Exercise 5-5a Periodic Inventory Costing Lo P3

Periodic inventory costing, a method employed to determine the cost of goods sold (COGS) and ending inventory at the end of an accounting period, requires a physical count of inventory. Understanding this method, especially when combined with different inventory valuation approaches such as FIFO (First-In, First-Out), LIFO (Last-In, First-Out), and weighted-average, is crucial for accurate financial reporting. Let's delve into Exercise 5-5A, which explores periodic inventory costing using the LIFO (Last-In, First-Out) method, and how it impacts a company's financial statements.

Understanding Periodic Inventory Costing

Periodic inventory costing contrasts with perpetual inventory costing, where inventory is updated continuously with each purchase and sale. In the periodic method, the inventory balance is only updated at the end of the accounting period. This makes it simpler to implement but requires a physical inventory count to determine the ending inventory and, consequently, the cost of goods sold.

Here's a breakdown of the key steps involved:

Physical Inventory Count: At the end of the period, a physical count of all inventory on hand is performed.
Cost Assignment: The cost flow assumption (FIFO, LIFO, or weighted-average) is applied to determine the cost of the ending inventory.
COGS Calculation: The cost of goods sold is calculated using the following formula:

Beginning Inventory + Purchases - Ending Inventory = Cost of Goods Sold

LIFO (Last-In, First-Out) Method

LIFO assumes that the last units purchased are the first ones sold. This means that the cost of the most recent purchases is assigned to the cost of goods sold, while the cost of the oldest purchases remains in the ending inventory.

Advantages of LIFO:

Tax Benefits: In periods of rising prices, LIFO can result in a higher cost of goods sold, leading to lower taxable income and potentially lower taxes.
Matching Principle: LIFO matches current revenues with current costs, providing a more accurate reflection of current profitability.

Disadvantages of LIFO:

Lower Net Income: During inflation, LIFO often leads to lower reported net income, which can be viewed negatively by investors.
Balance Sheet Distortion: The ending inventory is valued at older, potentially lower costs, which may not reflect its true market value.
IFRS Restrictions: International Financial Reporting Standards (IFRS) do not allow the use of LIFO.

Exercise 5-5A: Periodic Inventory Costing with LIFO

Let's assume the following scenario for Exercise 5-5A:

Company ABC uses a periodic inventory system and the LIFO method to value its inventory. Here is the data for the period:

Beginning Inventory (January 1): 100 units @ $10 each
Purchase 1 (March 15): 200 units @ $12 each
Purchase 2 (June 20): 300 units @ $15 each
Purchase 3 (October 10): 150 units @ $18 each
Sales during the year: 550 units
Ending Inventory (December 31): 200 units

Task: Calculate the cost of goods sold and the ending inventory using the periodic LIFO method.

Step-by-Step Solution

Determine the Ending Inventory:

Since LIFO assumes the last units purchased are sold first, the ending inventory consists of the oldest units. We have 200 units in ending inventory. These units will come from the beginning inventory and the first purchase.
- Beginning Inventory: 100 units @ $10 each = $1,000
- Purchase 1: 100 units @ $12 each = $1,200
Total Ending Inventory Value = $1,000 + $1,200 = $2,200
Calculate the Cost of Goods Sold (COGS):

First, determine the total goods available for sale:
- Beginning Inventory: 100 units
- Purchase 1: 200 units
- Purchase 2: 300 units
- Purchase 3: 150 units
Total Goods Available for Sale = 100 + 200 + 300 + 150 = 750 units

Total Cost of Goods Available for Sale:
- Beginning Inventory: 100 units * $10 = $1,000
- Purchase 1: 200 units * $12 = $2,400
- Purchase 2: 300 units * $15 = $4,500
- Purchase 3: 150 units * $18 = $2,700
Total Cost of Goods Available for Sale = $1,000 + $2,400 + $4,500 + $2,700 = $10,600

Now, calculate the Cost of Goods Sold (COGS):

COGS = Total Cost of Goods Available for Sale - Ending Inventory

COGS = $10,600 - $2,200 = $8,400
Detailed COGS Calculation based on LIFO:

Since 550 units were sold, we allocate these sales based on the LIFO method:
- Purchase 3: 150 units @ $18 each = $2,700
- Purchase 2: 300 units @ $15 each = $4,500
- Purchase 1: 100 units @ $12 each = $1,200
Total COGS = $2,700 + $4,500 + $1,200 = $8,400

Summary of Results:

Ending Inventory: 200 units valued at $2,200
Cost of Goods Sold: $8,400

Financial Statement Impact

The LIFO method significantly affects the financial statements:

Income Statement: The cost of goods sold will be higher compared to FIFO in an inflationary environment, resulting in a lower gross profit and net income.
Balance Sheet: The ending inventory will be valued at older costs, which may not reflect the current market value. This can result in an understated inventory value on the balance sheet.

Alternative Inventory Valuation Methods

Understanding LIFO is enhanced by contrasting it with other methods such as FIFO and the weighted-average method.

FIFO (First-In, First-Out) Method

FIFO assumes that the first units purchased are the first ones sold. This means the cost of the oldest inventory is assigned to the cost of goods sold, while the cost of the most recent purchases remains in the ending inventory.

Advantages of FIFO:

Higher Net Income: During inflation, FIFO typically results in a lower cost of goods sold and a higher net income, making the company appear more profitable.
Accurate Inventory Valuation: The ending inventory is valued at more current costs, providing a more accurate reflection of its market value.

