ACC 103-OL

Chapter 6 Lecture – Part 1

Chapter 6 –
Inventories

In this chapter, we will continue studying how merchandising companies account for
inventory.

Review

o Review Inventory
o Review Cost of Goods Sold
o Review Gross Profit

Review Inventory, Cost of Goods Sold & Gross Profit

The inventory of a merchandising company includes all the goods the company has
available for sale. For example, if you go into Scheels, all the items on the shelves,
racks and in the display cases are included in the company’s inventory account.

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Chapter 6 Lecture – Part 1

Inventory is a current asset account with a normal debit balance. It is a balance sheet
account.

Inventory items remain on the balance sheet as an asset until they are sold. Once the
inventory items have been sold, they are taken off the company’s book and the
expense, Cost of Goods Sold, is recorded. Cost of Goods Sold is an expense account
with a normal debit balance. It is an income statement account.

Review Exercise:
The trial balance of Carlton Company at the end of its fiscal year, December 31, 2021,
includes these accounts: Merchandise Inventory $34,000; Purchases $189,000; Sales
$380,000; Purchase Discounts $2,800; Freight-In $7,200; Freight-Out $8,100; Sales
Returns and Allowances $5,300; Sales Discounts $4,200; and Purchase Returns and
Allowances $3,700. The ending merchandise inventory is $49,000.

1. Calculate Cost of Goods Sold.

2. Calculate Gross Profit

Hint: There is one account given which you need to ignore.

Just as a review, whenever you see the accounts Purchases, Freight-In, Purchase
Returns & Allowances and Purchase Discounts, you know the company uses a periodic
inventory system. These accounts are not used under a perpetual inventory system.
Therefore, the $34,000 is actually the beginning Inventory balance. The Inventory
account is not continuously updated under a periodic inventory system.

In these problems, it may be helpful to write out the equation for Cost of Goods Sold
and then for Gross Profit and then go back and fill in the numbers.

Scroll down to the next page for the solutions……

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Calculation of Cost of Goods Sold

Beginning Inventory ……………………………….$ 34,000
Plus: Net Cost of Purchases……………………..189,700**
Cost of Goods Available for Sale………………..$223,700
Less: Ending Inventory……………………………(49,000)
Cost of Goods Sold…………………………….. $174,700

**Net Cost of Purchases

Purchases…………………………..$189,000
Plus: Freight-In…………………………7,200
Less: Purchase Discounts…………..(2,800)
Purchase Returns & Allow……(3,700)
Net Cost of Purchases…………….. $189,700

Calculation of Gross Profit

Sales………………………………………………….$380,000
Less: Sales Returns & Allowances………………… (5,300)
Sales Discounts…………………………… (4,200)
Net Sales…………………………………………….. 370,500
Less: Cost of Goods Sold………………………….(174,700)
Gross Profit…………………………………………$195,800

Remember, the Gross Profit section is the first main section on a multiple step income
statement. And, in this problem, you ignored Freight Out because Freight Out is
presented in the Selling Expense section of the multiple step income statement.

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Chapter 6 Lecture – Part 1

Inventory Cost Flow

Assumptions

o An Introduction

Inventory Cost Flow Assumptions – An Introduction

For this lecture, you need to access the Chapter 6 Handout – Intro to LIFO, FIFO &
Average Cost which is in this Module in Canvas.

In this example, you will notice that over the course of a month, the supermarket
purchased identical bags of flour at different prices. This happens frequently. An
example from a consumer point of view would be the purchase of gasoline. For
example, one week, you might fill up your car and pay $4.25/gallon for gasoline. You
may come back the next week and pay $4.58/gallon for the same quality of gasoline.
Companies frequently purchase items whose prices change over time.

First, let’s determine our total cost of goods available for sale. You will remember from
our Cost of Goods Sold Calculation that……

Beginning Inventory
Plus: Net Cost of Purchases
Cost of Goods Available for Sale
Less: Ending Inventory
Cost of Goods Sold

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In this example, we would first add the beginning inventory plus all the purchases to get
the Goods Available for Sale of 300 bags of flour that have a total cost of $312.

Quantity (Bags) Cost per Unit Total Cost

09/01/21 Beginning Inventory 100 $1.00 $100
09/05/21 Purchase 50 $1.02 51
09/15/21 Purchase 80 $1.05 84
09/27/21 Purchase 70 $1.10 77
Goods Available for Sale 300 $312

The problem tells us that there were 120 bags in ending inventory. If we had 300 bags
available for sale and 120 are left in Ending Inventory, the company must have sold 180
bags1.

