Chapter 6

Periodic and Perpetual Inventory Systems

There are two methods of handling inventories:

• the periodic inventory system, and

• the perpetual inventory system

With the periodic inventory system, the firm calculates its Cost of Goods Sold at
the end of the year. The firm takes its beginning inventory, and adds its
purchases for the period. This gives the firm all the goods that pass through the
firm for the period (the goods available for sale). The firm then takes a physical
inventory. This gives the firm what is left at the end of the period. The ending
inventory is then subtracted from the available goods figure to get the cost of
goods sold.

Two disadvantages of the periodic method are:

• This method does not give the firm much information on the theft or
spoilage of goods. (Everything not present is assumed to be sold.)
• Unless a physical inventory is taken, the firm does not know what its cost
of goods sold is during the period (as opposed to the end of the period).

An advantage of the periodic method is that it is a easy system to maintain.

With the perpetual inventory system, the firm keeps track of its cost of goods sold
on a continual basis. Thus, at any given time, the firm can estimate its current
inventory levels. At the end of the period, a physical inventory is taken. Any
discrepancy with the estimated inventory level and the actual inventory level is
then attributed to theft and spoilage.

An advantage of the perpetual system is that it provides information about theft

and you have a Cost of Goods Sold figure whenever needed. A disadvantage of
the perpetual system used to be that it was very expensive to maintain this type
of system. With the use of computers and scanners, the marginal cost to
implement a perpetual system may be minimal.

What we have discussed to date is the perpetual inventory system.

Differences Between Periodic and Perpetual Inventory Systems

Periodic Perpetual
a. Purchase inventory on credit:

D. Purchases D. Merchandise Inventory

Cr. Accounts Payable Cr. Accounts Payable

b. Transportation Costs on purchases:

D. Freight In D. Freight In
Cr. Accounts Payable Cr. Accounts Payable

c. Purchases Returns and Allowances:

D. Accounts Payable D. Accounts Payable

Cr. Purchases Ret & Allow. Cr. Merchandise Inventory

d. Payments on Accounts Payable:

D. Accounts Payable D. Accounts Payable

Cr. Cash Cr. Cash

e. Sale of Merchandise on Credit:

D. Accounts Receivable D. Accounts Receivable

Cr. Sales Cr. Sales
D. Cost of Goods Sold
Cr. Merchandise Inventory

f. Payment of Delivery Costs

D. Freight Out Expense D. Freight Out Expense

Cr. Cash Cr. Cash

g. Return of Merchandise Sold:

D. Sales Returns and Allowances D. Sales Returns and Allowances

Cr. Accounts Receivable Cr. Accounts Receivable
D. Merchandise Inventory
Cr. Cost of Goods Sold

f. Receipts on Accounts Receivable:

D. Cash D. Cash
Cr. Accounts Receivable Cr. Accounts Receivable
With the perpetual inventory system, you have the Cost of Goods Sold at any
given time. You just look at the balance of the Cost of Goods Sold account.
With the periodic inventory system, there is no Cost of Goods Sold account.
Instead, you must calculate the Cost of Goods Sold by netting all of the inventory
accounts. They are all closed to Income Summary, and the net amount which
results places the Cost of Goods Sold as a debit in the Income Summary account
-- as would have been the case under the perpetual inventory system if you had
just closed out the Cost of Goods Sold account.
Cost of Goods Sold:

Beginning Balance of Inventory (debit balance)

+ Purchases (debit balance)
- Purchase Returns & Allowances (credit balance)
- Purchase Discounts (credit balance)
+ Freight In (debit balance)
--------------------------------------------
Cost of Goods Available
- Ending Balance of Inventory
--------------------------------------------
Cost of Goods Sold

Income Summary Account:

INCOME SUMMARY (PARTIAL ENTRIES)

Beginning Balance of Purchase Returns &

Inventory Allowances
Purchases Purchase Discounts
Ending Balance of
Freight In
Inventory

Cost of Goods Sold

You close out the Inventory account. There were no additions to inventory during
the year. Thus, Inventory is the beginning inventory:

D. Income Summary $50,000

Cr. Inventory $50,000
You then close out all of the temporary/nominal accounts:

D. Income Summary $300,000

Cr. Purchases $300,000

D. Income Summary $10,000

Cr. Freight-In $10,000

D. Purchase Returns & Allowances $20,000

Cr. Income Summary $20,000

D. Purchase Discounts $30,000

Cr. Income Summary $30,000

You finally add the current inventory figure (from physical inventory at end of
year) to Income Summary and the Inventory account. You previously closed the
Inventory account. This now adds the ending inventory figure to the Inventory
account. After this, Inventory reflects the end of the year figure.

