Perpetual Inventory System - Study Notes
Inventory concepts under SSP 102 and the perpetual system
SSP 102 defines inventory as assets held for sale in the ordinary course of business, including: raw materials, work in progress (WIP), finished goods, and supplies awaiting use in production.
Example: a bakery would classify flour, sugar, butter, oil, yeast as raw materials; doughs as WIP; bread loaves as finished goods; packaging materials and labels as supplies.
All these items are inventories for accounting purposes and are carried in the double-entry accounting records (Assets side).
Perpetual inventory system (focus of this week): continuously update inventory records for every purchase and sale.
Purchases: inventory balance increases; records also cash or accounts payable.
Sales: revenue is recorded; inventory is reduced; cost of goods sold (COGS) is recognised simultaneously.
Stock takes: still required (annual/biannual) to verify physical stock vs ledger, and to adjust for discrepancies (theft, damage, recording errors).
Periodic inventory system (contrast): inventory and COGS are updated only at period end after a stock take; purchases go to Purchase account rather than Inventory; no immediate COGS recording at sale.
In perpetual system, even with continuous updates, you still perform stock takes to confirm accuracy and detect discrepancies.
How costs are defined for inventory (cost to bring to saleable condition and location):
Purchase price of goods
Conversion costs (especially for manufacturing: to convert raw materials to finished goods)
Other costs to bring inventory to present location: freight/freight-in, import duties, taxes, insurance in transit
These costs are included in the cost of inventory as appropriate.
Example to illustrate total cost per unit (importing watches):
Unit price: 50; quantity: 2{,}000
Trade discount (quantity-based): 5 ext{%} off if more than 1,000 units
Customs duties: 1{,}000; Transit insurance: 2{,}000; Transportation: 500
Total cost before discount:
After applying discount (2{,}000 × 50 × (1 − 0.05) = 95{,}000): add other costs: 95{,}000 + 1{,}000 + 2{,}000 + 500 = 98{,}500
Cost per unit:
ext{Unit Cost} = rac{98{,}500}{2{,}000} = 49.25 ext{
}Note: the transcript states the unit cost as 49.25¢, but the correct unit cost is ext{$49.25 per item}.
Price changes in practice require cost flow assumptions to allocate cost to each sold unit and ending inventory. Cost flow methods (costing methods) include: specific identification, FIFO, LIFO, and moving average (perpetual moving average for COGS).
Important contextual note about cost methods:
Accounting standards do not mandate a specific method; the choice affects reported COGS and ending inventory.
Australian standards do not allow LIFO (due to potential profit manipulation); US allows LIFO (often used in high inflation environments for tax considerations).
The actual physical flow of inventory is not necessarily the same as the chosen cost method; the method is for cost allocation, not a literal tracking of each physical unit.
Choice of method depends on inventory type and tracking capabilities of the entity (larger entities often have better tracking systems).
Once chosen, the method should be used consistently within a year; switching is allowed across years, but consistency is generally expected within a period.
Costing methods overview (definitions and implications)
Specific identification: tracks the cost of each individual item; best for high-value, easily identifiable items (e.g., cars, white goods).
FIFO (First In, First Out): oldest inventory items are assumed sold first. Ending inventory reflects more recent costs.
LIFO (Last In, First Out): most recently purchased items are assumed sold first.
Moving average (perpetual): compute a moving average cost per unit after each purchase; COGS for sales uses the current moving-average cost. Ending inventory uses the same moving-average cost.
Practical implications and considerations
Specific identification aligns COGS with actual items sold; but can enable profit manipulation if it’s easy to choose which items to sell to affect reported profit.
FIFO tends to match current costs with revenue by using older costs for COGS; ending inventory reflects newer costs. Pros: better balance sheet relevance for inventory value; Cons: possible poor matching of revenue/expense in some scenarios.
LIFO can reduce current-year profits in inflationary environments (and in some jurisdictions for tax advantages) but is not allowed in Australia.
Moving average smooths price fluctuations and is simple to implement in perpetual systems; however, it may mask current replacement costs.
Weighted average (a variant of moving average) is simple but can obscure the current replacement cost and has pros/cons regarding cost flow and matching.
Short summary of when to use each method (contextual guidance)
Specific identification: high-value, trackable items (cars, white goods).
FIFO: inventories that are abundant, fungible, and easy to track; generally aligns with current prices for ending inventory; potential mismatch with COGS for some revenue streams.
LIFO: not allowed in Australia; used in the US where inflation is a consideration and tax planning may motivate its use.
