Task Team of FUNDAMENTAL ACCOUNTING
School of Business, Sun Yat-sen University
Lesson Notes
Lesson 7 Merchandise Inventories and Cost of Sales
Learning Objectives
1. Identify the items included in merchandise inventory.
2. Identify the costs of merchandise inventory.
3. Compute the cost of goods sold and ending merchandise inventory in a perpetual system using
the costing methods of specific identification, moving weighted average, FIFO, and LIFO.
4. Analyze the effects of the choice between inventory costing methods on financial reporting.
5. Compute the lower of cost or market value of inventory.
6. Analyze the effects of inventory errors on current and future financial statements.
7. Apply both the gross profit and retail methods to estimate inventory.
Teaching Hours
Students major in accounting: 5 hours
Other students: 3 hours
Teaching Contents
While sales and purchases are the focus of operations, inventory is no less important.
Inventory costing and evaluation methods can substantially influence the bottom line. Since
China’s listed companies were permitted to write down inventories in 1998, inventory has long
been criticized as the “income adjustor”. Besides, inventory costing policies and the scope of
inventory can also significant change the current and future years’ income numbers.
Items included in inventory
Merchandise inventory includes goods held for resale. Assets not normally held for resale are
excluded from merchandise inventory.
An important aspect of inventory accounting is determining inventory ownership. Goods in
transit are to be included in the buyer’s inventory when ownership has passed to the buyer. If the
buyer is responsible for freight charges (FOB factory or shipping point), ownership passes to the
buyer as soon as goods are loaded aboard the carrier. If the seller pays for the freight charges
(FOB destination), ownership passes to the buyer only when the goods arrive at the destination.
When one company (the transferor or consignor) transfers inventory to another company
(the transferee or consignee) without transferring title to that inventory, the arrangement is
known as a consignment. Goods on consignment belong to the owner (consignor) even though
they are physically located at the consignee’s business place. Consigned goods should be omitted
from the consignee’s inventory count. When the goods are ultimately sold, the consignee will
remit to the consignor an amount equal to the selling price of the goods, less any commissions and
reimbursable expenses incurred by the consignee.
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Task Team of FUNDAMENTAL ACCOUNTING
School of Business, Sun Yat-sen University
Damaged, deteriorated, or obsolete goods should be omitted from inventory if not saleable.
If saleable at a reduced price and below cost, they should be included in inventory at their net
realizable value (sales price less the cost of making the sale).
Elements of inventory cost
The cost of inventory includes all expenditures made in bringing the goods or assets to their
existing condition and location for sale. Inventory cost therefore equals invoice price less
discounts, plus transportation, storage, import duties, insurance, and other costs of preparing the
inventory for sale. These additional or incidental costs add value to the inventory and should be
included in the purchase cost. In certain cases, however, the materiality principle allows firms to
charge incidental costs as expenses of the period, and not include them in inventory. Such a
practice is justified if the effort of computing costs on a precise basis outweighs the benefit from
the extra accuracy.
Four generally accepted methods of determining inventory costs
Specific identification inventory costing method
The specific identification inventory costing method identifies and uses the purchase
invoice of each item sold to determine the cost assigned to cost of goods sold and to the ending
inventory. Exact matching is possible when each item in inventory can be identified with a
specific purchase. Specific identification will produce identical results under either a perpetual or
a periodic inventory system.
First-in, first-out (FIFO) inventory costing method
The first-in, first-out inventory costing method is based on the assumption that the first
items received were the first items sold. In other words, items in the beginning inventory or the
oldest items are assumed to be sold first. The most recent inventory purchased is assumed to
remain in ending inventory. For many businesses, this is the actual flow of goods. FIFO will
produce identical results under both the perpetual and periodoic inventory systems.
Last-in, first-out (LIFO) inventory costing method
The last-in, first-out inventory costing method is based on the assumption that the last items
received were the first items sold. In other words, the most recent purchases are assumed to be
sold first and the old goods remain in inventory. However, the assumed flow of goods can differ
from the actual physical flow. (The results under LIFO periodic differ from LIFO perpetual.).