Quantity (Bags) Cost per Unit Total Cost

09/01/21 Beginning Inventory 100 $1.00 $100
09/05/21 Purchase 50 $1.02 51
09/15/21 Purchase 80 $1.05 84
09/27/21 Purchase 70 $1.10 77
Goods Available for Sale 300 $312
09/30/21 Ending Inventory (120)
Sold 180

Our issue is that we don’t know which 120 bags are still in ending inventory, and we
don’t know which 180 were sold. If you went into this store to purchase a bag of flour,
maybe you would pick up a bag that had cost $1.02, maybe you would pick up a bag
that had cost $1.10. The company does not know because the units are identical.
For accounting purposes, this means that the company doesn’t know which specific
costs to attach to the 120 units to calculate Ending Inventory (an asset account on the

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If any bags of flour were stolen or damaged and not properly recorded, they would be accounted for as
part of the 180 bags which we are going to allocate to Cost of Goods Sold.

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Balance Sheet), and the company doesn’t know which specific costs to attach to the
180 units which were sold to calculate Cost of Goods Sold (an expense account on the
Income Statement). Therefore, the company needs to use an inventory cost flow
assumption.

There are three cost flow assumptions: FIFO, LIFO, and average cost.

FIFO – First-In, First-Out

First-In means the first units purchased, and First-Out means the first units sold. This
means that under FIFO, the company allocates the oldest costs to Cost of Goods Sold
and the most recent costs to Ending Inventory.

If Mike’s Grocery uses FIFO, Cost of Goods Sold and Ending Inventory would be
calculated as follows:

Cost of Goods Sold – 180 units – oldest costs

Beg. Inventory 100 @$1.00 = $100.00
09/05 Purchase 50 @ $1.02 = 51.00
09/15 Purchase 30 @ $1.05 = 31.50
Cost of Goods Sold 180 $182.50

You’ll notice that we only allocated 30 units from the 09/15 Purchase to Cost of Goods
Sold to bring our total units to 180.

Ending Inventory – 120 units – most recent costs

09/15 Purchase 50 @ $1.05 = $52.50
09/27 Purchase 70 @ $1.10 = 77.00
Ending Inventory 120 $129.50
The total of Ending Inventory and Cost of Goods Sold must always equal the total Cost
of Goods Available for Sale, so you could just calculate Ending Inventory and then

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subtract from the Cost of Goods Available for Sale to get Cost of Goods Sold, as
follows:

Goods Available for Sale 300 $312.00

09/30/21 Ending Inventory (120) (129.50)
Goods Sold 180 182.50

However, be very careful if you solve the problems this way. The acronym FIFO
(First In, First Out) is telling you how to calculate Cost of Goods Sold (“Out” meaning
sold) not Ending Inventory. Under FIFO, Ending Inventory is the most recent costs.

LIFO – Last-In, First-Out

Last-In means the last units purchased, and First-Out means the first units sold. This
means that under LIFO, the company allocates the most recent costs to Cost of
Goods Sold and the oldest costs to Ending Inventory.

If Mike’s Grocery uses LIFO, Cost of Goods Sold and Ending Inventory would be
calculated as follows:

Cost of Goods Sold – 180 units – most recent costs

09/27 Purchase 70 @ $1.10 = $ 77.00
09/15 Purchase 80 @ $1.05 = 84.00
09/05 Purchase 30 @ $1.02 = 30.60
Cost of Goods Sold 180 $191.60

You’ll notice that we only allocated 30 units from the 09/05 Purchase to Cost of Goods
Sold to bring our total units to 180.

Ending Inventory – 120 units – oldest costs

Beg. Inventory 100 @$1.00 = $ 100.00

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09/05 Purchase 20 @ $1.02 = 20.40

Ending Inventory 120 $120.40

As I mentioned before, you could calculate Ending Inventory and subtract to get Cost of
Goods Sold, as follows:

Goods Available for Sale 300 $312.00

09/30/21 Ending Inventory (120) (120.40)
Goods Sold 180 191.60

However, be very careful if you solve the problems this way. The acronym LIFO
(Last In, First Out) is telling you how to calculate Cost of Goods Sold (“Out” meaning
sold) not Ending Inventory. Under LIFO, Ending Inventory is the oldest costs.

Average Cost
Under the average cost method, the company first calculates a weighted average cost
per unit:

Average Cost = Cost of Goods Available for Sale = $312 = $1.04

Number of Units Available for Sale 300

You will notice that this is a weighted average. It is taking into account that the
company purchased more units at $1.00, for example, than at $1.02.

