188 Accounting: Business Reporting for Decision Making
inventory is recorded using a perpetual system, an entity will always have a record of the cost price of its
inventory and the cost of the goods sold at any point in time.
In contrast, a periodic system of recording inventory does not keep a detailed record of the inventory on hand
and the cost of the inventory sold. Using this system of recording inventory, when inventory is purchased, an
expense account (purchases) is increased with the dual entry being a reduction in cash or increase in accounts
payable depending if the purchase was for cash or on credit. When inventory is sold, sales revenue is increased
and either cash increased (if the transaction is for cash) or accounts receivable increased (if the transaction is
on account). Thus, while an entity will know its purchases and sales, it does not keep a continuous record of its
inventory on hand and the cost of the inventory sold. To determine the inventory on hand, it is necessary for an
entity to do a stocktake at the end of the reporting period. The stocktake will identify the inventory on hand (in
quantities) but the entity will not necessarily know the particular cost price of that inventory given that inventory
items can be purchased multiple times during the year at different cost prices. Hence, if using a periodic system
to record inventory, a cost flow assumption is needed to determine the cost price of the inventory on hand.
To illustrate the different systems of recording inventory, consider the example of a retailer purchasing
200, 210, 175 and 200 units of the same inventory in month 1, month 3, month 7 and month 12 respec-
tively during a reporting period. The inventory’s unit cost per batch is $44, $45, $48 and $46 respec-
tively. Of the 785 units acquired during the year, 100 remain unsold at the end of the reporting period.
There was no inventory on hand at the start of the reporting period. The inventory on hand at the end of
the period needs to be measured for the balance sheet, and the cost of inventory sold needs to be deter-
mined for the statement of profit or loss. What is the cost price of the inventory?
If the entity is using a perpetual inventory system, the inventory items would be tagged and specifi-
cally identified. This enables the entity to keep track of the cost of each item sold and the cost of the
unsold items. Accordingly, the entity is keeping a running balance of the cost price of inventory and the
cost of the inventory sold. As such, the entity would know the specific items that have been sold and the
specific items, and their cost price, of the 100 units that remain unsold at the end of the reporting period.
This will be the balance in the inventory account given that the inventory account is increased for every
inventory item purchased and decreased for every inventory item sold.
While advances in technology mean that it is becoming more feasible to track individual inventory items,
many entities do not operate such systems. When inventory is not being tracked through from purchase to
point of sale, an entity is using a periodic inventory system. Under a periodic system there is no running bal-
ance of the inventory on hand or the cost price of the inventory sold. Hence, an assumption about the inven-
tory flow is necessary to determine the inventory on hand and the cost of inventory sold. There are only two
cost flow assumptions permitted by IFRS: first-in, first-out (FIFO); or weighted-average. A method known as
last-in, first-out (LIFO) is not permitted. The FIFO cost flow assumption assumes that the items sold are the
ones that have been in inventory the longest (so the unsold items are the ones that have been purchased most
recently). The weighted-average cost flow assumption calculates a weighted-average cost of inventory pur-
chased and on hand at the start of the period, and applies this to the number of units sold (unsold). The LIFO
cost flow assumption assumes that the items sold are the ones that have been in inventory the least amount of
time (hence the unsold items are the ones that have been in inventory for the longest period of time). The cost
assigned to the inventory under the FIFO and weighted-average methods for an entity using a periodic inven-
tory system is demonstrated in illustrative example 5.3.
ILLUSTRATIVE EXAMPLE 5.3Inventory cost flow assumptions
FIFO method
Of the 785 inventory items acquired during the year, it is assumed that the items sold are from the
earliest purchases, and the items remaining are from the most recent purchases. The 100 units unsold
at the end of the reporting period are assumed to be from the inventory purchased in month 12 at a unit
cost price of $46. The value assigned to the inventory on the balance sheet is 100 units @ $46 = $4600.