During inflationary times, recent costs are higher than old costs, resulting in higher cost of goods
sold, lower net income, and lower income taxes.
Weighted-average inventory costing method
The weighted-average inventory costing method uses a weighted-average cost per
inventory unit in assigning cost to units sold and to inventory. A weighted-average cost of goods
available for sale is recalculated at the time of each purchase. Notice that the most current average
cost is used to calculate the cost of each sale. Weighted-average will produce different results
under a perpetual than under a periodic inventory system.
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Task Team of FUNDAMENTAL ACCOUNTING
School of Business, Sun Yat-sen University
Inventory errors
Review the following equations that apply under both a perpetual and periodic inventory
system:
Cost of goods
Purchase returns Purchase
 Purchases 

 Transportation-in
discounts
purchased
and allowances
Cost of goods
 Beginning inventory  Cost of goods purchased
available for sale
Cost of goods sold = Cost of goods available for sale – Ending inventory
Therefore,
Cost of goods sold  Beginning inventory 
Cost of goods
 Ending inventory
purchased
The amount of ending inventory appears on the balance sheet, affects cost of goods sold on
the current income statement (through ending inventory), and the following year’s income
statement (through beginning inventory). Consequently, an error in determining the amount of
inventory will affect each of these statements. Inventory errors might occur as a result of
miscounting inventory items or failure to price inventory items correctly. Errors also occur due to
improper recognition being given to inventory that is still in transit. For example, goods purchased
FOB shipping point belong to the buyer when in transit and should be included in the buyer’s
inventory.
In the current year, an overstatement of ending inventory results in:
 current assets being overstated
 cost of goods sold being understated
 gross profit being overstated
 net income being overstated
 owner’s equity being overstated






The effect on the following year is:
beginning inventory is overstated
cost of goods sold is overstated
gross profit is understated
net income is understated
owner’s equity is now properly stated
An inventory error will self-correct in the following period, resulting in owner’s equity being
properly stated after the second period. Total net income over the two periods is correct, although
the allocation between periods was in error. If gross profit is overstated in year 1 but understated
in year 2 by the same amount, then owner’s equity will have the correct balance after year 2.
Although inventory errors self-correct, they distort management’s interpretation of the earnings
trend. This may consequently lead management to make poor decisions.
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Task Team of FUNDAMENTAL ACCOUNTING
School of Business, Sun Yat-sen University
Lower of cost or market
GAAP require that inventory be reported at market value whenever market value is lower than
cost. This is the lower-of-cost-or-market (LCM) rule.
The following points are essential to understand LCM:
 The cost of ending inventory is determined by using one of the four inventory pricing
methods. On the balance sheet, inventory is reported at market value whenever market is lower
than the cost reported under the chosen pricing method.
 Cost is the price paid for an item. Market value is defined as net realizable value
(NRV), which is sales price less additional costs to sell, or as replacement cost, which is the price
that would have to be paid to purchase (replace) the item on the inventory date.
 If the market value of inventory falls below its original cost, a holding loss occurs. It is
likely that the sales price of inventory will also decrease. The holding loss should be recorded in
the period during which the price declined. This is the basic concept of LCM.
 LCM allocates holding losses to the period during which a firm holds inventory, and all
remaining income to the period during which merchandise is sold.
 LCM may be applied to the inventory as a whole, by major category, or separately to
each product in the inventory.
Estimating inventories
Inventory estimation can be used in preparing interim financial statements to determine if
the physical inventory count is reasonable or in determining the amount of inventory lost in a
flood, destroyed in a fire, or stolen. The two common methods of inventory estimation are the
gross profit method and the retail inventory method.
