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Financial Accounting Unit 7: Inventory and Cost of Goods Sold (FIFO, LIFO, Average)

Merchandisers earn profit by selling inventory for more than it cost. This unit covers recording purchases and sales, the multi-step income statement, the FIFO, LIFO and average cost methods, inventory errors and inventory ratios.

Covers: Merchandising and the multi-step income statement, Perpetual vs periodic systems, Purchases, freight, returns and discounts, FIFO, LIFO and weighted average, Effects of cost flow methods, Lower of cost or net realizable value, Inventory errors, Inventory turnover and gross profit

Study guide

A merchandising company buys goods and resells them. Its income statement usually has a multi-step format: net sales (sales minus sales returns and allowances and sales discounts), minus cost of goods sold, equals gross profit; minus operating expenses equals operating income; then other revenues and expenses give income before taxes. The gross profit rate, gross profit divided by net sales, shows how much markup the company keeps. Inventory cost includes the purchase price plus all costs to get the goods ready for sale, such as freight-in, minus purchase returns and discounts. Freight-out to customers is a selling expense. Under FOB shipping point, the buyer owns goods in transit; under FOB destination, the seller does.

Companies track inventory with a perpetual or periodic system. A perpetual system updates Inventory for each purchase and records cost of goods sold at every sale, so each sale has two entries: one at selling price (debit A/R or Cash, credit Sales) and one at cost (debit COGS, credit Inventory). Purchase discounts and returns reduce Inventory directly. A periodic system records purchases in a Purchases account and computes cost of goods sold at period end: beginning inventory plus net purchases plus freight-in equals goods available for sale, and goods available minus the counted ending inventory equals cost of goods sold. Both systems still require physical counts.

When identical units are bought at different prices, the company needs a cost flow assumption. Specific identification tracks the actual cost of each unit and suits unique, expensive items. FIFO (first-in, first-out) assumes the oldest units are sold first, so ending inventory holds the newest costs. LIFO (last-in, first-out) assumes the newest units are sold first, so ending inventory holds the oldest costs. Weighted average divides the cost of goods available by the units available. When prices rise, FIFO gives the lowest cost of goods sold, highest net income and most current balance sheet value; LIFO gives the highest COGS, lowest income and lowest taxes. IFRS prohibits LIFO.

Inventory must also be reported conservatively. Under the lower-of-cost-or-net-realizable-value rule, if the expected selling price minus costs to sell falls below cost, inventory is written down and a loss is recorded. (LIFO and retail-method companies use a lower-of-cost-or-market rule.) Errors in counting inventory carry through the statements. Overstating ending inventory understates cost of goods sold and overstates net income in the same year, then reverses the next year because that ending inventory becomes the next beginning inventory. After two years the errors offset, and retained earnings is correct. When inventory is destroyed, the gross profit method estimates what was lost.

Analysts judge inventory management with inventory turnover, which equals cost of goods sold divided by average inventory, and days in inventory, which equals 365 divided by turnover. Higher turnover means goods move quickly, tying up less cash and reducing the risk of obsolescence, though turnover that is too high can mean stockouts. Because FIFO and LIFO produce different balances, comparisons between companies require care; U.S. LIFO users disclose a LIFO reserve, the difference between FIFO and LIFO inventory, so analysts can restate figures. Also watch for LIFO liquidations, when a company sells old, cheap layers and reports a temporary jump in profit.

Key ideas

• Cost of goods sold = Goods available for sale − Ending inventory.
• Perpetual systems record COGS at each sale; periodic systems compute it at period end.
• In rising prices, FIFO gives the lowest COGS and highest income; LIFO gives the highest COGS and lowest taxes.
• FIFO gives the same results under periodic and perpetual systems; LIFO and average may not.
• Inventory is reported at the lower of cost or net realizable value.
• An ending inventory overstatement overstates this year's income and understates next year's.
• Ownership under FOB terms, not physical location, decides what belongs in inventory.

Formulas and rules

Common mistakes

• Using a simple average of unit prices instead of a weighted average.
• Swapping FIFO and LIFO, for example putting the oldest costs in ending inventory under FIFO.
• Treating freight-out as part of inventory cost.
• Forgetting that inventory errors reverse in the following year.
• Dividing gross profit by COGS instead of by net sales to get the gross profit rate.

Before the test, make sure you can

• Prepare a multi-step income statement and compute net sales and gross profit.
• Journalize purchases, returns, discounts and sales under a perpetual system.
• Compute COGS from beginning inventory, purchases and ending inventory under a periodic system.
• Calculate ending inventory and COGS under FIFO, LIFO and weighted average.
• Explain how each cost flow method affects income, taxes and the balance sheet when prices change.
• Apply the lower-of-cost-or-NRV rule and FOB terms.
• Determine the effects of inventory errors over two years.
• Calculate inventory turnover, days in inventory and the gross profit rate.

Words to know

Merchandise inventory

Goods a company owns and holds for sale to customers.

Cost of goods sold

The cost of the inventory sold during the period, an expense matched against sales.

Gross profit

Net sales minus cost of goods sold.

Perpetual inventory system

A system that updates Inventory and Cost of Goods Sold with every purchase and sale.

Periodic inventory system

A system that determines ending inventory by count and computes COGS at period end.

FIFO

First-in, first-out: the earliest costs go to cost of goods sold, leaving the latest costs in inventory.

LIFO

Last-in, first-out: the latest costs go to cost of goods sold, leaving the earliest costs in inventory; not allowed under IFRS.

Weighted-average method

Assigns each unit the average cost of all goods available for sale.

Specific identification

Tracks the actual cost of each specific item sold; used for unique, high-value goods.

FOB shipping point

Terms under which ownership passes to the buyer when goods leave the seller.

FOB destination

Terms under which ownership passes to the buyer when goods arrive.

Freight-in

Shipping cost on purchased goods, added to inventory cost.

Purchase discount

A reduction for paying a supplier early, such as 2/10, n/30.

Lower of cost or net realizable value

Inventory is written down when its expected selling price less costs to sell falls below cost.

LIFO conformity rule

A U.S. tax rule requiring companies that use LIFO for taxes to use it in financial statements too.

LIFO liquidation

Selling old, low-cost LIFO layers when purchases fall short of sales, which temporarily raises income.

Inventory turnover

COGS divided by average inventory; how many times inventory is sold per year.

Gross profit method

Estimates ending inventory using the normal gross profit rate, often after a loss such as a fire.

Sample practice questions

30 more questions like these, from level 1 to 5, are in the practice set.