Inventory Accounting Systems

Perpetual systems maintain a running record to show the inventory on hand at all times. Periodic systems do not keep a continuous record of inventory on hand.

Periodic System
This type of inventory system does not keep an updated record of all goods bought, sold and on hand. In a periodic system cost of goods sold is only determined at the end of the accounting period once inventory is counted. This system is not as widely used as the perpetual system.

Periodic System
At the end of the period make a physical count and apply unit cost to determine ending inventory. Inventory purchases are debited to the purchases account. The merchandise inventory account carries the beginning inventory balance until adjusted at period end.

PURCHASES OF MERCHANDISE
When merchandise is purchased for resale to customers, the temporary account, Purchases, is debited for the cost of goods. Like sales, purchases may be made for cash or on account (credit). The purchase is normally recorded by the purchaser when the goods are received from the seller. Each credit purchase should be supported by a purchase invoice.

NORMAL BALANCES: COST OF GOODS PURCHASED ACCOUNTS

We used 4 accounts to record the purchase of inventory under a periodic inventory system. These accounts are:

Account Purchases Purchase Returns and Allowances Purchase Discounts Freight-in

Normal Balance
Debit Credit Credit Debit

PERIODIC SYSTEM TRANSACTIONS

Purchases is a temporary account whose normal balance is a debit.

CHELSEA VIDEO
Date May 4 Account Titles and Explanation Purchases Accounts Payable (To record goods purchased on account, terms 2/10, n/30) Debit Credit 3,800 3,800

PERIODIC SYSTEM TRANSACTIONS

Purchase Returns and Allowances is a temporary account whose normal balance is a credit.

CHELSEA VIDEO
Date May 8 Account Titles and Explanation Accounts Payable Purchase Returns and Allowances (To record return of inoperable goods purchased from Highpoint Electronic Debit Credit 300 300

Freight Costs On Incoming Inventory

PERIODIC SYSTEM TRANSACTIONS

Freight-in is a temporary account whose normal balance is a debit.

CHELSEA VIDEO
Date May 9 Account Titles and Explanation Freight-in Cash (To record payment of freight, terms FOB shipping point) Debit Credit 150 150

PERIODIC SYSTEM TRANSACTIONS

Purchase Discounts is a temporary account whose normal balance is a credit.

CHELSEA VIDEO
Date May 14 Account Titles and Explanation Accounts Payable Purchase Discounts Cash (To record payment to Highpoint Electronic within the discount period) Debit Credit 3,500 70 3,430

COST OF GOODS PURCHASED

To determine cost of goods purchased: 1 Subtract Purchase Returns and Allowances and Purchase Discounts from Purchases to produce net purchases. 2 Add Freight-in to net purchases to produce cost of goods purchased.

Net Purchases
Purchases $ 325,000 Less: Purchase returns and allowances $ 10,400 Purchase discounts 6,800 17,200 Net purchases 307,800

Net Purchases are gross purchases adjusted for returns and discounts.

Cost of Goods Purchased

Purchases $ 325,000 Less: Purchase returns and allowances $ 10,400 Purchase discounts 6,800 17,200 Net purchases 307,800 Add: Freight-in 12,200 Cost of goods purchased 320,000

Cost of goods purchased is net purchases plus freight-in.

Recording Inventory Purchases

Recording Inventory Sales

COST OF GOODS SOLD

To determine the cost of goods sold under a periodic inventory system, it is necessary to: 1 record purchases of merchandise, 2 determine the cost of goods purchased, and 3 determine the cost of goods on hand at the beginning and end of the accounting period.

DETERMINING COST OF GOODS SOLD

Computing cost of goods sold involves 2 steps: 1 Add the cost of goods purchased to the beginning cost of goods on hand to obtain the cost of goods available for sale. 2 Subtract the ending cost of goods on hand from the cost of goods available for sale to arrive at the cost of goods sold.

COMPUTATION OF COST OF GOODS AVAILABLE FOR SALE AND COST OF GOODS SOLD

Cost of Goods Sold is determined as follows: Beginning inventory $ 36,000

Add: Cost of goods purchased Cost of goods available for sale Less: Ending inventory Cost of goods sold