Retail inventory method
The retail inventory method is used to estimate the amount of ending inventory based on a
cost ratio, according to the following formula:
Cost ratio =
Amount of goods for sale at cost
Amount of goods for sale at markedselling price
Using the retail method of inventory estimation, interim financial statements can be prepared
monthly or quarterly without a physical inventory count. The ending inventory is estimated by
converting retail prices (or the marked selling price) to cost amounts. Records must be kept at both
cost and retail as follows:
At cost:
Goods available for sale = Beginning inventory + Net purchases
At retail:
Ending inventory = Beginning inventory + Net purchases – Net sales
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Task Team of FUNDAMENTAL ACCOUNTING
School of Business, Sun Yat-sen University
The cost ratio is applied to ending inventory at retail prices to estimate ending inventory at
cost.
The retail method merely provides an inventory estimate. The physical inventory can then be
compared to the estimated inventory. Any difference will be an estimate of shortages due to
breakage, loss, or theft. At least once a year, a company should take a physical inventory to
correct any errors or shortages.
Gross profit method
The gross profit method is used to estimate inventory for insurance purposes after a break-in,
fire, or flood, or for checking the accuracy of a physical inventory count. The gross profit method
uses the past gross profit rate to estimate the ending inventory as the difference between goods
available for sale and cost of goods sold. It is an approximation technique that applies an
estimated gross profit rate to net sales.
Gross profit ratio =
Sales  COGS
Sales
The gross profit ratio is applied to estimate the ending inventory using the following formulas:
Net sale at retail X (1-gross profit ratio) = Estimated cost of goods sold
Goods available for sale at cost – Estimated cost of goods sold = Estimated ending
inventory at cost
The gross profit rate is an average of the percentages for many products. As a result, estimated
inventory represents an approximation. If prices during the current period differ from normal
conditions, the gross profit method will yield less-than-accurate results.
Discussion Case: Northeast Pharmaceutical
When preparing financial statement of 1996, Northeast Pharmaceutical recorded RMB
21,280,000 expenses as inventory cost, which carries to next year’s beginning inventory. As a
result, the bottom line is RMB 19,950,000 profits, instead of a big loss. This was discovered and
was fined by CSRC as securities fraud.
Required:
（1） What’s the difference between expenses and inventory costs?
（2） What are the impacts of inventory errors on financial statements?
（3） Why Northeast Pharmaceutical chose to report false income numbers?
（4） How to prevent the occurrence of such kind of cases.
Summary
（1） Inventory includes all goods owned by a company and held for sale.
（2） Costs of merchandise inventory include all expenditures necessary to bring an item to a
saleable condition and location.
（3） There are four methods to assigning costs to inventory: specific identification, FIFO,
LIFO and average cost. The average cost method smoothes out purchase price changes.
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Task Team of FUNDAMENTAL ACCOUNTING
School of Business, Sun Yat-sen University
Ending inventory under FIFO approximates current replacement cost. LIFO better
matches current cost in cost of goods sold with revenue.
（4） Inventory must be reported at market value when market is lower than cost.
（5） Retail inventory method and gross profit method can be used to estimate ending
inventory.
Key Points
1. items included in merchandise inventory
2. costs of merchandise inventory
3. inventory costing methods
4. lower of cost or market
5. inventory errors
6. inventory estimations
Reading material
1. Larson, K.D., T. Jensen, and R. Carroll, 2002, Fundamental Accounting Principles,
McGraw-Hill Ryerson.
2. Libby, R., P.A. Libby, D.G. Short, G. Kanaan, and M. Gowing, 2003, Financial Accounting,
McGraw-Hill Ryerson.
3. Abdel-Khalik, A.R., The effect of LIFO-Switching and Firm Ownership on Executive Pay,
Journal of Accounting Research (Autumn 1985), 427-477.
4. Cushing, B.E. and M.J. Leclere, Evidence on the Determinants of Inventory Accounting
Policy Choice, The Accounting Review (April 1992), 355-366.
5. Dopuch, N. and M. Pincus, Evidence on the Choice of Inventory Accounting Methods: LIFO
vs. FIFO, Journal of Accounting Research (Spring 1988), 28-59.
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