1. CHAPTER F9
Challenging Issues Under Accrual Accounting: Merchandise Inventory and Cost of Goods Sold
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2. Explain goods available for sale (GAFS) and name its components.
Learning Objective 1:
Explain goods available for sale (GAFS) and name its components.
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3. Tracking Inventory Costs
Inventory (or merchandise inventory) consists of the items that a company offers for sale to their customers.
Inventory is often thought of as the “physical goods” that are for sale, but in accounting we are usually referring to the cost of the inventory. These inventory costs need to be “tracked” through the accounting system.
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4. Goods Available for Sale
Most companies start an accounting period with some inventory on hand, this is known as beginning inventory.
Additional items are usually acquired during the period, known as purchases.
Add these two amounts together to determine the goods available for sale.
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5. Learning Objective 2:
Describe the relationship between ending inventory and cost of goods sold.
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6. Cost of Goods Sold
The goods available for sale represents the amount that “could have been” sold. The goods that are NOT sold are called ending inventory.
Subtracting the ending inventory from the goods available for sale determines the amount of cost of goods sold (or cost of sales).
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7. Flow of Inventory
We’ll use a simple example of inventory flow to help visualize the process.
Assume that we started the period with only 3 items in inventory. During the period we purchased 8 more items, making a total of 11 items available for sale.
At the end of the period, we see that 5 items are still on hand, the other 6 were sold.
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8. Flow of Inventory + = 8 units purchased 5 units, Ending Inv.
11 units, Goods
Available for Sale
3 units, beginning inventory + =
6 units, Cost of
Goods Sold
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9. COGS Schedule Assume that each unit cost $6
All available goods must be accounted
for as either ending inventory or COGS. 2

10. Manufacturing Companies
A manufacturer typically has three different types of inventory:
Raw materials inventory: the various items that are used in the production process,
Work-in-process inventory: those items that have been started but not finished, and
Finished goods inventory: those items that are ready to be sold.
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11. Learning Objective 4:
Explain the differences between periodic and perpetual inventory systems.
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12. Inventory Systems
Many different ways have been developed for determining how to account for the costs of inventory.
A company needs to choose an inventory system, and then apply the concepts of that system to the purchases and sales of the inventory items.
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13. Periodic Inventory System
When using the periodic inventory system, the accounting records for inventory and cost of goods sold are updated only at the end of the accounting period.
Thus, in the middle of the period, there is no record that shows how much inventory is on hand or how much has been sold (COGS).
This is an easy, inexpensive method.
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14. Perpetual Inventory System
When using a perpetual inventory system, the inventory records are continually updated to provide the company with useful information at any time.
Each purchase of new inventory is shown as an increase in the inventory account, and each sale is recorded as a reduction to the inventory account.
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15. Perpetual Inventory System
The perpetual inventory system is much more time consuming than the periodic system, if the accounting records are kept manually.
However, most companies now use a computerized accounting system, and these systems can just as easily (and cheaply) maintain inventory records on the perpetual basis as on the periodic basis.
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16. Taking a Physical Count
Regardless of the type of accounting system in use, the inventory needs to be physically counted on a regular basis, at least once a year.
This physical count is used to either update the inventory account (periodic system) or verify the amount (perpetual system) of inventory that is shown in the account.
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17. Physical Count - Periodic
Your Company uses the periodic inventory system. At the beginning of the year, the inventory value was $10,000.
It is now the end of the year. Your inventory account still has a balance of $10,000. You need to take a physical count of the inventory on hand at year end.
If the count equals $15,000, you will adjust your inventory account accordingly.
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18. Physical Count - Perpetual
Your Company uses the perpetual inventory system. The inventory balance is “updated” every time you buy or sell some inventory. You accomplish this easily through the use of scanners and bar codes.
It is now the end of the year. Your inventory account has a balance of $16,000. You take a physical count that equals $15,000. You will adjust your inventory account accordingly.
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19. Discussion Questions
What might have caused the discrepancy between the “book inventory” of $16,000 and the actual inventory of $15,000?
How would you account for that $1,000?
