Chapter-1

Accounting for Inventories

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 Definition of Inventory

 The definition of inventory depends up on the business they

are owned:
 In a merchandising company, the inventory consists of
all goods owned and held for sale to customers in the
normal operations of the business.
 In a manufacturing company, inventory consists of (1)
finished goods, which are ready to sell; (2) work in process,
which are goods in the process of being manufactured; and
(3) materials, which are the raw materials and component
parts used in the manufacture of finished products.
• Inventories are asset items held for sale in the
ordinary course of business or goods that will be used
or consumed in the production of goods to be sold.
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 Importance of Inventories

 Merchandise purchased and sold is the most active elements of

merchandising business, i.e. in wholesale and retail type of businesses. This

is due to the following reasons:

 The sale of merchandise is the principal source of revenue for them.

 The cost of merchandise sold is the largest deductions from sales.

 Inventories (ending inventories) are the largest of the current assets or those firms.

 Because of the above reasons inventories, have effects on the current and the

following period’s financial statements. If inventories are misstated

(understated of overstated), the financial statements will be distorted.

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 The effect of inventory errors in the financial statements

Income Statement Effects

• Under a periodic inventory system, both the beginning and ending inventories
appear in the income statement.

• The ending inventory of one period automatically becomes the beginning

inventory of the next period.

• Thus, inventory errors affect the computation of cost of goods sold and net income
CGS = Beginning inventory + cost of goods purchased-
in two periods.
ending inventory

• If the error understates beginning inventory, cost of goods sold will be understated.

If the error understates ending inventory, cost of goods sold will be overstated.
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 Cont….

When inventory error CGS is Net income is

Understates beginning inventory Understated Overstated

Overstates beginning inventory Overstated Understated

Understates ending inventory Overstated Understated

Overstates ending inventory Understated Overstated

An error in the ending inventory of the current period will have a reverse effect on net
income of the next accounting period

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 Cont…

Balance Sheet Effects

• Companies can determine the effect of ending inventory errors on the balance sheet
by using the basic accounting equation: Assets =Liabilities + Owner’s Equity.
• Errors in the ending inventory have the effects shown below:

Ending inventory error Asset Liability Owner’s equity

Overstated Overstated No effect Overstated

understated understated No effect understated

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 Inventory costing methods

• Inventory is accounted for at cost.

– Cost includes all expenditures necessary to acquire goods and place them in
a condition ready for sale. For example, freight costs incurred to acquire
inventory are added to the cost of inventory, but the cost of shipping goods to a
customer are a selling expense.
• After a company has determined the quantity of units of inventory, it applies unit
costs to the quantities to compute the total cost of the inventory and the cost of
goods sold.
• This process can be complicated if a company has purchased inventory items at
different times and at different prices.

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 Inventory costing methods under periodic inventory system

• A periodic inventory system determines cost of merchandise sold and inventory at the
end of the period.
• We must record cost of merchandise sold and reductions in inventory as sales occur
using a perpetual inventory system.
• How we assign these costs to inventory and cost of merchandise sold affects the
reported amounts for both systems.
• There are four methods commonly used in assigning costs to inventory and cost of
merchandise sold. These are:
 Specific identification
 First-in first-out(FIFO)
 Last-in first-out (LIFO)
 Weighted average

• Let us see these costing methods under periodic inventory system based on the
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following illustration
 Illustration

Beza Company began the year and purchased merchandise as follows:

Jan 1 Beginning Inventory 80 units@ Br 60 4,800

Feb 16 Purchase 400 units @ Br 56 22,400
Sep 2 Purchase 160 units @ Br 50 8,000
Nov 26 purchase 320 units @ Br 46 14,720
Dec 4 Purchase 240 units @ Br 40 9,600
Total 1,200 units Br 59,520

• The ending inventory consists of 300 units, 100 from each of the last three
purchases.

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 Specific Identification Method

• When each item in inventory can be directly identified with a specific purchase and its invoice,
we can use specific identification (also called specific invoice pricing) to assign costs.

• This method is appropriate when the variety of merchandise carried in stock is small and the
volume of sales is relatively small.

• We can specifically identify the items sold and the items on hand.