320,000 356,000 40,000 $ 316,000

INCOME STATEMENT FOR A MERCHANDISING COMPANY USING A PERIODIC INVENTORY SYSTEM

HIGHPOINT ELECTRONIC INC. Income Statement For the Year Ended December 31, 1996
Sales revenues Sales $480,000 Less: Sales returns and allowances $ 12,000 Sales discounts 8,000 20,000 Net sales 460,000 Cost of goods sold Inventory, January 1 36,000 Purchases $325,000 Less: Purchases returns and allowances 10,400 Purchases discounts 6,800 Net purchases 307,800 Add: Freight-in 12,200 Cost of goods purchased 320,000 Cost of goods available for sale 356,000 The income statement under a Inventory, December 31 40,000 periodic inventory system Cost of goods sold 316,000 contains 3 distinctive features: Gross profit 144,000 1 a sales revenue section, Operating expenses 2 a cost of goods sold section, and Store salaries expense 45,000 Rent expense 19,000 3 gross profit. Utilities expense 17,000 Advertising expense 16,000 Depreciation expense store equipment 8,000 Freight-out 7,000 Insurance expense 2,000 Total operating expenses 114,000 Net income $ 30,000

Objective
Compute periodic inventory amounts under weighted-average cost, FIFO, and LIFO.

DETERMINING COST OF GOODS ON HAND

Under the periodic method, cost of inventory on hand is determined from a physical inventory requiring: 1 Counting the units on hand for each inventory item. 2 Applying unit costs to the total units on hand for each inventory item. 3 Aggregating the cost of each item of inventory to determine total cost of goods on hand.

Taking a Physical Inventory

Counting, weighting or measuring each type of inventory Determining ownership of goods Quantity of each kind of inventory listed on inventory summary sheets where unit costs are applied

ALLOCATING INVENTORIABLE COSTS

Inventoriable costs are allocated between ending inventory and cost of goods sold. Under a periodic inventory system, the allocation is made at the end of the accounting period. 1 The costs assignable to the ending inventory are determined. 2 The cost of the ending inventory is subtracted from the cost of goods available for sale to determine the cost of goods sold. 3 Cost of goods sold is then deducted from sales revenues in accordance with the matching principle.

Inventory Costing
Specific Identification method Assumed Cost Flow methods
FIFO- First-in, First-Out- earliest goods purchased first to be sold LIFO- Last-in,First-Out- latest goods purchased the first to be sold Average Cost Method- costs are charged on the basis of weighted average unit cost

ALLOCATION OF COSTS - FIFO METHOD

Pool of Costs Cost of Goods Available for Sale Unit Total Explanation Units Cost Cost Beginning inventory 100 $10 $ 1,000 Purchase 200 11 2,200 Purchase 300 12 3,600 Purchase 400 13 5,200 Total 1,000 $ 12,000

Date 01/01 04/15 08/24 11/27

Step 1 Ending Inventory Unit Total Date Units Cost Cost 11/27 400 $ 13 $ 5,200 08/24 50 12 600 $ 5,800 450

Step 2 Cost of Goods Sold

Cost of goods available for sale $ 12,000 Less: Ending inventory 5,800 $ 6,200 Cost of goods sold

PROOF OF COST OF GOODS SOLD

The accuracy of the cost of goods sold can be verified by recognizing that the first units acquired are the first units sold.

Date Units 01/01 100 04/15 200 08/24 250 Total 550

Unit Cost X X X
$ 10 11 12

Total Cost = $ 1,000 = 2,200 = 3,000

$ 6,200

ALLOCATION OF COSTS - LIFO METHOD

Pool of Costs Cost of Goods Available for Sale Unit Total Explanation Units Cost Cost Beginning inventory 100 $10 $ 1,000 Purchase 200 11 2,200 Purchase 300 12 3,600 Purchase 400 13 5,200 Total 1,000 $ 12,000

Date 01/01 04/15 08/24 11/27

Step 1 Ending Inventory Unit Total Date Units Cost Cost 01/01 100 $ 10 $ 1,000 04/15 200 11 2,200 08/24 150 12 1,800 $ 5,000 450

Step 2 Cost of Goods Sold

Cost of goods available for sale Less: Ending inventory Cost of goods sold

$ 12,000 5,000
$ 7,000

PROOF OF COST OF GOODS SOLD

The cost of the last goods in are the first to be assigned to cost of goods sold. Under a periodic inventory system, all goods purchased during the period are assumed to be available for the first sale, regardless of the date of purchase.

Date Units 11/27 400 08/24 150 Total 550

X X

Unit Cost $ 13 12

Total Cost = $ 5,200 = 1,800 $ 7,000

The average cost method assumes that goods available for sale are homogeneous. The allocation of the cost of goods available for sale is made on the basis of the weighted average unit cost incurred.

The average cost method assumes that goods available for sale are homogeneous.