If you were using the periodic system instead of the perpetual, would you have known about the $1,000 difference?
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20. Learning Objective 3:
Differentiate between the physical flow of merchandise and the cost flow of merchandise.
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21. Physical Movement of Goods
Assume you own a company called Middleman, Inc.
You buy a gadget from the Gadget Manufacturing Company for $50.
You put a price of $90 on the gadget and make it available for sale to your customers.
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22. Physical Movement of Goods
Thus, the product flows from the manufacturer to your company and then to your customer.
This represents the reality of the movement of the inventory.
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23. Physical Movement of Goods
When the gadgets and other products “flow through” your company, you may desire that they do it in a particular order.
In some cases, the newest goods should be sold first, and in other cases the oldest goods should be sold first, and possibly it doesn’t make any difference at all.
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24. Learning Objective 5:
List the different inventory cost flow assumptions and contrast how the use of each affects reported net income on the income statement.
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25. FIFO and LIFO
If you sell the gadgets in the same order that you purchase them, you have what is known as a first-in, first-out (FIFO) flow of goods.
If you sell the most recent purchases first, then you have a last-in, first-out (LIFO) flow of goods.
Possibly, they are sold randomly instead.
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26. FIFO Physical Flow
Most grocery stores follow the practice of “rotating stock.” When new boxes of breakfast cereal arrive, they are placed at the back of the shelf, and the older boxes are moved to the front of the shelf.
The grocer is taking these steps so that the inventory items flow through the store on a first-in, first-out basis.
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27. LIFO Physical Flow
Old-fashioned hardware stores usually sell nails in big wooden bins. When the supply of nails is getting low, they pour in a new batch. When the customer reaches in for some nails, they are removing the nails that are on the top.
These inventory items flow through the store on a last-in, first-out basis.
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28. Average Physical Flow
The local gas station has large underground storage tanks. The last delivery of gas cost them 90 cents per gallon. The tank is still about 1/4 full when the tanker arrives to refill. The new cost of gas is 95 cents per gallon.
The dealer now has a mixture of gasoline from different deliveries at different costs.
Future gallons pumped from the tank would represent the average cost of all the gallons. 2

29. Specific Physical Flow
Assume the local sports card collector opens a shop in a strip mall. He buys three Mickey Mantle cards on his first day of business, one from 1952, one from 1954, and one from 1956.
He paid different prices for each card due to quality and age.
When he sells one of those cards, he is selling a specific card, not necessarily the last one, the first one, or the average one.
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30. Flow of Inventory Cost
Recall our previous discussions about reality and the measurement of reality.
The physical flow of products is the reality of the situation.
The cost flow assumption that we adopt determines our measurement of reality.
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31. Cost Flow Assumptions
We will look at four different cost flow assumptions that are commonly used to account for inventory:
1. FIFO (first-in, first-out)
2. LIFO (last-in, first-out)
3. Average cost
4. Specific identification
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32. Cost Flow Assumptions
As seen before, the measurement of reality need not always match that reality.
For example, we could choose to use the LIFO method even if our actual flow of goods does not match the LIFO flow.
In other words, even if our “physical inventory flow reality” is FIFO, we could choose to use the LIFO or Average methods as our measurement of that reality.
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33. Specific Identification
Review the example on page F-309 for the Dobbs Motor Company that sells antique automobiles.
They use the specific identification method to determine the cost of the vehicles that are bought and sold.
The FIFO, LIFO, or Average methods would not be reasonable in this case.
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34. Sample Inventory Data
For all of the following examples, we will use the following data:
6/1/01 Beg. Inv. = 150 $12 = $1,800
6/8/01 Purchase of 150 $13 = $1,950
6/12/01 Sale of 200 units
6/17/01 Purchase of 200 $14 = $2,800
6/25/01 Sale of 150 units
Total units available = 500, units sold = 350.
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35. Cost Flow - Periodic System
In the periodic system, we make the calculations of ending inventory and cost of goods sold at the end of the month (or year).
The timing of the individual purchases and sales is irrelevant.
