CHAPTER F9
Challenging Issues Under
Accrual Accounting:
Merchandise Inventory and
Cost of Goods Sold
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Learning Objective 1:
Explain goods available
for sale (GAFS) and
name its components.
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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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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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Learning Objective 2:
Describe the relationship
between ending
inventory and cost of
goods sold.
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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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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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Flow of Inventory
8 units purchased
+
=
5 units,
Ending Inv.
11 units, Goods
Available for Sale 6 units, Cost of
3 units, beginning inventory
Goods Sold
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COGS Schedule
Assume that each unit cost $6
Beg. Inventory
+ Purchases
= Goods Available
- End. Inventory
= Cost of Goods Sold
Units
Cost
3
8
11
5
6
$18
48
$66
30
$36
BI
+ Purch
GAFS
- EI
COGS
All available goods must be accounted
for as either ending inventory or COGS.
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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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Learning Objective 4:
Explain the differences
between periodic and
perpetual inventory
systems.
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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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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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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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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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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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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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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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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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Learning Objective 3:
Differentiate between the
physical flow of
merchandise and the cost
flow of merchandise.
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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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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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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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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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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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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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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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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.
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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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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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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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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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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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Sample Inventory Data
 For all of the following examples, we will
use the following data:
6/1/01 Beg. Inv. = 150 units @ $12 = $1,800
 6/8/01 Purchase of 150 units @ $13 = $1,950
 6/12/01 Sale of 200 units
 6/17/01 Purchase of 200 units @ $14 = $2,800
 6/25/01 Sale of 150 units

 Total units available = 500, units sold = 350.
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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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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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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 = (150 @ $12) + (150 @ $13) +
(50 @ $14) = $4,450
 End. Inventory = 150 @ $14 = $2,100
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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 = (200 @ $14) + (150 @ $13) = $4,750
 End. Inventory = 150 @ $12 = $1,800
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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
500
 COGS = 350 @ $13.10 =
$4,585
 End. Inv. = 150 @ $13.10 = $1,965
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Summary of Results
 Below is a summary of the results from
the periodic system, all three methods.
Account
FIFO
LIFO
Average
Inventory (Asset)
2,100
1,800
1,965
COGS (Expense)
4,450
4,750
4,585
Goods Available
6,550
6,550
6,550
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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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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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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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Perpetual - LIFO Method
 We need to separately calculate the COGS
for each sale made to customers:
 COGS on 6/12 =
(150 @ $13) + (50 @ $12) = $2,550
 COGS on 6/25 = (150 @ $14) = $2,100
 Total COGS = $4,650
 End. Inv. =
(100 @ $12) + (50 @ $14) = $1,900
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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 units @ $12 = $1,800
 6/8 Purchase of 150 units @ $13 = $1,950
300
$3,750
Average = $3,750 / 300 = $12.50 each

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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 = 200 @ $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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Perpetual - Average Method
 Calculate the average cost as of the 6/25
sale:
Remaining units = 100 units @ $12.50 =$1,250
 6/17 Purchase of
200 units @ $14.00 =$2,800
300
$4,050

Average = $4,050 / 300 = $13.50 each
 COGS for 6/25 = 150 @ $13.50 = $2,025
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Perpetual - Average Method
 To summarize the previous data:
 COGS 6/12 = 200 @ $12.50 = $2,500
 COGS 6/25 = 150 @ $13.50 = $2,025
Total = $4,525
 End. Inv. = 150 units @ $13.50 = $2,025
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Summary of Results
 Below is a summary of the results from
the perpetual system, all three methods.
Account
FIFO
LIFO
Average
Inventory (Asset)
2,100
1,900
2,025
COGS (Expense)
4,450
4,650
4,525
Goods Available
6,550
6,550
6,550
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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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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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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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End of Chapter 9
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