1 challenging issues under accrual accounting: merchandise inventory and cost of goods sold chapter...

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Challenging Issues Challenging Issues Under Accrual Under Accrual Accounting:Accounting:

Merchandise Inventory Merchandise Inventory and Cost of Goods Soldand Cost of Goods Sold

CHAPTER F9

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Explain goods Explain goods available for sale available for sale

(GAFS) and name its (GAFS) and name its components.components.

Learning Objective 1:


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Tracking Inventory Tracking Inventory CostsCosts

InventoryInventory (or (or merchandise inventorymerchandise inventory) consists ) consists of the items that a company offers for sale to of the items that a company offers for sale to their customers.their customers.

Inventory is often thought of as the “physical Inventory is often thought of as the “physical goods” that are for sale, but in accounting we goods” that are for sale, but in accounting we are usually referring to the are usually referring to the costcost of the of the inventory. These inventory costs need to be inventory. These inventory costs need to be “tracked” through the accounting system.“tracked” through the accounting system.


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Goods Available for Goods Available for SaleSale

Most companies start an accounting Most companies start an accounting period with some inventory on hand, period with some inventory on hand, this is known as this is known as beginning inventory.beginning inventory.

Additional items are usually acquired Additional items are usually acquired during the period, known asduring the period, known as purchases.purchases.

Add these two amounts together to Add these two amounts together to determine the determine the goods available for sale.goods available for sale.

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Describe the Describe the relationship between relationship between ending inventory and ending inventory and

cost of goods sold.cost of goods sold.



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Cost of Goods SoldCost of Goods Sold The goods available for sale The goods available for sale

represents the amount that “could represents the amount that “could have been” sold. The goods that are have been” sold. The goods that are NOT sold are called NOT sold are called ending inventory.ending inventory.

Subtracting the ending inventory from Subtracting the ending inventory from the goods available for sale the goods available for sale determines the amount of determines the amount of cost of cost of goods soldgoods sold (or cost of sales). (or cost of sales).


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Flow of InventoryFlow of Inventory We’ll use a simple example of inventory We’ll use a simple example of inventory

flow to help visualize the process.flow to help visualize the process. Assume that we started the period with only Assume that we started the period with only

3 items in inventory. During the period we 3 items in inventory. During the period we purchased 8 more items, making a total of purchased 8 more items, making a total of 11 items available for sale.11 items available for sale.

At the end of the period, we see that 5 items At the end of the period, we see that 5 items are still on hand, the other 6 were sold.are still on hand, the other 6 were sold.


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6 units, Cost ofGoods Sold

Flow of InventoryFlow of Inventory

+ =

3 units, beginning inventory

8 units purchased

11 units, GoodsAvailable for Sale

5 units, Ending Inv.


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COGS ScheduleCOGS Schedule

Units CostBeg. Inventory 3 $18 BI

+ Purchases 8 48 + Purch= Goods Available 11 $66 GAFS- End. Inventory 5 30 - EI = Cost of Goods Sold 6 $36 COGS

All available goods must be accounted for as either ending inventory or COGS.

Assume that each unit cost $6

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Manufacturing Manufacturing CompaniesCompanies

A manufacturer typically has three different A manufacturer typically has three different types of inventory:types of inventory:

Raw materials inventory:Raw materials inventory: the various the various items that are used in the production items that are used in the production process,process,

Work-in-process inventory:Work-in-process inventory: those items those items that have been started but not finished, andthat have been started but not finished, and

Finished goods inventory:Finished goods inventory: those items those items that are ready to be sold.that are ready to be sold.


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Explain the Explain the differences between differences between

periodic and periodic and perpetual inventory perpetual inventory

systems.systems.



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Inventory SystemsInventory Systems Many different ways have been Many different ways have been

developed for determining how to developed for determining how to account for the costs of inventory.account for the costs of inventory.