Using the previous data, the goods available for sale equals $6,550, regardless of which cost flow assumption we make.
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36. Learning Objective 6:
Calculate cost of goods sold and ending inventory using FIFO,LIFO, and average cost inventory cost flow assumptions.
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37. Periodic - FIFO Method
Using the FIFO method, the 350 units sold were the first 350 units, and the 150 units remaining were the last units purchased.
COGS = $12) + $13) + $14) = $4,450
End. Inventory = $14 = $2,100
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38. Periodic - LIFO Method
Using the LIFO method, the 350 units sold were the last 350 units, and the 150 units remaining are the first units (beginning inv).
COGS = $14) + $13) = $4,750
End. Inventory = $12 = $1,800
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39. Periodic - Average Method
Using the Average method, we need to calculate the average cost of all 500 units: Total Cost = $6,550 = $13.10
Total Units
COGS = $ = $4,585
End. Inv. = $13.10 = $1,965
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40. Summary of Results
Below is a summary of the results from the periodic system, all three methods.
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41. Discussion Questions
In the previous example, which system would result in the highest reported net income for the period?
If your only concern was to reduce your income taxes, which system would you prefer to use in the previous example? Would that always be the case?
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42. Cost Flow-Perpetual System
Under the perpetual system, the cost of goods sold is calculated every time we make a sale, rather than waiting until the end of the accounting period.
We now need to pay attention to the date of each transaction, and apply the concept of the cost flow assumption (FIFO, LIFO, etc.) to each individual sale.
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43. Perpetual - FIFO Method
Using the perpetual FIFO method, we get exactly the same answers as the periodic FIFO method. The 350 units sold were the first 350 units, and the 150 units remaining were the last units purchased.
COGS = $4,450
End. Inventory = $2,100
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44. Perpetual - LIFO Method
We need to separately calculate the COGS for each sale made to customers:
COGS on 6/12 = $13) + $12) = $2,550
COGS on 6/25 = $14) = $2,100
Total COGS = $4,650
End. Inv. = $12) + $14) = $1,900
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45. Perpetual - Average Method
For this method, we need to calculate the “moving” average cost of the units on hand. When we sell a unit, the cost of goods sold is recorded at this average cost.
Calculate the average cost as of the 6/12 sale:
6/1 Beg. Inv. = 150 $12 = $1,800
6/8 Purchase of 150 $13 = $1, $3,750 Average = $3,750 / 300 = $12.50 each
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46. Perpetual - Average Method
Of the 300 units on hand, 200 units were sold at an average cost of $12.50 each. COGS for 6/12 = $12.50 = $2,500
The remaining 100 units are carried forward at the average cost of $12.50 until the next purchase of 200 units $14 each) on 6/17. Then a new average must be calculated.
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47. Perpetual - Average Method
Calculate the average cost as of the 6/25 sale:
Remaining units = 100 $12.50 =$1,250
6/17 Purchase of $14.00 =$2, $4,050 Average = $4,050 / 300 = $13.50 each
COGS for 6/25 = $13.50 = $2,025
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48. Perpetual - Average Method
To summarize the previous data:
COGS 6/12 = $12.50 = $2,500
COGS 6/25 = $13.50 = $2, Total = $4,525
End. Inv. = 150 $13.50 = $2,025
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49. Summary of Results
Below is a summary of the results from the perpetual system, all three methods.
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50. Effects of Inventory Cost Flow Method Choice
The choice of inventory methods has a clear impact on two of the major financial reports: the income statement and the balance sheet.
The total cost of goods available for sale must be accounted for. This amount is split into two amounts, the ending inventory (balance sheet) and the cost of goods sold (income statement).
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51. Discussion Questions
In the example just completed, the cost of the inventory item was increasing. What impact would it have on the results if the cost of the item was decreasing?
What impact would it have if the cost was stable, not increasing or decreasing?
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52. Discussion Questions
Over the long run (several years), do you think the reported results will be much different between the periodic system and the perpetual system?
Over the long run, do you think the reported results will be much different among the FIFO, LIFO, and Average methods?
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53. End of Chapter 9