Question

1. There are two different types of inventory systems--perpetual and periodic. What is the difference between the two in terms of how inventory is tracked and how it is recorded on the books.

2. In regards to inventory costing methods (LIFO, FIFO, Weighted Average), in most situations, the flow of goods would actually resemble FIFO. For example, a grocery store will push the oldest milk to the front of the shelf to try to sell it first. If that is the case, then why would a business choose to use LIFO instead to cost out its inventory? Is this allowed?

Answer 1

1. a)The periodic and perpetual inventory systems are different methods used to track the quantity of goods on hand. b) The more sophisticated of the two is the perpetual system, but it requires much more record keeping to maintain. The periodic system relies upon an occasional physical count of the inventory to determine the ending inventory balance and the cost of goods sold, while the perpetual system keeps continual track of inventory balances.

c) Under the perpetual system, there are continual updates to either the general ledger or inventory ledger as inventory-related transactions occur. Unlike, under a periodic inventory system, there is no cost of goods sold account entry at all in an accounting period until such time as there is a physical count, which is then used to derive the cost of goods sold.

d) Under the perpetual system, inventory purchases are recorded in either the raw materials inventory account, while there is also a unit-count entry into the individual record that is kept for each inventory item. But, under a periodic inventory system, all purchases are recorded into a purchases asset account, and there are no individual inventory records to which any unit-count information could be added.

2. a) FIFO method is based on the perception that the first inventories purchased are the first ones to be sold. It is a cost flow assumption for most companies. Since the theory perfectly matches to the actual flow of goods, therefore it is considered as the right way to value inventory.

b) The above example of a grocery store that it will push the oldest milk to the front of the shelf to try to sell it first is the principle on which FIFO method is based.

c) LIFO method is useful for business like supermarkets, drug stores,auto dealers, auto parts, etc.

d) However LIFO method is also very useful. Following are the advantages of LIFO method: i) Companies that use the LIFO method gain a tax advantage because the method assumes the most recently acquired inventory is what is sold. As inflation continues to rise, LIFO produces a higher cost of goods sold and a lower inventory. The higher cost of goods sold leads to a lower tax liability.

ii) LIFO method leads to a better matching of costs and revenues than the other methods.

iii) When a company uses LIFO, the income statement reports both sales revenue and cost of goods sold in current dollars.

e) The LIFO method of inventory valuation is  permitted under the U.S. Generally Accepted Accounting Principles (GAAP) but is prohibited under the International Financial Reporting Standards (IFRS).