A company needs to choose an A company needs to choose an inventory system,inventory system, and then apply the and then apply the concepts of that system to the concepts of that system to the purchases and sales of the inventory purchases and sales of the inventory items.items.


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Periodic Inventory Periodic Inventory SystemSystem

When using the When using the periodic inventory system,periodic inventory system, the accounting records for inventory and the accounting records for inventory and cost of goods sold are updated only at the cost of goods sold are updated only at the end of the accounting period. end of the accounting period.

Thus, in the middle of the period, there is no Thus, in the middle of the period, there is no record that shows how much inventory is on record that shows how much inventory is on hand or how much has been sold (COGS).hand or how much has been sold (COGS).

This is an easy, inexpensive method.This is an easy, inexpensive method.


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When using a When using a perpetual inventory system,perpetual inventory system, the inventory records are continually the inventory records are continually updated to provide the company with updated to provide the company with useful information at any time.useful information at any time.

Each purchase of new inventory is shown Each purchase of new inventory is shown as an increase in the inventory account, as an increase in the inventory account, and each sale is recorded as a reduction and each sale is recorded as a reduction to the inventory account.to the inventory account.

Perpetual Inventory Perpetual Inventory SystemSystem


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The perpetual inventory system is much The perpetual inventory system is much more time consuming than the periodic more time consuming than the periodic system, if the accounting records are kept system, if the accounting records are kept manually. manually.

However, most companies now use a However, most companies now use a computerized accounting system, and computerized accounting system, and these systems can just as easily (and these systems can just as easily (and cheaply) maintain inventory records on the cheaply) maintain inventory records on the perpetual basis as on the periodic basis.perpetual basis as on the periodic basis.

Perpetual Inventory Perpetual Inventory SystemSystem


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Regardless of the type of accounting Regardless of the type of accounting system in use, the inventory needs to be system in use, the inventory needs to be physically counted on a regular basis, at physically counted on a regular basis, at least once a year.least once a year.

This physical count is used to either This physical count is used to either update the inventory account (periodic update the inventory account (periodic system) or verify the amount (perpetual system) or verify the amount (perpetual system) of inventory that is shown in the system) of inventory that is shown in the account.account.

Taking a Physical Taking a Physical CountCount


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Your Company uses the periodic inventory Your Company uses the periodic inventory system. At the beginning of the year, the system. At the beginning of the year, the inventory value was $10,000.inventory value was $10,000.

It is now the end of the year. Your inventory It is now the end of the year. Your inventory account still has a balance of $10,000. You need account still has a balance of $10,000. You need to take a physical count of the inventory on hand to take a physical count of the inventory on hand at year end.at year end.

If the count equals $15,000, you will adjust your If the count equals $15,000, you will adjust your inventory account accordingly.inventory account accordingly.

Physical Count - Physical Count - PeriodicPeriodic


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Your Company uses the perpetual Your Company uses the perpetual inventory system. The inventory inventory system. The inventory balance is “updated” every time you balance is “updated” every time you buy or sell some inventory. You buy or sell some inventory. You accomplish this easily through the use accomplish this easily through the use of scanners and bar codes.of scanners and bar codes.

It is now the end of the year. Your It is now the end of the year. Your inventory account has a balance of inventory account has a balance of $16,000. You take a physical count that $16,000. You take a physical count that equals $15,000. You will adjust your equals $15,000. You will adjust your inventory account accordingly.inventory account accordingly.

Physical Count - Physical Count - PerpetualPerpetual


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Discussion Discussion QuestionsQuestions

What might have caused the What might have caused the discrepancy between the “book discrepancy between the “book inventory” of $16,000 and the actual inventory” of $16,000 and the actual inventory of $15,000?inventory of $15,000?

How would you account for that $1,000?How would you account for that $1,000? If you were using the periodic system If you were using the periodic system

instead of the perpetual, would you have instead of the perpetual, would you have known about the $1,000 difference?known about the $1,000 difference?


