7.2 Inventory and Cost Flow Errors

Inventory and Cost Flow Errors

Inventory is a 2026 FAR Area II topic, and the AICPA task list is practical: calculate carrying amounts, prepare entries under costing methods, apply lower-of-cost measurement, prepare rollforwards, and reconcile the subledger to the general ledger. The exam target is not merely memorizing FIFO and weighted-average; it is proving the ending inventory number is supported by units, costs, cut-off, and valuation.

Cost Flow Methods

Inventory costing begins with goods available for sale = beginning inventory + purchases (and, for a manufacturer, production costs). Cost flow methods split that pool between ending inventory and cost of goods sold (COGS).

Under FIFO the oldest costs flow to COGS first, leaving recent (higher) costs in ending inventory. Under LIFO the newest costs flow to COGS first. Weighted average smooths cost changes with one average unit cost (recomputed after each purchase under a perpetual system).

FIFO produces the same ending inventory whether records are perpetual or periodic, but LIFO and weighted average can differ between the two systems because the timing of cost layers and averages changes. A periodic LIFO question pools all purchases before assigning the latest costs to COGS; a perpetual LIFO question peels layers as each sale occurs. Read whether the company keeps perpetual or periodic records before you build the layers, because the same fact pattern can yield different answers.

LIFO candidates also face two U.S.-GAAP-only wrinkles. First, a company using LIFO must also disclose a LIFO reserve, the difference between LIFO inventory and what FIFO (or current cost) would report; the reserve lets an analyst restate to FIFO. Second, LIFO liquidation occurs when a company sells more units than it purchases and dips into old, low-cost layers, inflating gross profit with outdated costs. International Financial Reporting Standards (IFRS) prohibit LIFO entirely, a frequent comparison point on FAR.

Worked Cost-Flow Example

Units and costs: beginning 100 @ $10 = $1,000; purchase 1 of 200 @ $12 = $2,400; purchase 2 of 100 @ $15 = $1,500. Goods available = 400 units, $4,900. Units sold = 300; ending units = 100.

• FIFO ending inventory: the 100 newest units @ $15 = $1,500; COGS = $4,900 - $1,500 = $3,400.
• LIFO ending inventory: the 100 oldest units @ $10 = $1,000; COGS = $4,900 - $1,000 = $3,900.
• Weighted average: $4,900 / 400 = $12.25 per unit; ending inventory 100 @ $12.25 = $1,225; COGS 300 @ $12.25 = $3,675.

Notice FIFO produces the highest ending inventory and lowest COGS in this rising-price scenario, and LIFO the reverse. The numbers tie out only because every unit is forced into either ending inventory or COGS.

Lower-of-Cost Tests

For inventory measured under FIFO or average cost, ASU 2015-11 requires the lower of cost and net realizable value (NRV). NRV = estimated selling price in the ordinary course of business minus reasonably predictable costs of completion, disposal, and transportation. If NRV is below cost, write inventory down and recognize a loss.

For inventory measured under LIFO or the retail inventory method, the older lower of cost or market (LCM) model still applies. Market is replacement cost, bounded by a ceiling of NRV and a floor of NRV minus a normal profit margin. The trap: choose the impairment model based on the costing method before computing anything.

Rollforward Structure and Cut-Off

A useful inventory rollforward:

1. Beginning inventory per general ledger.
2. Add purchases, freight-in, direct materials, direct labor, and allocable manufacturing overhead as applicable.
3. Subtract COGS or transfers to finished goods.
4. Adjust for purchase returns, vendor credits, shrinkage, obsolete goods, and write-downs.
5. Tie ending inventory to the physical count, subledger, and general ledger.

Cut-off is a frequent simulation hook. Goods shipped FOB shipping point belong to the buyer once shipped (include in buyer's year-end inventory if in transit). Goods shipped FOB destination belong to the seller until delivered. Consigned goods remain inventory of the consignor, never the consignee.

Error Effects

Inventory errors create predictable, self-reversing income effects:

• Ending inventory overstated -> COGS understated -> current-year net income overstated.
• Next period opens with overstated beginning inventory -> next-period COGS overstated -> next-period income understated.
• Over two periods the income effect washes out if the error is not repeated, but the balance sheet (assets, retained earnings) stays wrong until corrected.

FAR Simulation Checklist

• Recalculate units before recalculating dollars.
• Confirm whether freight, discounts, and overhead belong in inventory cost.
• Separate physical-count adjustments from valuation write-downs.
• Reconcile the perpetual subledger to the general ledger control account.
• Investigate unexplained shrinkage before booking it as a loss.

Force every figure into one of three buckets: units, unit cost, or valuation adjustment. That discipline keeps the rollforward from becoming a pile of unrelated exhibits.

Gross Profit and Retail Methods

FAR also tests two estimation techniques used when a physical count is impractical (for example, estimating inventory destroyed in a fire). The gross profit method works backward: beginning inventory + purchases = goods available; estimated COGS = sales x (1 - gross profit %); ending inventory = goods available - estimated COGS. The trap is a gross profit percentage stated on sales versus on cost: a 25% markup on cost equals a 20% gross margin on sales, so convert carefully.

The retail inventory method converts ending inventory at retail to cost using a cost-to-retail ratio and is commonly used by retailers; under the conventional (lower-of-cost-or-market) variation, markdowns are excluded from the ratio denominator to approximate LCM.