Chapter 7 – Reporting and Interpreting Cost of Goods Sold and Inventory
Based on Financial Accounting, 11th Edition by Libby, Libby, and Hodge
Introduction
Inventory plays a central role in measuring a company’s financial performance. Accurate
reporting of inventory and cost of goods sold (COGS) ensures that the income statement and
balance sheet reflect the company’s true operational efficiency. This chapter explores how to
apply the cost principle, report inventory under various costing methods, understand valuation
at lower of cost or net realizable value, and evaluate inventory control, errors, and turnover.
1. The Cost Principle in Inventory Valuation
The cost principle requires that inventory be reported at its original cost. This includes all costs
necessary to bring the goods to their present location and condition for sale.
Inventory by Business Type:
Retailers & Wholesalers: Include purchase price, shipping, handling, import duties.
Manufacturers: Include raw materials, direct labour, and manufacturing overhead.
Example (Retail):
Inventory purchase: $15,000
Shipping: $600
Handling: $200
→ Total inventory cost: $15,800
Example (Manufacturing):
Raw materials: $10,000
Labour: $4,000
Overhead: $3,000
→ Inventory cost: $17,000
2. Reporting Inventory and Cost of Goods Sold: Four
Costing Methods
There are four generally accepted inventory costing methods:
2.1 Specific Identification
, Tracks the actual cost of each item sold.
Used for unique, high-value goods (e.g., vehicles, art).
Pros: Accurate for low-volume, high-value sales
Cons: Impractical for mass inventory
2.2 First-In, First-Out (FIFO)
Assumes oldest inventory is sold first.
Ending inventory reflects most recent costs.
Example:
Purchases:
100 units @ $10
100 units @ $12
Sell: 120 units → COGS = (100×$10) + (20×$12) = $1,000 + $240 = $1,240
Results in:
Lower COGS, higher net income in inflationary periods
Ending inventory is closer to current market value
2.3 Last-In, First-Out (LIFO) (Not allowed under IFRS)
Assumes newest inventory is sold first.
Not permitted for Canadian companies using IFRS, but taught for conceptual contrast.
Results in:
Higher COGS and lower taxable income during inflation
Ending inventory based on older, possibly outdated costs
2.4 Weighted Average Cost
Uses the average cost per unit for all inventory.
Average Cost=Total Cost of Goods AvailableTotal Units Available\text{Average Cost} = \frac{\
text{Total Cost of Goods Available}}{\text{Total Units Available}}
Based on Financial Accounting, 11th Edition by Libby, Libby, and Hodge
Introduction
Inventory plays a central role in measuring a company’s financial performance. Accurate
reporting of inventory and cost of goods sold (COGS) ensures that the income statement and
balance sheet reflect the company’s true operational efficiency. This chapter explores how to
apply the cost principle, report inventory under various costing methods, understand valuation
at lower of cost or net realizable value, and evaluate inventory control, errors, and turnover.
1. The Cost Principle in Inventory Valuation
The cost principle requires that inventory be reported at its original cost. This includes all costs
necessary to bring the goods to their present location and condition for sale.
Inventory by Business Type:
Retailers & Wholesalers: Include purchase price, shipping, handling, import duties.
Manufacturers: Include raw materials, direct labour, and manufacturing overhead.
Example (Retail):
Inventory purchase: $15,000
Shipping: $600
Handling: $200
→ Total inventory cost: $15,800
Example (Manufacturing):
Raw materials: $10,000
Labour: $4,000
Overhead: $3,000
→ Inventory cost: $17,000
2. Reporting Inventory and Cost of Goods Sold: Four
Costing Methods
There are four generally accepted inventory costing methods:
2.1 Specific Identification
, Tracks the actual cost of each item sold.
Used for unique, high-value goods (e.g., vehicles, art).
Pros: Accurate for low-volume, high-value sales
Cons: Impractical for mass inventory
2.2 First-In, First-Out (FIFO)
Assumes oldest inventory is sold first.
Ending inventory reflects most recent costs.
Example:
Purchases:
100 units @ $10
100 units @ $12
Sell: 120 units → COGS = (100×$10) + (20×$12) = $1,000 + $240 = $1,240
Results in:
Lower COGS, higher net income in inflationary periods
Ending inventory is closer to current market value
2.3 Last-In, First-Out (LIFO) (Not allowed under IFRS)
Assumes newest inventory is sold first.
Not permitted for Canadian companies using IFRS, but taught for conceptual contrast.
Results in:
Higher COGS and lower taxable income during inflation
Ending inventory based on older, possibly outdated costs
2.4 Weighted Average Cost
Uses the average cost per unit for all inventory.
Average Cost=Total Cost of Goods AvailableTotal Units Available\text{Average Cost} = \frac{\
text{Total Cost of Goods Available}}{\text{Total Units Available}}