• From the above illustration, the ending inventory consists of 300 units, 100 from each of the
last purchases.
Br. 40 x 100 = Br. 4,000
Br. 46 x 100 = 4,600
Br. 50 x 100 = 5,000
300units Br. 13,600

 Cost of ending inventory = Br.13,600

 Cost of merchandise sold = CGAFS - Ending inventory

= Br 59,520 – Br 13,600

= Br 45,920 10
 First-in, First-out (FIFO) method

• This method assumes that the units purchased first are sold first. Thus, the remaining
inventory is comprised of the most recent purchases.
• Under this method, goods sold are valued at the oldest unit costs, and goods
remaining in inventory are valued at the most recent unit cost amounts.
Br. 40 x 240 = Br. 9,600
Br. 46 x 60 = 2,760
300units Br. 12,360

 Cost of ending inventory = Br.12,360

 Cost of merchandise sold = CGAFS - Ending inventory

= Br 59,520 – Br 12,360

= Br 47,160

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 Last-in, First-out (LIFO) method

• Under LIFO assumption the most recently purchased merchandise is assumed to be

sold first. Therefore, the remaining inventory is assumed to consist of the earliest
purchases. In this method the units remaining in ending inventory are coasted at the
oldest unit cost incurred, and the units included in cost of goods are coasted at the
newest unit costs incurred.
• The cost-ending inventory under FIFO method
Br. 60 x 80 = Br. 4,800
Br. 56 x 220 = 12,320
300units Br. 17,120

 Cost of ending inventory = Br.17,120

 Cost of merchandise sold = CGAFS - Ending inventory
= Br 59,520 – Br 17,120
= Br 42,400

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 Weighted Average Method

• This assumption values all merchandise, units sold and units remaining in inventory, at the
average per unit cost.
• In effect the average cost method assumes that units are withdrawn from the inventory in
random order.
• To calculate the cost of ending inventory, we will calculate first the cost per unit of goods
available for sale
Average cost per unit = Cost of goods available for sale
Total units Available for ale
• Then the weighted average unit cost is multiplied by units on hand at the end of the period to
calculate the cost of ending inventory. Also, the same average unit cost is applied in the
computation of cost of goods sold.
 Weighted average unit cost =
 Ending inventory cost = Br 49.60× 300 = Br 14,880
 Cost of merchandise sold = Br 59,520-Br 14,880 = Br 44,640

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 Comparison of Inventory costing methods

• If the cost of units and prices at which they are sold remains stable, all the four methods yield the

same results. But if prices change, the three methods usually yield different amounts for:

 Ending inventory

 Cost of merchandise sold

 Gross profit or net income

 In periods of rising (increasing) prices: (or if there is inflationary trend):

FIFO yields

– higher ending inventory

– Lower cost of merchandise sold

– Higher gross profit (net income)

LIFO yields

– Lower ending inventory

– Higher cost of merchandise sold

– Lower gross profit (net income)

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 Weighted average yields the results between the two.
 Cont…….

 In periods of declining (decreasing) prices:

FIFO yields
– Lower ending inventory
– Higher cost of merchandise sold
– Lower gross profit or net income

LIFO yield
– higher ending inventory
– Lower cost of merchandise sold
– Higher gross profit or net income

 Weighted average- between the two

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 Inventory costing methods under perpetual inventory system

• Under perpetual inventory systems we will apply the inventory costing methods each time sale
of merchandise is made.
• We calculate the cost of goods (merchandise) sold and inventory on hand at the time of each
sale.
• This means the merchandise inventory account is continually updated to reflect purchase and
sales.
Illustration:
The beginning inventory, purchases and sales of ABC-Company for the month of January
fare as follows:

unit cost
Jan 1 Inventory 15 Br10
6 sales 5
10 purchase 10 Br. 12.00
20 sales 8
25 purchase 8 Br. 12.50
27 sales 10
30 purchase 15 Br. 14,00
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 First-in first-out Method (FIFO)

• The assignment of costs to goods sold and inventory using FIFO is the same for both the
perpetual and periodic inventory systems. Because each withdrawal of goods is from the
oldest stock on hand, the oldest is the same whether we use periodic inventory system or
perpetual inventory system.
Date Purchase Cost of merchandise sold Inventory
Qty. Unit cost Total cost Qty Unit cost Total cost Qty Unit cost Total cost