ALLOCATION OF COSTS AVERAGE COST METHOD

Pool of Costs Cost of Goods Available for Sale Unit Total Explanation Units Cost Cost Beginning inventory 100 $10 $ 1,000 Purchase 200 11 2,200 Purchase 300 12 3,600 Purchase 400 13 5,200 $ 12,000 Total 1,000

Date 01/01 04/15 08/24 11/27

Step 1 Ending Inventory $ 12,000 1,000 = $12.00 Unit Total Units Cost Cost 450 x $ 12.00 = $ 5,400

Step 2 Cost of Goods Sold Cost of goods available for sale $ 12,000 Less: Ending inventory 5,400 Cost of goods sold $ 6,600

Factors Used in Selecting an Inventory Cost Method

Income statement effects Balance sheet effects Tax Effects

Income Statement Effects

In periods of increasing prices FIFO reports the highest net income LIFO the lowest average cost falls in the middle. In periods of decreasing prices FIFO will report the lowest net income LIFO the highest average cost in the middle.

Balance Sheet Effects

In a period of increasing prices costs

allocated to ending inventory using:

FIFO will approximate current costs

LIFO will be understated

Why Do Companies Use Lifo?

Higher cost of goods sold Lower net income

Lower Income Taxes

Cost-of-Goods-Sold Model
Budgeted Cost of Goods Sold
+ = = Budgeted Ending Inventory Budgeted Cost of Goods Available for Sale Actual Beginning Inventory Purchases

Cost of Goods Sold under a periodic

Beginning Inventory $100,000 Cost of Goods Available for Sale $660,000 + Net Purchases $560,000 =

Ending Inventory $120,000

Cost of Goods = Sold $540,000

Periodic System
Inventory
100,000 100,000 Beginning Beginning Balance Balance 120,000 Ending Balance

Purchases
560,000 560,000 Purchases Purchases

Cost of Goods Sold

100,000 560,000 540,000 120,000 Ending Balance

Accounts Payable
560,000 Purchases

Units Purchased in 20xx

January 8 May 19 October 23 Total units Units sold Units left

20 units @ $20 = $ 400 55 units @ $30 = $1,650 25 units @ $31 = $ 775 100 70 30

Units Sold and in Ending Inventory

Units sold by date: Jan 5 17 May 19 33 Oct 23 20 Total sales 70 30 units left in inventory

Specific Identification
20 Units @ $31
Cost of Goods Sold Oct 23 $ 620 May 19 990 Jan 5 340 Total $1,950 5 Units @ $31

33 Units @ $30
22 Units @ $30

17 Units @ $20
3 Units @ $20

Specific Identification
20 Units @ $31
Ending Inventory Oct 23 $155 May 660 Jan 60 Total $875 5 Units @ $31

33 Units @ $30
22 Units @ $30

17 Units @ $20
3 Units @ $20

Weighted Average
25 Units @ $31 (Oct) 55 Units @ $30 (May) = $ 775

= 1,650
= 400

20 Units @ $20 (Jan)

100 Total Units = $2,825 Total Cost

Weighted Average
$2,825 total cost/100 units = $28.25/unit
Cost of goods sold = 70 $28.25 = $1977.50

Ending inventory = 30 $28.25 = $847.50

First-In, First-Out

25 Units @ $31 (Oct) Cost of Goods Sold Jan $ 400 May 1,500 Total $1,900

5 Units @ $30 (May)

50 Units @ $30 20 Units @ $20 (Jan)

First-In, First-Out

25 Units @ $31 (Oct) Ending Inventory Oct $775 May 150 Total $925

5 Units @ $30 (May)

50 Units @ $30 20 Units @ $20 (Jan)

Last-In, First-Out

25 Units @ $31 (Oct) Cost of Goods Sold Oct $ 775 May 1,350 Total $2,125

45 Units @ $30 (May)

10 Units @ $30 20 Units @ $20 (Jan)

Last-In, First-Out

25 Units @ $31 (Oct) Ending Inventory Oct $300 May 400 Total $700

45 Units @ $30 (May)

10 Units @ $30 20 Units @ $20 (Jan)

Comparison of Methods

Ending Inventory Specific identification $875.00 FIFO $925.00 LIFO $700.00 Weighted-average $847.50

Comparison of Methods

Cost of Goods Sold Specific identification $1,965.00 FIFO $1,900.00 LIFO $2,125.00 Weighted-average $1,977.50

Comparison of Methods
Gross Margin from Sales: Specific identification $1,035.00 FIFO $1,100.00 LIFO $ 875.00 Weighted-average $1,022.50

When prices are rising LIFO produces the lowest income and lowest income tax.

The Income Tax Advantage of LIFO

During periods of inflation, LIFOs income is the lowest. The most attractive feature of LIFO is reduced income tax payments.