D. Inventory $40,000
Cr. Income Summary $40,000

You now have the correct Cost of Goods figure as a debit balance in the Income
Summary. If you had used the perpetual system and maintained a Cost of
Goods Sold account, it would have had a debit balance (it is an expense). The
Cost of Goods Sold account would have been closed, and it would have resulted
in a debit entry to the Income Summary account.

INCOME SUMMARY
(PARTIAL ENTRIES)

Beginning Balance of $50,000 Purchase Returns & $20,000

Inventory Allow.
Purchases 300,000 Purchase Discounts 30,000
10,000 Ending Balance of 40,000
Freight In
Inventory

Cost of Goods Sold $270,000

You get the same result if you use the formula:

Beginning Balance of Inventory (debit balance) $50,000

+ Purchases (debit balance) 300,000
- Purchase Returns & Allowances (credit balance) -20,000
- Purchase Discounts (credit balance) -30,000
+ Freight In (debit balance) 10,000
-------------------------------------------- ----------
Cost of Goods Available $310,000
- Ending Balance of Inventory -40,000
-------------------------------------------- ------------
Cost of Goods Sold $270,000

Inventory Categories

Inventory is often referred to as merchandise inventory by a retailer.

Manufacturers have three types of inventory: raw materials, work in process, and
finished goods. When they purchase raw materials, it goes into raw materials.
When the company starts to make the product, the materials leave raw materials
and get added to work in process. In work in process, the cost of the materials
are combined with the cost of the labor (direct labor) and the factory overhead.

Components of Inventory Cost

Inventory cost is defined as the price paid to acquire the inventory and generally
includes invoice price less purchases discounts, freight, insurance in transit,
taxes, tariffs, inspection costs and preparation costs. It is basically everything
that is paid in order to get the inventory ready to sell.

Ownership of Goods

The term "FOB shipping point" means that the seller transfers title to the goods at
the seller’s place of business. The buyer pays shipping costs. For example, if you
order a car from Ford and the invoice says FOB Detroit, then you pay the
shipping costs and the car belongs to you as soon as it leaves the factory.

The term "FOB destination" means that the seller transfers title to the goods at
the buyer’s place of business. The seller pays shipping costs. For example, if you
order a car from Ford and the invoice says FOB Los Angeles, then Ford pays the
shipping costs and the car belongs to you when it arrives.

Merchandise in transit is included in the buyer'

s inventory if title to the goods has
passed (e.g., FOB shipping point). Goods in transit shipped FOB destination
belong to the seller.
Sometimes companies enter into a consignment agreement where goods are
transferred physically to another company without title transferring. Consigned
goods belong to the consignor. They are not included in the consignee’s (the
company doing the sale … not the actual owner) inventory.

Inventory Costing Methods Under the Periodic Method

A company must choose an inventory costing method. When identical items of

merchandise are purchased at different prices during the year, it usually is
impractical to monitor the actual goods flow and record the corresponding costs.
Instead, the accountant will make an assumption about the cost flow and will use
one of the following methods:

• specific identification
• average-cost
• first-in, first-out (FIFO)
• last-in, first-out (LIFO)

The alternative methods have different effects on net income, income taxes, and
cash flows. The implementation of these methods is effected by whether the
company uses the perpetual system or the periodic system. We will first discuss
the periodic system.

In the following discussion, we will assume that the following purchases of

inventory were made during June:

Units Purchased:
June 1 50 units @ $1.00
6 50 units @ $1.10
13 150 units @ $1.20
20 100 units @ $1.30
25 150 units @ $1.40
------
500 units
Units Sold:
June 10 70 units
30 210 units
------
280 units

Units in Ending Inventory: 220 units

Specific Identification

Under the specific identification method, you identify which goods were
purchased on which dates (e.g., using serial numbers or labels). You then keep
track of which goods were sold and which goods are still on hand at the end of
the period. This method reflects the actual flow of goods.

Assume that you identify that you sold the following units:

50 units from June 6 60 x $1.10 = $55

50 units from June 13 50 x $1.20 = $60
100 units from June 20 100 x $1.30 = $130
80 units from June 25 80 x $1.40 = $112
------
Cost of Goods Sold : $357

You identify that you still have these goods in inventory at the end of the year:

50 units from June 1 50 x $1.00 = $50

100 units from June 13 100 x $1.20 = $120
70 units from June 25 70 x $1.40 = $98
------
Cost of Remaining Inventory : $268

This method is not common because it is expensive to keep track of which items
are sold. This is especially true when you sell high volumes of goods. This
method permits companies to manipulate income by choosing to sell the high- or
low-cost items.