Moving average / Weighted average: simple for many businesses, especially with large volumes of homogenous goods where individual tracking is not feasible.
Journal entries under perpetual inventory (general forms)
Purchase/inventory recognition: Dr Inventory, Cr Accounts Payable (or Cash) for cost of goods purchased.
Freight-in and other costs that bring inventory to saleable condition: Dr Inventory, Cr Cash/Accounts Payable
Sale of goods (revenue side): Dr Cash/Accounts Receivable, Cr Sales Revenue
Recognise COGS and reduce Inventory on sale: Dr COGS, Cr Inventory
Returns to supplier: Dr Accounts Payable, Cr Inventory
Customer returns: Dr Sales Returns and Allowances, Cr Accounts Receivable; Dr Inventory, Cr COGS (to put returned goods back into stock and reverse COGS), and Dr Inventory or Freight if applicable; Cr COGS accordingly
Example structure to illustrate COGS under different cost methods (illustrative values)
Snapshot of a small batch: eight items sold on Sept 20; ten items sold on Jan 12
Specific identification (example):
Sept 20: 4 from beginning inventory at cost 10; 4 from Sep 15 at cost 11 → COGS Sept 20 = 4×10 + 4×11 = 84.
Jan 12: 4 from beginning (10), 3 from Sep 15 (11), 3 from Dec 7 (12) → COGS Jan 12 = 4×10 + 3×11 + 3×12 = 109.
FIFO (example):
Sept 20: oldest inventory sold first → 8 items from beginning at 10 → COGS Sept 20 = 8×10 = 80.
Jan 12: 2 from beginning (2×10) and 8 from next batch (8×11) → COGS Jan 12 = 20 + 88 = 108.
Moving average (perpetual) (example, with a clear, consistent data set):
Beginning: 10 units @ $10; purchase 12 units @ $11; moving-average after purchase:
Average cost = rac{(10×10) + (12×11)}{10+12} = rac{100 + 132}{22} = rac{232}{22} ≈ 10.55.
Sept 20 sale of 8 units: COGS = 8 × 10.55 = 84.40; ending inventory = 14 × 10.55 = 147.70.
December 7 purchase of 15 units @ $12 (example): new average cost = rac{(14×10.55) + (15×12)}{29} = rac{147.70 + 180}{29} ≈ 11.30.
Jan 12 sale of 10 units: COGS = 10 × 11.30 = 113.00; ending inventory = 19 × 11.30 = 214.70.
NRV and lower of cost and net realizable value (LCNRV)
NRV definition: estimated selling price less costs to complete and costs to sell/distribute.
LCNRV rule: measure inventory at cost, then compare with NRV; if NRV < cost, write down to NRV.
Example 1 (general): cost = $1,000,000; NRV = $500,000; write-down of $500,000
Entry: Dr Inventory Write-down Expense (or COGS, if appropriate for the business) $500{,}000, Cr Inventory $500{,}000
Example 2 (inventory write-down): cost = $22{,}000; estimated selling price = $23{,}500; selling costs = $1{,}800; NRV = $23{,}500 − $1{,}800 = $21{,}700; since NRV < cost, write down by $300:
Entry: Dr Inventory Write-down Expense $300, Cr Inventory $300
Inventory errors and stock takes
Even with perpetual updates, physical stock takes are necessary to detect discrepancies from theft, damage, or recording errors.
If a discrepancy is found, adjust Inventory and recognize a corresponding expense (shortage or loss).
Example adjustment: If physical stock is $13.86 less than ledger balance, record Dr Shortage Expense $13.86, Cr Inventory $13.86.
Normal inventory losses as part of ongoing operations may be included in COGS.
Practical implications and real-world relevance
The selection of a costing method affects reported profit, asset value, and potentially tax considerations (especially LIFO in some jurisdictions).
Perpetual vs periodic affects the timing of when COGS and Inventory are updated; perpetual provides more timely information but requires stronger internal controls.
Freight, insurance, duties, and other costs are typically capitalised into inventory, not expensed immediately, under the cost-of-inventory principle.
The next topic in this course
The periodic inventory system and a direct comparison of journal entries under perpetual vs periodic systems.
Quick notes on a few definitions and concepts you should remember
NRV: Net Realizable Value = Estimated Selling Price − Costs to Complete and Sell.
COGS: Cost of Goods Sold is the cost incurred to produce or acquire goods that were sold during the period.
Freight-in and other costs are included in the cost of inventory if they bring the goods to saleable condition and location.
Sales returns and allowances is a contra-revenue account used to reflect customer returns and allowances; effects both revenue and COGS when appropriate.