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Differentiate between Differentiate between the physical flow of the physical flow of

merchandise and the merchandise and the cost flow of cost flow of

merchandise.merchandise.



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Physical Movement of Physical Movement of GoodsGoods

Assume you own a company called Assume you own a company called Middleman, Inc.Middleman, Inc.

You buy a gadget from the Gadget You buy a gadget from the Gadget Manufacturing Company for $50. Manufacturing Company for $50.

You put a price of $90 on the gadget You put a price of $90 on the gadget and make it available for sale to your and make it available for sale to your customers.customers.


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Thus, the product Thus, the product flowsflows from the from the manufacturer to your company and manufacturer to your company and then to your customer.then to your customer.

This represents the This represents the realityreality of the of the movement of the inventory.movement of the inventory.



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When the gadgets and other products When the gadgets and other products “flow through” your company, you may “flow through” your company, you may desire that they do it in a particular order.desire that they do it in a particular order.

In some cases, the newest goods should In some cases, the newest goods should be sold first, and in other cases the be sold first, and in other cases the oldest goods should be sold first, and oldest goods should be sold first, and possibly it doesn’t make any difference at possibly it doesn’t make any difference at all.all.



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List the different List the different inventory cost flow inventory cost flow

assumptions and contrast assumptions and contrast how the use of each how the use of each affects reported net affects reported net

income on the income income on the income statement.statement.



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FIFO and LIFOFIFO and LIFO If you sell the gadgets in the same order If you sell the gadgets in the same order

that you purchase them, you have what is that you purchase them, you have what is known as a first-in, first-out (FIFO) flow of known as a first-in, first-out (FIFO) flow of goods. goods.

If you sell the most recent purchases first, If you sell the most recent purchases first, then you have a last-in, first-out (LIFO) flow then you have a last-in, first-out (LIFO) flow of goods. of goods.

Possibly, they are sold randomly instead.Possibly, they are sold randomly instead.


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FIFO Physical FlowFIFO Physical Flow Most grocery stores follow the practice of Most grocery stores follow the practice of

“rotating stock.” When new boxes of “rotating stock.” When new boxes of breakfast cereal arrive, they are placed at breakfast cereal arrive, they are placed at the back of the shelf, and the older boxes the back of the shelf, and the older boxes are moved to the front of the shelf.are moved to the front of the shelf.

The grocer is taking these steps so that The grocer is taking these steps so that the inventory items flow through the store the inventory items flow through the store on a on a first-in, first-outfirst-in, first-out basis. basis.


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LIFO Physical FlowLIFO Physical Flow Old-fashioned hardware stores usually sell Old-fashioned hardware stores usually sell

nails in big wooden bins. When the supply nails in big wooden bins. When the supply of nails is getting low, they pour in a new of nails is getting low, they pour in a new batch. When the customer reaches in for batch. When the customer reaches in for some nails, they are removing the nails some nails, they are removing the nails that are on the top.that are on the top.

These inventory items flow through the These inventory items flow through the store on a store on a last-in, first-outlast-in, first-out basis. basis.


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Average Physical Average Physical FlowFlow

The local gas station has large underground The local gas station has large underground storage tanks. The last delivery of gas cost storage tanks. The last delivery of gas cost them 90 cents per gallon. The tank is still them 90 cents per gallon. The tank is still about 1/4 full when the tanker arrives to refill. about 1/4 full when the tanker arrives to refill. The new cost of gas is 95 cents per gallon.The new cost of gas is 95 cents per gallon.

The dealer now has a mixture of gasoline The dealer now has a mixture of gasoline from different deliveries at different costs.from different deliveries at different costs.

Future gallons pumped from the tank would Future gallons pumped from the tank would represent the represent the averageaverage cost of all the gallons.cost of all the gallons.

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Specific Physical Specific Physical FlowFlow

Assume the local sports card collector opens a Assume the local sports card collector opens a shop in a strip mall. He buys three Mickey shop in a strip mall. He buys three Mickey Mantle cards on his first day of business, one Mantle cards on his first day of business, one from 1952, one from 1954, and one from 1956.from 1952, one from 1954, and one from 1956.

