Question

Explain in detail the purpose, advantages and the effect of using FIFO method on the financial statements in perpetual inventory system. Support your answer with the help of examples of your own.

Answer 1

Under the perpetual system the Inventory account is constantly (or perpetually) changing. When a retailer purchases merchandise, the retailer debits its Inventory account for the cost; when the retailer sells the merchandise to its customers its Inventory account is credited and its Cost of Goods Sold account is debited for the cost of the goods sold. Rather than staying dormant as it does with the periodic method, the Inventory account balance is continuously updated.

The FIFO method has four major advantages:

(1) it is easy to apply,

(2) the assumed flow of costs corresponds with the normal physical flow of goods,

(3) During inflation, FIFO has the potential to enhance the value of remaining inventory and bring higher net income.

(4) Showing more assets and income helps businesses to fish in potential investors and lenders.

(5) Since closing stock comprises of more recent purchases, therefore closing stock of materials are valued at market price

All the advantages of FIFO occur because when a company sells goods, the first costs it removes from inventory are the oldest unit costs. A company cannot manipulate income by choosing which unit to ship because the cost of a unit sold is not determined by a serial number. Instead, the cost attached to the unit sold is always the oldest cost. Under FIFO, purchases at the end of the period have no effect on cost of goods sold or net income.

Effects;

(1) the recognition of paper profits and

(2) a heavier tax burden if used for tax purposes in periods of inflation.

Example:

We are going to use one company as an example to demonstrate calculating the cost of goods sold with both FIFO and LIFO methods.

Ted’s Televisions is a business in New York City. Ted has been in operation now for a year. This is what his inventory costs looks like:

Month Amount Price Paid

January 100 Units $800.00
February 100 Units $800.00
March 100 Units $825.00
April 100 Units $825.00
May 100 Units $825.00
June 100 Units $850.00
July 100 Units $850.00
August 150 Units $875.00
September 150 Units $875.00
October 150 Units $900.00
November 150 Units $900.00
December 150 Units $900.00

1450 units acquired.
Units = Televisions.

As you can see, the unit price of televisions steadily increased. Assuming Ted kept his sales prices the same (which he did, in order to stay competitive), this means there was less profit for Ted’s Televisions by the end of the year.

For the year, the number of televisions sold was 1100.

Let’s calculate cost of goods sold using the:

FIFO METHOD

Going by the FIFO method, Ted needs to use the older costs of acquiring his inventory and work ahead from there.

So Ted’s COGS calculation is as follows:

200 units x $800 = $160,000
300 units x $825 = $247,500
200 units x $850 = $170,000
300 units x $875 = $262,500
100 units x $900 = $90,000

Ted’s cost of goods sold is $930,000.

LIFO method

Going by the LIFO method, Ted needs to go by his most recent inventory costs first and work backwards from there.

450 units x 900 = $405,000
300 units x 875 = $262,500
200 units x 850 = $170,000
150 units x $825 = $125,750

Ted’s cost of goods sold is $961,250.

The remaining unsold 350 televisions will be accounted for in “inventory”.