Disadvantages of FIFO:

Higher Taxes: Higher net income can lead to higher taxable income and potentially higher taxes during inflation.
Mismatching: FIFO may not accurately match current revenues with current costs.

Weighted-Average Method

The weighted-average method calculates the weighted-average cost of all goods available for sale during the period and assigns this average cost to both the cost of goods sold and the ending inventory.

Calculation:

Weighted-Average Cost = Total Cost of Goods Available for Sale / Total Units Available for Sale

Advantages of Weighted-Average:

Simplicity: It is straightforward to calculate and apply.
Smoothing Effect: It smooths out price fluctuations, providing a more stable cost of goods sold.

Disadvantages of Weighted-Average:

Less Accurate: It may not accurately reflect the actual flow of inventory.
Moderate Impact: It generally falls between FIFO and LIFO in terms of its impact on net income and inventory valuation.

Comprehensive Example: Comparing LIFO, FIFO, and Weighted-Average

Let’s use the same data from Exercise 5-5A and compare the results under all three methods:

Company ABC uses a periodic inventory system. Here is the data for the period:

Beginning Inventory (January 1): 100 units @ $10 each
Purchase 1 (March 15): 200 units @ $12 each
Purchase 2 (June 20): 300 units @ $15 each
Purchase 3 (October 10): 150 units @ $18 each
Sales during the year: 550 units
Ending Inventory (December 31): 200 units

FIFO Calculation

Ending Inventory:

The ending inventory consists of the latest purchases.
- Purchase 3: 150 units @ $18 each = $2,700
- Purchase 2: 50 units @ $15 each = $750
Total Ending Inventory Value = $2,700 + $750 = $3,450
Cost of Goods Sold (COGS):

COGS = Total Cost of Goods Available for Sale - Ending Inventory

COGS = $10,600 - $3,450 = $7,150

Weighted-Average Calculation

Weighted-Average Cost:

Total Cost of Goods Available for Sale = $10,600 Total Units Available for Sale = 750 units

Weighted-Average Cost = $10,600 / 750 = $14.13 (rounded)
Ending Inventory:

Ending Inventory = 200 units * $14.13 = $2,826
Cost of Goods Sold (COGS):

COGS = Total Cost of Goods Available for Sale - Ending Inventory

COGS = $10,600 - $2,826 = $7,774

Comparative Summary

Method	Ending Inventory	Cost of Goods Sold
LIFO	$2,200	$8,400
FIFO	$3,450	$7,150
Weighted-Average	$2,826	$7,774

Analysis:

Ending Inventory: FIFO results in the highest ending inventory value, followed by the weighted-average method, and LIFO yields the lowest value.
Cost of Goods Sold: LIFO results in the highest cost of goods sold, followed by the weighted-average method, and FIFO yields the lowest COGS.

Practical Implications and Considerations

The choice of inventory costing method can have significant impacts on a company's financial statements, tax liabilities, and overall financial performance. Here are some practical implications and considerations:

Tax Planning: Companies often choose LIFO to reduce their taxable income during periods of inflation. However, the tax benefits should be weighed against the potential negative impact on net income.
Financial Reporting: The choice of inventory method can influence how a company's profitability is perceived by investors and creditors.
Industry Practices: Some industries may have a preference for a particular inventory method based on industry standards and practices.
Management Decisions: The decision to use LIFO, FIFO, or weighted-average should be carefully considered and aligned with the company's overall financial goals and strategies.
Regulatory Compliance: Companies must comply with accounting standards and regulations when choosing an inventory costing method.

Advanced Topics and Extensions

LIFO Reserve: The LIFO reserve is the difference between the value of inventory under LIFO and the value of the same inventory under FIFO. It is disclosed in the notes to the financial statements.
LIFO Liquidation: LIFO liquidation occurs when a company sells more inventory than it purchases during a period, resulting in the sale of older, lower-cost inventory. This can lead to a sudden increase in net income.
Tax Implications: The tax implications of LIFO can be complex and vary depending on the tax laws of the jurisdiction.
IFRS vs. GAAP: It is important to note that IFRS prohibits the use of LIFO, while U.S. GAAP allows it. This can create differences in financial reporting for companies that follow different accounting standards.

Common Mistakes to Avoid

Incorrect Application of LIFO: Ensure that the last units purchased are correctly assigned to the cost of goods sold.
Errors in Physical Inventory Count: Accuracy in the physical inventory count is crucial for accurate inventory valuation.
Inconsistent Application of Method: Once an inventory method is chosen, it should be applied consistently from period to period.
Ignoring Tax Implications: Be aware of the tax implications of the chosen inventory method.

Conclusion

Exercise 5-5A provides a practical understanding of periodic inventory costing using the LIFO method. LIFO can significantly impact a company's financial statements, particularly during periods of rising prices. While it may offer tax benefits, it can also result in lower reported net income and an understated inventory value on the balance sheet. Contrasting LIFO with FIFO and the weighted-average method provides a comprehensive view of the different approaches to inventory valuation and their respective implications. Understanding these methods and their impacts is essential for accurate financial reporting and informed decision-making. Companies must carefully consider their specific circumstances, industry practices, and regulatory requirements when choosing an inventory costing method to align with their financial goals and strategies.