Inventory and cost of goods sold

Learning goals

• Reconcile inventory units and costs from source evidence.
• Contrast perpetual and periodic recording systems.
• Compute cost of goods sold and ending inventory using FIFO and weighted average.
• Apply an introductory lower-of-cost-and-net-realizable-value check.
• Explain how inventory errors affect two periods and key decisions.

Prerequisite check

1. Why is merchandise usually an asset when purchased and an expense when sold?
2. What two entries does a perpetual system normally record for a credit sale?

Vocabulary

• Inventory: assets held for sale, in production for sale, or consumed in production/service delivery, as applicable.
• Cost of goods sold (COGS): carrying cost of inventory recognized when related goods are sold.
• Perpetual system: updates inventory and COGS continuously.
• Periodic system: determines COGS through period-end records and count.
• FIFO: assigns earliest costs to units sold first.
• Weighted average: assigns an average cost to interchangeable units available for sale.
• Net realizable value (NRV): estimated selling price less estimated completion and selling costs.
• Freight-in: qualifying cost to bring inventory to its present location and condition; terms matter.

Core idea

Inventory accounting has three separate questions:

1. Quantity: Which units does the entity control at the reporting date?
2. Cost: Which expenditures bring those units to present location and condition?
3. Allocation/measurement: Which valid cost formula assigns cost to units sold and remaining, and does carrying amount exceed NRV?

Specific identification, FIFO, and weighted-average methods apply in appropriate circumstances. LIFO is not an acceptable cost formula under IFRS inventory guidance and is not part of this Canadian common-core treatment. Confirm ASPE requirements and consistency for the entity's circumstances.

Why this treatment makes sense

Physical flow and cost formula need not be identical. The formula allocates a pool of valid costs systematically. Because unsold inventory cannot support an amount above expected net recovery, a write-down may be required. Counts and cut-off evidence prevent ownership errors that no cost formula can repair.

A repeatable method

Use COUNT–CUT OFF–COST–FLOW–LOWER–PROVE:

1. Count and control tags; investigate damaged or consigned goods.
2. Test purchase and sales cut-off using shipping/receiving terms and documents.
3. Build goods available: beginning units/cost + valid purchases/cost.
4. Apply the chosen cost formula consistently.
5. Compare cost with NRV at the required level and record supported write-downs.
6. Prove units and dollars: available = sold + ending.

Worked example

Northline Mugs has:

It sells 220 units for $35 each.

Periodic FIFO: COGS = 100($20) + 120($22) = $4,640. Ending inventory = 30($22) + 100($25) = $3,160. Gross profit = sales $7,700 − $4,640 = $3,060.

Periodic weighted average: $7,800 ÷ 350 = $22.285714 per unit. COGS ≈ 220 × $22.285714 = $4,902.86; ending inventory ≈ $2,897.14. Retain unrounded unit cost in calculations so COGS + ending equals $7,800.

Under a perpetual system, a $770 cash sale of 22 units with assigned FIFO cost $440 produces:

At year-end, suppose FIFO ending batches have NRV of $21 for the 30 units and $24.50 for the 100 units. Cost exceeds NRV by 30($1) + 100($0.50) = $80. In a simple direct method: Dr Inventory Write-down Expense $80 / Cr Inventory $80. Presentation, grouping, and reversal requirements depend on the framework.

Journal, ledger, and statement connection

The inventory subsidiary record tracks receipts, issues, and balances by item. Its total reconciles to the Inventory control account and physical count. Sales revenue and COGS create gross profit. Ending inventory is a current asset. If ending inventory is overstated by $1,000, current-year COGS is understated and profit/assets/equity are overstated by $1,000; if uncorrected, the opening error typically reverses through next-period COGS.

Common mistakes

• Costing goods the entity does not control, or omitting goods in transit it does control.
• Adding recoverable GST/HST to inventory cost without checking tax-credit eligibility.
• Treating sales price as inventory cost.
• Mixing periodic weighted average with moving-average perpetual calculations.
• Rounding average cost too early.
• Applying FIFO to quantity but average cost to dollars.
• Ignoring obsolete, damaged, or slow-moving stock because the total count agrees.

Guided practice

Beginning inventory is 60 units at $12; purchases are 90 at $14 and 50 at $15. The entity sells 140 units for $24 each. Compute goods available, ending units, FIFO COGS/ending inventory/gross profit, and periodic weighted-average results.

Independent practice

Maple Peak Gear begins with 80 units at $30, buys 120 at $32 and 100 at $35, and sells 230 at $50. Compute periodic FIFO and weighted-average COGS, ending inventory, and gross margin percentage. Then investigate this count discrepancy: book quantity is 70, physical count is 66, and four units costing $35 are held on consignment for another business but were counted. Determine Maple Peak's correct owned quantity and adjustment from the book quantity, assuming no other issues.

Self-check and solutions

Guided: Available 200 units costing $2,730; ending 60. FIFO COGS = 60($12) + 80($14) = $1,840; ending = 10($14) + 50($15) = $890; sales $3,360; gross profit $1,520. Average cost $13.65; COGS $1,911; ending $819; gross profit $1,449.

Independent: Available 300 units, cost $9,740; ending 70; sales $11,500. FIFO COGS = $2,400 + $3,840 + 30($35) = $7,290; ending $2,450; gross margin = ($11,500 − $7,290)/$11,500 = 36.61%. Average cost $32.466667; COGS $7,467.33; ending $2,272.67; gross margin 35.07%.

Physical count 66 includes four consigned units not owned, so owned count is 62. Compared with book 70, shortage is 8 owned units, not four. Trace receipts/issues and authorization; under the stated $35 cost, Dr Inventory Shrinkage/COGS $280 / Cr Inventory $280.

Retrieval practice

1. Write the goods-available cost and unit equations.
2. What is the difference between perpetual and periodic recording?
3. Define NRV in words.
4. State the current- and next-period effects of overstated ending inventory.

Exam-style application

Available goods cost $96,000. Correct ending inventory is $21,000, but a student reports $26,000. Sales are $130,000. Compute correct and reported COGS and gross profit, then state the error.

Target: Correct COGS $75,000 and gross profit $55,000. Reported COGS $70,000 and gross profit $60,000. Inventory, profit, and equity are overstated $5,000.

Lesson summary

Prove ownership and quantities before allocating cost. Then apply a consistent cost formula, test recoverability, and connect inventory directly to COGS, gross profit, working capital, and next-period results.