The specific identification method is used primarily for high-priced items such as
computer processors, automobiles, expensive furniture & jewelry.

Average Cost

Under the average cost method, a weighted average cost per unit is first
computed for the goods available for sale during the period.

This is accomplished by dividing the cost of goods available for sale by the units
available for sale.

June 1 50 units @ $1.00 = $50

6 50 units @ $1.10 = $55
13 150 units @ $1.20 = $180
20 100 units @ $1.30 = $130
25 150 units @ $1.40 = $210
------ --------
Units Purchased: 500 units $625

Average Cost Per Unit $625/500 = $1.25

Then the average cost per unit is multiplied by the number of units in ending
inventory to obtain the cost of ending inventory.

Ending Inventory = 220 units @ $1.25 = $275

Cost of Goods Sold = 280 units @ $1.25 = $350

This method has the advantage of leveling the effects of variations in cost. Cost
increases and decreases are leveled out.

A disadvantage of this method is that the most current costs are not used in
income determination.

First-In, First-Out

Under the first-in, first-out (FIFO) method the cost of the first items purchased is
assigned to the first items sold. The 280 units sold are assumed to come from
the first units:

50 units from June 1 60 x $1.00 = $50

50 units from June 6 50 x $1.10 = $55
150 units from June 13 100 x $1.20 = $180
30 units from June 20 80 x $1.30 = $39
------
Cost of Goods Sold : $324

Therefore, ending inventory consists of the most recent purchases.

70 units from June 20 70 x $1.30 = $91

150 units from June 25 150 x $1.40 = $210
------
Cost of Remaining Inventory : $301

During periods of rising prices, FIFO yields the highest net income of the four
methods.

Last-In, First-Out

Under the last-in, first-out (LIFO) method, the last items purchased are assumed
to be the first items sold. The 280 units sold are assumed to be:

150 units from June 25 150 x $1.40 = $210

100 units from June 20 100 x $1.30 = $130
30 units from June 13 30 x $1.20 = $36
------
Cost of Goods Sold : $376
Therefore, ending inventory is assumed to consist of items from the earliest
purchases.

50 units from June 1 50 x $1.00 = $50

50 units from June 6 50 x $1.10 = $55
120 units from June 13 120 x $1.20 = $144
------
Cost of Remaining Inventory : $249

When a company uses LIFO, it must report, in the notes to its financial
statements, what its inventory would have been using FIFO. The difference
between the two numbers is called the LIFO Reserve:

Inventory Using LIFO $249

LIFO Reserve 52
-------
Inventory Assuming FIFO $301

Reporting LIFO reserve enables financial analysts to make allowances for the
use of LIFO when comparing companies. The LIFO reserve, if positive, indicates
how much higher retained earnings would have been had the company used
FIFO. In the prior example, the difference in net income would have been equal
to the difference in Cost of Goods Sold (an expense):

COGS Under FIFO $324

LIFO Reserve 52
-------
COGS Under LIFO $376

An advantage of LIFO is that, during periods of rising prices, LIFO best matches
current merchandise costs with current sales prices. This results in the lowest
net income of the four methods. This is a major advantage when considering tax
costs. Lower income results in lower income taxes. You have to use the same
method for financial & tax purposes.

The lower net income is also a major disadvantage of LIFO when financial
reporting is considered. LIFO makes the company look less profitable (lower
income), however most users of financial statements will take this into account
when evaluating the company. Another disadvantage is that the inventory
valuation under LIFO is often unrealistic. Also, LIFO is not accepted in most
other countries.

A LIFO liquidation occurs when sales have reduced inventories below the levels
established in prior years. When prices have been rising steadily, a LIFO
liquidation produces unusually high profits. This retrains the company from
reducing inventory levels when it may be in the company’s best interests to do
so.

Comparison of the Methods

During periods of rising prices, FIFO produces a higher net income than LIFO,
and the average-cost method produces net income that is somewhere between
those of FIFO and LIFO. During periods of falling prices, the reverse is true.

Even though LIFO best follows the matching rule, FIFO provides a more up-to-
date ending inventory figure for balance sheet purposes.

Inventory Methods Under the Perpetual System

The pricing of inventories under the perpetual system differs from pricing under
the periodic system. Under the perpetual system, the cost of goods sold is
determined at the time of sale, and the cost of ending inventory is determined
after every inventory transaction. The specific identification method produces the
same results under the perpetual system as under the periodic system. The
FIFO method also produces the same results regardless of the system used.
The first units are always the first units no matter when you do the calculation.

