $10). If the bookstore sells the textbook for $110, its gross profit under perpetual LIFO will be $21 ($110 – $89).
5 Applying LIFO and Averaging to Determine Reported Inventory Balances
Purchase Returns and Allowances is acontra account and is used to reduce Purchases. Many companies counter this with periodic partial inventory counts, which provide a baseline for the perpetual system and are designed to provide a full physical inventory by the end of the period. The cost of goods sold (COGS) is an important accounting metric derived by adding the beginning balance of inventory to the cost of inventory purchases and subtracting the cost of the ending inventory. With a perpetual inventory system, COGS is updated constantly instead of periodically with the alternative physical inventory. The perpetual inventory system keeps track of inventory balances continuously.
Moving Average
The system allows for integration with other areas, including finance and accounting teams. Employees can use perpetual inventory data to provide more accurate customer service regarding the availability of products, replacement parts, and other physical components. A perpetual inventory does not need to be adjusted manually by the company’s accountants, except to the extent that it deviates from the physical inventory count due to loss, breakage, or theft. This is why many companies perform a physical count only once a quarter or even once a year.
Understanding Perpetual Inventory Systems
There are advantages and disadvantages to both the perpetual andperiodic inventory systems. They can use a perpetual or periodic inventory system.Let’s look at the characteristics of these two systems. The ability to estimate COGS continuously also provides a company using a perpetual inventory system the ability to estimate gross profit continuously. That’s because every transaction is recorded in real-time under a perpetual inventory system. At a grocery store using the perpetual inventory system, when products with barcodes are swiped and paid for, the system automatically updates inventory levels in a database.
FitTees sold 700 units of designer shirts and 900 units of jeans at $39 each. When inventory is sold under the periodic system, we only record the income from the sale and don’t make any adjustments to inventory. The purchase of the inventory (above) was originally recorded in COGS and remains there without adjustment. In contrast, balances reported by periodic and perpetual LIFO frequently differ.
With the LIFO cost flow assumption, the latest (or most recent) costs are the first ones to leave inventory and become the cost of goods sold on the income statement. The first/oldest costs will remain in inventory and will be reported as the cost of the ending inventory on the balance sheet. Under the FIFO cost flow assumption, the first (oldest) costs are the first costs to leave inventory and be reported as the cost of goods sold on the income statement.
1Because ending inventory for one period becomes the beginning inventory for the next, application of a cost flow assumption does change that figure also. However, the impact is only indirect because the number is simply carried over from the previous period. No current computation of beginning inventory is made based activity method of depreciation example limitation on the cost flow assumption in use. Here, we’ll briefly discussthese additional closing entries and adjustments as they relate tothe perpetual inventory system. The use of a perpetual inventory system makes it particularly easy for a company to use the economic order quantity (EOQ) method to purchase inventory.
A physical inventory count requires companies to do a manual “stock-check” of inventory to make sure what they have recorded on the books matches what they physically have in stock. Differences could occur due to mismanagement, shrinkage, damage, or outdated merchandise. Shrinkage is a term used when inventory or other assets disappear without an identifiable reason, such as theft. For a perpetual inventory system, the adjusting entry to show this difference follows. This example assumes that the merchandise inventory is overstated in the accounting records and needs to be adjusted downward to reflect the actual value on hand. There are some key differences between perpetual and periodic inventory systems.