He paid different prices for each card due to He paid different prices for each card due to quality and age.quality and age.

When he sells one of those cards, he is selling When he sells one of those cards, he is selling a a specific specific card, not necessarily the last one, card, not necessarily the last one, the first one, or the average one.the first one, or the average one.


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Flow of Inventory Flow of Inventory CostCost

Recall our previous discussions Recall our previous discussions about about realityreality and the and the measurement of measurement of reality.reality.

The The physical flowphysical flow of products is the of products is the reality of the situation. reality of the situation.

The The cost flow assumptioncost flow assumption that we that we adopt determines our measurement adopt determines our measurement of reality.of reality.

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We will look at four different cost flow We will look at four different cost flow assumptions that are commonly used to assumptions that are commonly used to account for inventory:account for inventory: 1. FIFO (first-in, first-out)1. FIFO (first-in, first-out) 2. LIFO (last-in, first-out)2. LIFO (last-in, first-out) 3. Average cost3. Average cost 4. Specific identification4. Specific identification

Cost Flow Cost Flow AssumptionsAssumptions


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As seen before, the measurement of reality As seen before, the measurement of reality need not always match that reality.need not always match that reality.

For example, we could choose to use the For example, we could choose to use the LIFO method even if our actual flow of goods LIFO method even if our actual flow of goods does not match the LIFO flow.does not match the LIFO flow.

In other words, even if our “physical In other words, even if our “physical inventory flow reality” is FIFO, we could inventory flow reality” is FIFO, we could choose to use the LIFO or Average methods choose to use the LIFO or Average methods as our measurement of that reality.as our measurement of that reality.

Cost Flow Cost Flow AssumptionsAssumptions


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Specific Specific IdentificationIdentification

Review the example on page F-309 for the Review the example on page F-309 for the Dobbs Motor Company that sells antique Dobbs Motor Company that sells antique automobiles.automobiles.

They use the specific identification method They use the specific identification method to determine the cost of the vehicles that to determine the cost of the vehicles that are bought and sold.are bought and sold.

The FIFO, LIFO, or Average methods would The FIFO, LIFO, or Average methods would not be reasonable in this case.not be reasonable in this case.


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For all of the following examples, we will For all of the following examples, we will use the following data:use the following data: 6/1/01 Beg. Inv. = 150 units @ $12 = $1,8006/1/01 Beg. Inv. = 150 units @ $12 = $1,800 6/8/01 Purchase of 150 units @ $13 = $1,9506/8/01 Purchase of 150 units @ $13 = $1,950 6/12/01 Sale of 200 units6/12/01 Sale of 200 units 6/17/01 Purchase of 200 units @ $14 = $2,8006/17/01 Purchase of 200 units @ $14 = $2,800 6/25/01 Sale of 150 units6/25/01 Sale of 150 units

Total units available = 500, units sold = 350.Total units available = 500, units sold = 350.

Sample Inventory Sample Inventory DataData


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Cost Flow - Periodic Cost Flow - Periodic SystemSystem

In the periodic system, we make the In the periodic system, we make the calculations of ending inventory and cost calculations of ending inventory and cost of goods sold at the end of the month (or of goods sold at the end of the month (or year).year).

The timing of the individual purchases and The timing of the individual purchases and sales is irrelevant.sales is irrelevant.

Using the previous data, the goods Using the previous data, the goods available for sale equals $6,550, regardless available for sale equals $6,550, regardless of which cost flow assumption we make.of which cost flow assumption we make.


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Calculate cost of Calculate cost of goods sold and ending goods sold and ending

inventory using inventory using FIFO,LIFO, and FIFO,LIFO, and

average cost inventory average cost inventory cost flow assumptions.cost flow assumptions.