Average Cost Under the Perpetual System

Using the average-cost method in a perpetual system, a moving average is

computed after each purchase.

June 1 50 units @ $1.00 = $50

6 50 units @ $1.10 = $55
------ --------
Units Purchased: 100 units $105

Average Cost Per Unit $105/100 = $1.05

This cost is used for the 70 units sold on June 10 ($73.50). The remaining units
will be considered to cost $1.05 until the next calculation.

Calculation -June 10 100 units @ $1.05 = $105.00

Sale 10 -70 units @ $1.05 = -$73.50
------ ----------
Balance 10 30 units @ $1.05 $31.50
13 150 units @ $1.20 $180.00
20 100 units @ $1.30 $130.00
25 150 units @ $1.40 $210.00
------ --------
Units Purchased: 430 units $551.50

Average Cost Per Unit $551.50/430 = $1.28

This cost is used when 210 units are sold on June 30 ($268.80). The remaining
220 units in inventory are valued using the $1.28 cost ($282.70).

The Cost of Goods Sold is $342.30 ($73.50 + 268.80).

LIFO Under the Perpetual System

LIFO produces different figures under the perpetual system because you use the
last units purchased before the individual sale:

June 10 Sale
50 units from June 6 50 x $1.10 = $55
20 units from June 1 20 x $1.00 = $20
------
Cost of Goods Sold : $75

Remaining inventory is assumed to consist of items from the earliest purchases.

June 10 Remaining Units

30 units from June 1 30 x $1.00 = $30
------
Cost of Remaining Inventory : $30

The most recent goods acquired prior to the June 30 sale is used on that date:

150 units from June 25 150 x $1.40 = $210

60 units from June 20 100 x $1.30 = $78
------
Cost of Goods Sold : $288
The Cost of Goods Sold for the month is $363 ($75 + $288). The ending
inventory is assumed to consist of items from the earliest purchases that have
not been sold previously:

30 units from June 1 30 x $1.00 = $30

150 units from June 13 150 x $1.20 = $180
40 units from June 29 40 x $1.30 = $52
------
Cost of Remaining Inventory : $262

Lower of Cost or Market

Inventory is carried at the lower of cost or market. This is an example of

conservatism. We do not want unsold obsolete inventory carried at high
historical costs. The market value of inventory is defined as current replacement
cost or net realizable value (sales price less selling expenses). Market value of
inventory may fall below its cost because of physical deterioration, obsolescence,
or a decline in price level.

There are three basic methods for implementing the lower of cost or market
comparison. You may do it on a:

• specific item level

• major category level, or
• total inventory level

To determine the lower of cost or market:

• First, cost is determined by using the FIFO, LIFO, Specific Identification or

Weighted Average methods;
• Second, calculate the market value (Replacement cost or Net Realizable
Value; and
• Third, compare cost to market.

The tax rules do not permit all of the methods described above. For example,
the total inventory comparison is not acceptable for federal income tax purposes.
Also, for tax purposes, you may not use lower of cost or market method when
using the LIFO method.

Inventory Errors

Cost of goods available is assigned to goods sold and ending inventory.

Recalling that cost of goods available less ending inventory equals cost of goods
sold, it can be seen that the higher the cost of ending inventory, the lower the
cost of goods sold and the higher the gross profit and net income. The converse
also is true.
Because the cost of ending inventory is needed to compute the cost of goods
sold, it affects net income dollar for dollar. It is most important to match cost of
goods sold with sales so that a proper determination of net income will result.

This year' s ending inventory automatically becomes next year' s beginning

inventory. Because beginning inventory also affects net income dollar for dollar,
an error in this year'
s ending inventory results in misstated net income for both
this year and next year.

When ending inventory is understated, the Cost of Goods Sold will be too high.
Because you are subtracting a high number as an expense (COGS), the net
income for the period will be understated. This year’s ending inventory becomes
next year’s beginning inventory. Thus, next year’s beginning inventory will be too
low. This will result in a lower Cost of Goods Sold for the second period.
Because you are subtracting a COGS figure that is too low, the net income in the
second year will be overstated. The differences in net income for the two years
will offset each other.

