Inventories and Cost of Goods Sold | Financial Accounting | CPA Exam FAR | Chapter 6

These lectures covers inventory, inventory cost flow assumption including FIFO, LIFO, weighted average method, effect of inventory errors, periodic and perpetual inventory.

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Classifying Inventory

In a manufacturing company, some inventory may not yet be ready for sale. As a result, manufacturers usually classify inventory into three categories: finished goods, work in process, and raw materials. Finished goods inventory is manufactured items that are completed and ready for sale. Work in process is that portion of manufactured inventory that has been placed into the production process but is not yet complete. Raw materials are the basic goods that will be used in production but have not yet been placed into production.
For example, Caterpillar classifies earth-moving tractors completed and ready for sale as finished goods. It classifies the tractors on the assembly line in various stages of production as work in process.

Determining Inventory Quantities

No matter whether they are using a periodic or perpetual inventory system, all companies need to determine inventory quantities at the end of the accounting period. If using a perpetual system, companies take a physical inventory for the following reasons:

  • 1.To check the accuracy of their perpetual inventory records.
  • 2.To determine the amount of inventory lost due to wasted raw materials, shoplifting, or employee theft.
Companies using a periodic inventory system take a physical inventory for two different purposes: to determine the inventory on hand at the balance sheet date, and to determine the cost of goods sold for the period.
Determining inventory quantities involves two steps: (1) taking a physical inventory of goods on hand and (2) determining the ownership of goods.


Companies take a physical inventory at the end of the accounting period. Taking a physical inventory involves actually counting, weighing, or measuring each kind of inventory on hand. In many companies, taking an inventory is a formidable task.


One challenge in computing inventory quantities is determining what inventory a company owns. To determine ownership of goods, two questions must be answered: Do all of the goods included in the count belong to the company? Does the company own any goods that were not included in the count?


A complication in determining ownership is goods in transit (on board a truck, train, ship, or plane) at the end of the period. The company may have purchased goods that have not yet been received, or it may have sold goods that have not yet been delivered. To arrive at an accurate count, the company must determine ownership of these goods.
Goods in transit should be included in the inventory of the company that has legal title to the goods.
  • 1.When the terms are FOB (free on board) shipping point, ownership of the goods passes to the buyer when the public carrier accepts the goods from the seller.
  • 2.When the terms are FOB destination, ownership of the goods remains with the seller until the goods reach the buyer.

If goods in transit at the statement date are ignored, inventory quantities may be seriously miscounted. Assume, for example, that Hargrove Company has 20,000 units of inventory on hand on December 31. It also has the following goods in transit:

  • 1.Sales of 1,500 units shipped December 31 FOB destination.
  • 2.Purchases of 2,500 units shipped FOB shipping point by the seller on December 31.


In some lines of business, it is common to hold the goods of other parties and try to sell the goods for them for a fee, but without taking ownership of the goods. These are called consigned goods.
For example, you might have a used car that you would like to sell. If you take the item to a dealer, the dealer might be willing to put the car on its lot and charge you a commission if it is sold. Under this agreement, the dealer would not take ownership of the car, which would still belong to you. Therefore, if an inventory count were taken, the car would not be included in the dealer’s inventory because the dealer does not own it.
Many car, boat, and antique dealers sell goods on consignment to keep their inventory costs down and to avoid the risk of purchasing an item that they will not be able to sell. Today, even some manufacturers are making consignment agreements with their suppliers in order to keep their inventory levels low.
Inventory is accounted for at cost. Cost includes all expenditures necessary to acquire goods and place them in a condition ready for sale. For example, freight costs incurred to acquire inventory are added to the cost of inventory, but the cost of shipping goods to a customer is a selling expense.
After a company has determined the quantity of units of inventory, it applies unit costs to the quantities to compute the total cost of the inventory and the cost of goods sold. This process can be complicated if a company has purchased inventory items at different times and at different prices.

Cost Flow Assumptions

Because specific identification is often impractical, other cost flow methods are permitted. These differ from specific identification in that they assume flows of costs that may be unrelated to the physical flow of goods. There are three assumed cost flow methods:

  • 1.First-in, first-out (FIFO)
  • 2.Last-in, first-out (LIFO)
  • 3.Average-cost

There is no accounting requirement that the cost flow assumption be consistent with the physical movement of the goods. Company management selects the appropriate cost flow method.

To demonstrate the three cost flow methods, we will use a periodic inventory system. We assume a periodic system because very few companies use perpetual LIFO, FIFO, or average-cost to cost their inventory and related cost of goods sold. Instead, companies that use perpetual systems often use an assumed cost (called a standard cost) to record cost of goods sold at the time of sale. Then, at the end of the period when they count their inventory, they recalculate cost of goods sold using periodic FIFO, LIFO, or average-cost as shown in this chapter and adjust cost of goods sold to this recalculated number.


The first-in, first-out (FIFO) method assumes that the earliest goods purchased are the first to be sold. FIFO often parallels the actual physical flow of merchandise. That is, it generally is good business practice to sell the oldest units first. Under the FIFO method, therefore, the costs of the earliest goods purchased are the first to be recognized in determining cost of goods sold.


The last-in, first-out (LIFO) method assumes that the latest goods purchased are the first to be sold. LIFO seldom coincides with the actual physical flow of inventory. (Exceptions include goods stored in piles, such as coal or hay, where goods are removed from the top of the pile as they are sold.) Under the LIFO method, the costs of the latest goods purchased are the first to be recognized in determining cost of goods sold. Illustration 6-8 shows the allocation of the cost of goods available for sale at Houston Electronics under LIFO.


The average-cost method allocates the cost of goods available for sale on the basis of the weighted-average unit cost incurred. The average-cost method assumes that goods are similar in nature