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Periodic - FIFO Periodic - FIFO MethodMethod

Using the FIFO method, the 350 units Using the FIFO method, the 350 units sold were the first 350 units, and the 150 sold were the first 350 units, and the 150 units remaining were the last units units remaining were the last units purchased.purchased.

COGS = (150 @ $12) + (150 @ $13) + COGS = (150 @ $12) + (150 @ $13) + (50 @ $14) = (50 @ $14) = $4,450$4,450

End. Inventory = 150 @ $14 = End. Inventory = 150 @ $14 = $2,100$2,100


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Periodic - LIFO Periodic - LIFO MethodMethod

Using the LIFO method, the 350 units sold Using the LIFO method, the 350 units sold were the last 350 units, and the 150 units were the last 350 units, and the 150 units remaining are the first units (beginning remaining are the first units (beginning inv).inv).

COGS = (200 @ $14) + (150 @ $13) = COGS = (200 @ $14) + (150 @ $13) = $4,750$4,750

End. Inventory = 150 @ $12 = End. Inventory = 150 @ $12 = $1,800$1,800


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Periodic - Average Periodic - Average MethodMethod

Using the Average method, we need to Using the Average method, we need to calculate the average cost of all 500 units:calculate the average cost of all 500 units:

Total CostTotal Cost = = $6,550$6,550 = $13.10 = $13.10

Total UnitsTotal Units 500 500

COGS = 350 @ $13.10 = COGS = 350 @ $13.10 = $4,585$4,585 End. Inv. = 150 @ $13.10 = End. Inv. = 150 @ $13.10 = $1,965$1,965


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Below is a summary of the results from Below is a summary of the results from the periodic system, all three methods.the periodic system, all three methods.

Summary of ResultsSummary of Results

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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In the previous example, which system In the previous example, which system would result in the highest reported net would result in the highest reported net income for the period?income for the period?

If your only concern was to reduce your If your only concern was to reduce your income taxes, which system would you income taxes, which system would you prefer to use in the previous example? prefer to use in the previous example? Would that always be the case?Would that always be the case?


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Cost Flow-Perpetual Cost Flow-Perpetual SystemSystem

Under the perpetual system, the cost of Under the perpetual system, the cost of goods sold is calculated every time we goods sold is calculated every time we make a sale, rather than waiting until the make a sale, rather than waiting until the end of the accounting period.end of the accounting period.

We now need to pay attention to the date We now need to pay attention to the date of each transaction, and apply the of each transaction, and apply the concept of the cost flow assumption concept of the cost flow assumption (FIFO, LIFO, etc.) to each individual sale. (FIFO, LIFO, etc.) to each individual sale.


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Perpetual - FIFO Perpetual - FIFO MethodMethod

Using the perpetual FIFO method, we get Using the perpetual FIFO method, we get exactly the same answersexactly the same answers as the periodic as the periodic FIFO method. The 350 units sold were FIFO method. The 350 units sold were the first 350 units, and the 150 units the first 350 units, and the 150 units remaining were the last units purchased.remaining were the last units purchased.

COGS = COGS = $4,450$4,450 End. Inventory = End. Inventory = $2,100$2,100


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Perpetual - LIFO Perpetual - LIFO MethodMethod

We need to separately calculate the We need to separately calculate the COGS for each sale made to customers:COGS for each sale made to customers:

COGS on 6/12 = COGS on 6/12 = (150 @ $13) + (50 @ $12) = (150 @ $13) + (50 @ $12) = $2,550$2,550

COGS on 6/25 = (150 @ $14) = COGS on 6/25 = (150 @ $14) = $2,100$2,100 Total COGS = Total COGS = $4,650$4,650 End. Inv. = End. Inv. =

(100 @ $12) + (50 @ $14) = (100 @ $12) + (50 @ $14) = $1,900$1,900


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Perpetual - Average Perpetual - Average MethodMethod

For this method, we need to calculate the For this method, we need to calculate the “moving” average cost of the units on hand. “moving” average cost of the units on hand. When we sell a unit, the cost of goods sold is When we sell a unit, the cost of goods sold is recorded at this average cost.recorded at this average cost.