This Year Next Year

COGS COGS
Beg. Bal. $ XXX
+ Purch. +XXX
---------
Available $XXX
-End. Inv. -Too Low Beg. Bal. $ Too Low
------------ + Purch. + XXX
COGS Too High --------------
======= Available $ Too Low
-End. Inv. XXX
Net Too Low --------------
Income
COGS $ Too Low
========

Net Income Too High

When ending inventory is overstated, the Cost of Goods Sold will be too low.
Because you are subtracting a low number for COGS, the net income for the
period will be overstated. This year’s ending inventory becomes next year’s
beginning inventory. Thus, next year’s beginning inventory will be too high. This
will result in a higher COGS for the second period. Because you are subtracting
a COGS figure that is too high, the net income for the second period will be
understated.
 This Year Next Year
COGS COGS
Beg. Bal. $ XXX
+ Purch. +XXX
---------
Available $XXX
-End. Inv. -Too High Beg. Bal. $ Too High
------------ + Purch. + XXX
COGS Too Low --------------
======= Available $ Too High
-End. Inv. -XXX
Net Too High --------------
Income
COGS $ Too High
========

Net Income Too Low

Financial Statement Analysis

Financial Analysts pay particular attention to a company’s inventory. Although a

company wants to have enough inventory to meet the demands of its customers,
it doesn’t want to have too much inventory because it ties up resources, and the
inventory can become obsolete.

The desire to minimize inventory levels has led to the implementation of a Just-
In-Time operating environment by many companies. Under the Just-In-Time
system, a company tries to have its inventory arrive just at the time they are
needed.

In determining inventory levels, management must balance the cost of handling,

storing, and financing inventories with the cost of lost sales and dissatisfied
customers.

For example, Dell is considered to have a competitive advantage over its

competitors because it keeps relatively low levels of inventory and still meets the
demands of its customers very quickly.

Two ratios used in this area are:

• Inventory Turnover Ratio

• Days in Inventory
Inventory Turnover Ratio

The Inventory Turnover Ratio is used to measure inventory levels and is

computed by dividing cost of goods sold by the average inventory. It indicates the
number of times, on average, inventory is sold during the period.

Cost of Goods Sold

----------------------------
Average Inventory

Days In Inventory

This is also called “Average Days’ Inventory On Hand”. This ratio indicates the
average number of days between the purchase and sale of inventory. It is
traditionally computed by dividing the number of days in a year by the inventory
turnover.

365
-------------------------------------------
Inventory Turnover Ratio

It is easier for me to remember this formula if I think of it as follows. First,

calculate how much inventory you sell in a day:

Cost of Goods Sold

--------------------------
365

Now that you have the inventory sold in one day, divide that figure into your
average inventory level for the year:

Average Inventory
-------------------------------------------
Inventory Sold in One Day

Mathematically, this is the same formula.

Estimating Inventory

If you use the periodic inventory system, then you probably take a physical
inventory once a year because it is very expensive. When preparing interim
financial statements, companies usually do not want to go to the expense of
conducting a physical inventory. Instead, the company estimates its inventories
based upon its sales figures using two methods:

• retail method, and

• gross margin method.

As you can see below, they are really doing the same thing, but they approach it
from different angles. Both are based on knowing the relationship between
product cost and retail values.

Retail Method of Inventory Valuation

The retail method of inventory estimation can be used when there is an overall
constant relationship between the cost and the sales price for goods over a
period of time. To apply the retail method:

a. Goods available for sale is first determined both at cost and at retail.

Cost Retail
Beginning Inventory $ 40,000 $ 55,000
Net Purchases (includes Freight-In) 110,000 145,000
------------ ------------
Goods Available For Sale $150,000 $200,000

b. Then, calculate the cost-to-retail ratio. In this case, it is 75%

($150,000/$200,000).

c. Sales for the period are subtracted from goods available for sale (using retail
values) to produce ending inventory at retail.

Retail Value of Goods Available for Sale $200,000

Less: Sales for Period -160,000
-------------
Retail Value of Remaining Inventory $40,000

d. Finally, ending inventory at retail is multiplied by the cost-to-retail ratio to

produce an estimate of ending inventory at cost. The estimated cost of remaining
inventory in this case is $30,000 ($40,000 x 75%).
Gross Margin Method of Inventory Valuation

The gross margin method (gross profit method) of inventory estimation assumes
that the percentage of gross profit for a business remains relatively stable from
year to year. The gross profit method involves three steps.

First, estimate the cost of goods sold by multiplying sales by (one minus the
gross profit percentage). In this case, the gross profit percentage is 25%, and
one minus the gross profit percentage is 75% (1-25%).

Sales $160,000
x 1 - Gross Profit Percentage X 75%
--------------
Estimated Cost of Goods Sold $120,000

Next, use the estimated Cost of Goods Sold in the Calculation of ending
inventory.

Beginning Inventory $40,000

Net Purchases at Cost 110,000
-------------
Goods Available For Sale $150,000
Less: Estimated COGS -120,000
------------
Estimated Ending Inventory $30,000