Inventory and the Cost of Goods Sold

Chapter 9


Learning Objectives

ü      Define inventory for a merchandising business and identify the different types of inventory for a manufacturer

ü      Explain the advantages and disadvantages of the periodic and perpetual inventory systems

ü      Compute total inventory acquisition cost

ü      Show competency in using the four basic inventory valuation methods:  specific identification, average cost, FIFO, and LIFO

ü      Explain how LIFO inventory layers are created and describe the significance of the LIFO reserve

ü      Select an inventory valuation method based on the trade-offs among income tax effects, bookkeeping costs, and the impact on the financials

ü      Apply the lower of cost or market (LCM) to reflect declines in the  market value of inventory

ü      Use the gross profit method to estimate ending inventory

ü      Determine the financial statement impact of inventory recording errors

ü      Analyze inventory using financial ratios


Items held for resale in the normal course of business are classified as inventory.  A merchandiser typically has one inventory control account whereas a manufacturer has three inventory accounts including raw materials inventory, work in process inventory (partially completed work) and finished goods inventory (completed products awaiting sale). 


In a periodic inventory system only revenue is recorded each time a sale occurs.  No adjusted is made to inventory until the end of the year.  In the periodic system the cost of inventory may be regarded as a pool of costs consisting of two elements:  Beginning inventory plus merchandise purchases during the year.  The sum of these two figures equals goods available.  At the end of the year after the physical inventory is taken, ending inventory is subtracted from goods available to determine cost of goods sold.  In other words in the periodic system, cost of goods sold is a calculation not a formal account (as it is in the perpetual inventory method).  Note there is no running balance of inventory through the year and the Merchandise Inventory account has the beginning of the year balance throughout the year.


In a perpetual inventory system revenue and cost of goods sold is recorded for each sale.  Two journal entries are required at each sale as follows:
          Accounts Receivable (or Cash)
                             Sales Revenue
          Cost of Goods Sold
                             Merchandise Inventory


In this way a continuous record of inventory is maintained.  Of course, it is still necessary at year end to take a physical inventory and make appropriate adjustments to book inventory.


As the authors note, a periodic inventory system is simple and inexpensive to operate but also provides relatively low quality information.  A perpetual inventory system can require costly technology, but the quality of information is much higher.  Carefully study the section entitled Inventory Systems on Page 448-450. 


Goods in transit belong to the seller if shipped FOB destination and belong to the buyer if shipped FOB shipping point.  Consigned goods are included in the inventory of the consignor.


All significant costs incurred to acquire inventory are charged to purchases (periodic inventory system) or inventory (perpetual inventory system.  Some smaller expenditures relating to inventory are normally excluded from inventory cost and recognized as expenses in the current period (period costs). 


Purchase returns and allowances are adjustments to invoice cost due to damage to goods or poor quality.   Under the periodic method debit accounts payable and credit a contra purchase account, purchase returns and allowances.  Under the perpetual method debit accounts payable and credit Inventory.


GAAP provides for a number of acceptable inventory costing methods regardless of the actual physical flow of inventory.  We'll study the following methods:     

Specific Identification
Average Cost
FIFO (First In, First Out)
LIFO (Last In, First Out)


In the specific identification method, the original cost of each item is identified, resulting in actual costs being accumulated for the specific items sold and on hand in ending inventory.  This method is used when each inventory item is unique and has a high cost.  For example, an auto dealer might use the specific identification method.  Because most inventory consists of many similar or identical products acquired at different times and costs, the use of the specific identification method is relatively rare.  The specific identification method may facilitate income manipulation depending on which specific items are selected as those sold and which are selected as remaining in ending inventory.


In the average cost method, the same average cost is assigned to each unit.  The average is weighted by the number of units acquired at each cost.  The average cost method provides the same cost for similar items and does not permit profit manipulation.  Its limitation is that inventory values may lag significantly behind prices in periods of rapidly rising  (or falling) prices.  See Pages 458-9.


In the FIFO method, the first goods purchased are assumed to be the first sold.  Cost of goods sold and ending inventory are calculated as if the first items purchased are the first sold, leaving the most recently purchased items in inventory.  This method often matches the physical flow of goods.  FIFO affords little opportunity for profit manipulation and approximates the current replacement value of ending inventory.  The FIFO method is by far the most common method used.  See Page 459.