Calculate the average cost as of the 6/12 sale:Calculate the average cost as of the 6/12 sale: 6/1 Beg. Inv. = 150 units @ $12 = $1,8006/1 Beg. Inv. = 150 units @ $12 = $1,800 6/8 Purchase of 6/8 Purchase of 150150 units @ $13 = units @ $13 = $1,950$1,950

300 300 $3,750 $3,750Average = $3,750 / 300 = $12.50 each Average = $3,750 / 300 = $12.50 each


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Of the 300 units on hand, 200 units were sold Of the 300 units on hand, 200 units were sold at an average cost of $12.50 each.at an average cost of $12.50 each.

COGS for 6/12 = 200 @ $12.50 = $2,500COGS for 6/12 = 200 @ $12.50 = $2,500

The remaining 100 units are carried The remaining 100 units are carried forward at the average cost of $12.50 until forward at the average cost of $12.50 until the next purchase of 200 units (@ $14 the next purchase of 200 units (@ $14 each) on 6/17. Then a new average must each) on 6/17. Then a new average must be calculated. be calculated.


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Calculate the average cost as of the 6/25 Calculate the average cost as of the 6/25 sale:sale: Remaining units = 100 units @ $12.50 =$1,250Remaining units = 100 units @ $12.50 =$1,250 6/17 Purchase of 6/17 Purchase of 200200 units @ $14.00 = units @ $14.00 =$2,800$2,800

300 300 $4,050$4,050

Average = $4,050 / 300 = $13.50 eachAverage = $4,050 / 300 = $13.50 each

COGS for 6/25 = 150 @ $13.50 = $2,025COGS for 6/25 = 150 @ $13.50 = $2,025© 2007 Pearson Custom Publishing© 2007 Pearson Custom Publishing

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To summarize the previous data:To summarize the previous data: COGS 6/12 = 200 @ $12.50 = $2,500COGS 6/12 = 200 @ $12.50 = $2,500 COGS 6/25 = 150 @ $13.50 = COGS 6/25 = 150 @ $13.50 = $2,025$2,025

Total = $4,525 Total = $4,525

End. Inv. = 150 units @ $13.50 = $2,025End. Inv. = 150 units @ $13.50 = $2,025


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Below is a summary of the results from Below is a summary of the results from the perpetual system, all three methods.the perpetual system, all three methods.

Summary of ResultsSummary of Results

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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The choice of inventory methods has a clear The choice of inventory methods has a clear impact on two of the major financial reports: impact on two of the major financial reports: the income statement and the balance sheet.the income statement and the balance sheet.

The total cost of goods available for sale The total cost of goods available for sale must be accounted for. This amount is split must be accounted for. This amount is split into two amounts, the ending inventory into two amounts, the ending inventory (balance sheet) and the cost of goods sold (balance sheet) and the cost of goods sold (income statement).(income statement).

Effects of Inventory Cost Effects of Inventory Cost Flow Method ChoiceFlow Method Choice


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In the example just completed, the cost In the example just completed, the cost of the inventory item was increasing. of the inventory item was increasing. What impact would it have on the What impact would it have on the results if the cost of the item was results if the cost of the item was decreasing?decreasing?

What impact would it have if the cost What impact would it have if the cost was stable, not increasing or was stable, not increasing or decreasing?decreasing?


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Over the long run (several years), do you Over the long run (several years), do you think the reported results will be much think the reported results will be much different between the periodic system and different between the periodic system and the perpetual system?the perpetual system?

Over the long run, do you think the Over the long run, do you think the reported results will be much different reported results will be much different among the FIFO, LIFO, and Average among the FIFO, LIFO, and Average methods? methods?


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End of Chapter 9

1 challenging issues under accrual accounting: merchandise inventory and cost of goods sold chapter...

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