Inventory Accounting and Cost of Goods Sold — FIFO vs. LIFO, Inventory Turnover, and the COGS Model Explained | Chapter 6 of Financial Accounting

Chapter 6 of Financial Accounting (12th Edition) by Thomas, Tietz, and Harrison introduces one of the most important topics for merchandising companies: how to account for inventory and calculate cost of goods sold (COGS). These elements directly impact gross profit, taxes, and decision-making. Whether using FIFO, LIFO, or the average-cost method, your choice of inventory system can significantly influence a company's financial outcomes.

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📘 Book Overview

Unlike service companies, merchandising businesses such as Under Armour must account for both sales revenue and cost of goods sold. The difference yields gross profit, a key profitability measure. This chapter explains how inventory is purchased, tracked, and eventually expensed through the sale of goods, with detailed attention to freight costs, returns, allowances, and discounts.

📦 Periodic vs. Perpetual Inventory Systems

Companies choose between two systems for tracking inventory:

• Periodic Inventory System — Inventory updates occur at set intervals (e.g., monthly or quarterly). COGS is calculated with this formula:

  Beginning Inventory + Purchases − Ending Inventory = COGS

• Perpetual Inventory System — Real-time inventory updates occur as sales and purchases happen, often using barcodes and inventory software.

📊 Inventory Costing Methods

To determine the value of inventory and COGS, businesses choose one of the following GAAP-approved methods:

• Specific Identification — Used for unique, high-value items.
• FIFO (First-In, First-Out) — Assumes the oldest items are sold first.
• LIFO (Last-In, First-Out) — Assumes the newest items are sold first.
• Average-Cost Method — Distributes cost evenly by averaging inventory cost per unit.

Each method affects income statements, tax liabilities, and balance sheet values differently. For example, LIFO may reduce taxable income in times of rising prices, but FIFO often shows higher net income and inventory values.

⚖️ GAAP and Inventory Valuation

The chapter highlights key U.S. GAAP principles that govern inventory accounting:

• Consistency Principle — Use the same method year to year unless changes are disclosed.
• Disclosure Principle — Financial statements must explain which method is used and why.
• Representational Faithfulness — Inventory values must reflect actual conditions.
• Lower-of-Cost-or-Market (LCM) Rule — Inventory must be recorded at the lower of historical cost or market value (net realizable value).

📈 Inventory Analysis and Efficiency Ratios

Three core ratios are used to assess inventory efficiency and profitability:

• Gross Profit Percentage = Gross Profit ÷ Net Sales
• Inventory Turnover = COGS ÷ Average Inventory
• Days’ Inventory Outstanding (DIO) = 365 ÷ Inventory Turnover

These metrics help managers understand how quickly inventory is sold and how well the business manages purchasing and storage costs.

📉 Inventory Estimation and Error Impact

When physical counts are not available, companies may use the gross margin method to estimate ending inventory. However, the chapter warns of the long-term impact of inventory errors, which can distort gross profit and net income for multiple accounting periods.

📚 Summary

Chapter 6 gives students the tools to understand how inventory flows through a merchandising business—from purchase to sale to reporting. By learning how different inventory methods affect profits, taxes, and balance sheets, students are better prepared to make informed decisions and spot potential red flags in financial statements. Understanding COGS, turnover, and inventory valuation isn't just useful for accountants—it's vital for any business leader.

📺 Need help choosing between FIFO and LIFO? Watch the full video breakdown here for real-world examples and guided explanations of every inventory concept.

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