Describe the complications that arise when LIFO or average cost is used with a perpetual inventory system. Use specific examples and references.
The part that I am having trouble with is finding examples. I have the rest of the work done now I just need help with getting some examples to use.
When using LIFO (Last-In, First-Out) or average cost methods with a perpetual inventory system, several complications can arise. Let's break down the complexities and provide specific examples:
1. LIFO Method:
LIFO assumes that the most recent inventory items are sold first, which can lead to the following complications:
a. Cost Inflation: During periods of rising prices, LIFO can result in inflated costs of goods sold (COGS). This can distort net income and tax obligations. For example, if a company purchased 100 units of a product at $10 each and 100 units at $15 each, LIFO would consider the $15 units as sold first. Consequently, COGS will be higher and net income will be lower compared to other costing methods.
b. Inventory Valuation: Under LIFO, the ending inventory may not reflect the current market value accurately. The older inventory items (costing less) are assumed to remain in stock. This can result in understated inventory values. For instance, if a company sells its products at a higher price than their LIFO cost, the reported inventory value would not reflect the increased market worth.
2. Average Cost Method:
The average cost method calculates the average cost per unit of inventory, which can introduce the following complications:
a. Fluctuating COGS: As the average cost method considers all purchases in determining COGS, the resulting cost per unit can fluctuate with each purchase. This can make it challenging to track and analyze the cost of goods sold, especially when prices vary significantly. For example, if a company purchases 100 units at $10 each and then buys an additional 100 units at $20 each, the average cost would be ($10 + $20) / 2 = $15 per unit.
b. Inventory Valuation: Similar to LIFO, the average cost method can lead to inventory valuation issues. If the average cost does not accurately represent the current market value for a specific period or if purchases occur at different prices, the reported inventory value might not reflect the true worth.
To find specific examples and references, you can consult accounting textbooks, scholarly articles, or examples from real-world companies. Additionally, you can review financial statements of companies that disclose their inventory costing methods to illustrate the complications mentioned above.