Cost of Goods Sold and Ending Inventory are then calculated as follows:

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Cost of Goods Sold – 180 units

180 units x $1.04/unit = $187.20

Ending Inventory – 120 units

120 units x $1.04/unit = $124.80

Again, you could calculate Ending Inventory and subtract to get Cost of Goods Sold, as
follows:

Goods Available for Sale 300 $312.00

09/30/21 Ending Inventory (120) (124.80)
Goods Sold 180 $187.20

FIFO, LIFO & Average Cost – VIDEO AVAILABLE

As you begin watching the Ch 6 Video – FIFO, LIFO & Average Cost, you may want to
pause the video, try to complete the Cost of Goods Sold & Ending Inventory
calculations on your own, and then return to the video to hear my explanation.

Inventory Cost Flow

Assumptions

Analyzing the results

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Chapter 6 Lecture – Part 1

Analysis of Inventory Cost Flow Assumptions

Using Mike’s Grocery example, we can compile the following table which clearly shows
different Cost of Goods Sold and Ending Inventory valuations depending on whether the
company used FIFO, LIFO, or Average Cost.

FIFO LIFO Average Cost

Cost of Goods $182.50 $191.60 $187.20
Sold highest
(an expense on
the Income
Statement)

Ending Inventory $129.50 $120.40 $124.80

(an asset on the highest
Balance Sheet)

You will notice that the inventory cost flow assumption used directly impacts both the
Income Statement and Balance Sheet. Therefore, the company must disclose the
inventory cost flow assumption that was used in the notes to the financial statements.

Income Statement Effects

From the example above, you will notice that during periods of rising prices (the bags of
flour were slightly more expensive as the month went on), Cost of Goods Sold is the
highest under LIFO. And, since Cost of Goods Sold is an expense; a higher expense
results in lower net income. For this reason, many companies choose LIFO. You may
think it is odd that companies would choose an accounting method which results in a
lower net income. However, if a company has lower net income, they will also have
lower income taxes. This is an important issue for corporations.

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In Chapter 1, I mentioned that the rules of financial accounting are set by the FASB (the
Financial Accounting Standards Board) and are very different than the tax laws which
are set by Congress. There are many situations in which companies use different
methods of accounting for tax purposes than for financial statement purposes.
However, if a company uses LIFO for tax purposes, they are required to use LIFO for
financial statement purposes. This is known as the LIFO Conformity Rule.

Balance Sheet Effects

From the example above, you will also notice that during periods of rising prices, Ending
Inventory is the highest under FIFO. Under FIFO, the most recent (highest) costs are
allocated to Ending Inventory. Under LIFO, the oldest (lowest) costs are allocated to
Ending Inventory. One of the advantages of using FIFO is that Ending Inventory is on
the balance sheet at its approximate replacement cost. A disadvantage of using LIFO is
that inventory on the balance sheet is typically severely undervalued because the oldest
costs basically get “stuck” in ending inventory.

Keep in mind, that FIFO, LIFO, and Average Cost are methods of allocating costs.
The company is not saying those are the actual units which were sold or the actual
units which are still in ending inventory. Instead, since the company does not know
which specific units were sold and which units are still in ending inventory, FIFO, LIFO,
and Average Cost are a way to allocate costs.

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Chapter 6 Lecture – Part 1

Inventory Cost Flow Assumptions

o Cost flow assumptions are needed

when identical goods are purchased at
different costs.

o According to GAAP, the cost flow

assumptions do not have to match the
actual physical flow of inventory
through the company.

For most companies, the physical flow of goods follows FIFO – i.e. – a company sells its
oldest items first. For example, a grocery store will sell milk which expires on October 6
before milk which was purchased later and expires on October 20. However, under
generally accepted accounting principles, companies do not have to use the cost flow
assumption which matches the actual physical flow of inventory. (Just as a hint, that is
often a true/false question on quizzes and exams, and it is often missed by students.)

Stop and Practice

In a period of rising prices, the inventory

method that results in the lowest income
tax expense is

A. LIFO
B. FIFO
C. Average Cost
D. Inventory methods do not affect
income tax expense

The answer is A.

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Chapter 6 Lecture – Part 1

Another FIFO, LIFO & Average Cost Problem – VIDEO AVAILABLE

As you begin watching the Ch 6 Video – Another FIFO, LIFO & Average Cost
Problem, you may want to pause the video, try to complete the calculations on your
own, and then return to the video to hear my explanation.

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