In the LIFO method, the newest units are assumed to be sold first.  Cost of goods sold and ending inventory are calculated as if the most recently acquired units are sold first leaving the oldest items in inventory.  LIFO does not match the usual flow of goods and results in old values on the balance sheet especially when inventory levels decline.  The LIFO method is the best method at matching current inventory costs with current revenues and usually results in lower income taxes and consequently greater cash flows.  See Page 459-60.


Please study the Inventory Valuation Methods section on Pages 456-461 and Exhibit 9-10 Comparison of Inventory Valuation Methods on Page 460.


Computation of average cost and LIFO in a perpetual inventory system is complicated because the average cost of units available for sale changes every time a purchase is made and the identification of the “last in” units also changes with every purchase.  In a FIFO system cost of goods sold and ending inventory are the same whether a periodic or perpetual system is used.  See Exhibit 9-11, Page 462.


When using the LIFO system each year in which the number of units purchased exceeds the number of units sold, a new LIFO layer is created in ending inventory.  As long as the inventory continues to grow, a new LIFO layer is created each year and the old LIFO layers remain untouched.  The difference between the value of ending inventory under LIFO and the value which would have been obtained under FIFO or average cost is known as the LIFO reserve.  Many companies which use LIFO report the amount of their LIFO reserve in their notes.


LIFO liquidation occurs when purchases are so low (less than sales) that LIFO layers of older inventory costs must be utilized in determining cost of goods sold.  When a business uses LIFO during a period of rising prices, any LIFO liquidation which occurs will result in a relatively low COGS and an inflated amount of net income. 


On Page 468-9 the authors offer an overall comparison of FIFO, LIFO, and average cost.  This comparison analyzes the three inventory costing methods based on four factors of income tax effect, bookkeeping costs, impact on financials, and industry comparison.  Note that international accounting standards do not allow the LIFO method of inventory valuation.


The lower of cost or market (LCM) rule reflects conservatism in accounting.  LCM has the effect of recognizing unrealized decreases in the value of inventory but not unrealized increases.  Market in this context means replacement cost.  Ceiling and floor constraints are placed on the use of replacement cost as the measure of an inventory’s market value.  To apply the LCM method to inventory (where NRV = net realizable value) complete the following steps:

  1. Define pertinent values:  historical cost, floor (NRV - normal profit), replacement cost, ceiling (NRV)

  2. Determine market (replacement cost as constrained by ceiling and floor limits

  3. Compare cost with market and select the lower amount

The gross profit method allows ending inventory and the cost of goods sold to be approximated without performing a physical inventory.  This estimation technique is based on a relationship between gross profit and sales.  The gross profit percentage is applied to sales to estimate the cost of goods sold.  This cost of goods sold is then subtracted from cost of goods available for sale to arrive at an estimated ending inventory balance.  See Pg. 476-8.

Misstated inventory results in reporting errors in both the balance sheet and the income statement.  Because the ending inventory of one period becomes the beginning inventory of the next period, undetected errors affect two consecutive accounting periods and counter balance one another over a two year period.  This is not to minimize the effect of an inventory error on a specific year though.  If the error is found in the current period, adjustments can be made to current accounts and the reported net income and inventory amounts will be correct.  If found in a subsequent period the net income of the prior period was misstated and the correcting entry takes the form of a prior period adjustment to retained earnings. 


Inventory balances are often used to measure a company’s efficiency in using inventory to generate sales.  See discussion of inventory turnover and number of days’ sales in inventory on Pages 481-2. 


Please skip the Expanded Material Section in Chapter 9 except for Foreign Currency Inventory Transactions on Pages 495-7. 


Accounting for international transactions involves an additional step because in the international marketplace each country uses its own currency.  Sales to or purchases from companies outside the U.S. involve two different currencies.  For example, if Microsoft sells 50,000 copies of Vista to a Japanese trading company, an additional step is added to the transaction.  Either the transaction takes place in dollars or in yen.  In either case Microsoft or the Japanese trading company must convert domestic currency into foreign currency.  This conversion involves the exchange rate.  We can define the exchange rate as the measure of one currency against another currency.  This rate varies from day to day and is quoted on the currency exchanges and at various web sites.


In our coverage of  international transactions we will only deal with simple transactions involving sales on credit and subsequent receipt of cash by a U.S. company and purchases on credit and subsequent payment in cash by a U.S. company.  See transactions on pages 496-7.