Jan. 1 15 Br. 10.00 Br. 150.00

6 5 Br. 10.00 Br. 50.00 10 10.00 100.00
10 10.00 100.00
10 10 Br. 12.00 Br.120.00 10 12.00 120.00
20 8 10.00 80.00 2 10.00 20.00
10 12.00 120.00
2 10.00 20.00
25 8 12.50 100.00 10 12.00 120.00
8 12.50 100.00
27 2 10.00 20.00 2 12.00 24.00
8 12.00 96.00 8 12.50 100.00
2 12.00 24.00
30 15 14.00 210.00 8 12.50 100.00
15 14.00 210.00
23 Br. 246.00 25 Br. 334.00

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 Cont….

• So, the cost of merchandise sold and ending inventory under perpetual- FIFO method
are Br. 246 and Br. 334 respectively.

• Let us see them under periodic - FIFO method:

 Units on hand = units available for sale – units sold

= (15 + 10 + 8 + 15) – (5+ 8 + 10)

= 48 - 23 = 25

 Cost of ending inventory = Br. 14 x 15 = Br. 210

=Br. 12.50 x 8 = 100

=Br. 12 x 2 = 24

Br. 334
 Cost of goods available for sale = Br. 120 + Br. 100 + Br. 210 = Br. 580
 Cost of goods sold = Br. 580 – Br. 334 = Br 246

• So, the same results of cost of gods sold and ending inventory under both periodic
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inventory systems.
 Last-in, First-Out method

• Unlike FIFO method, different results may occur under periodic and perpetual inventory system.
The most recent purchases change when new purchase occurs.
Date Purchase Cost of merchandise Sold Inventory

Qty Unit cost Total cost Qty Unit cost Total cost Qty Unit cost Total cost
Jan. 1 15 Br. 10.00 Br. 150.00
6 5 Br. 10.00 Br. 50.00 10 10.00 100.00

10 10 Br. 12.00 Br. 120.00 10 10.00 100.00

10 12.00 120.00
20 8 Br. 12.00 Br. 96.00 10 10.00 100.00
2 12.00 24.00
25 8 12.50 100.00 10 10.00 100.00
2 12.00 24.00
8 12.50 100.00
27 8 12.50 100.00 10 10.00 100.00
2 12.00 24.00
30 15 14.00 210.00 10 10.00 100.00
15 24.00 210.00
23 Br. 270.00 25 Br. 310.00
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 Cont…

• So, the cost of merchandise sold and ending inventory under perpetual inventory
system are Br. 270 and Br. 310 respectively.
• The results under periodic inventory system are
 Cos of ending inventory = Br 10×15=Br150

= Br 12×10=Br 120
25= 270
 Cost of merchandise sold= Br 580-270 = Br 310

• As you see the results are different under periodic & perpetual inventory system.

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 Weighted average cost method

• Under this method, the average unit cost is calculated each time purchased is made to be
applied on the sales made after the purchases.
• The results may be different under periodic and perpetual inventory system.
Purchase Cost of merchandise sold Inventory
Date
Qty Unit cost Total cost Qty Unit cost Total cost Qty Unit cost Total cost

Jan. 1 15 Br. 10.00 Br. 150.00

6 5 Br. 10.00 Br. 50.00 10 10.00 100.00

20 11.00= 100+120 220.00

10 10 12.00 Br. 120.00 10+10
20 8 11.00 88.00 12 11.00 132.00
20 11.60 = 132+100 232.00
25 8 12.00 100.00 12+8
27 10 11.60 116.00 10 11.60 116.00

30 15 14.00 210.00 15 13.04= 116+210 326.00

10+15
23 Br. 254.00 25 Br. 13.04 Br 326.00

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 Cont…..

• So, the cost of goods sold and ending inventory under perpetual inventory system
are Br. 254.00 and Br. 326.00, respectively.
• The result under periodic inventory system is:
 Weighted average unit cost = Br. 580 = Br. 12.08
48
 Ending inventory cost = Br. 12.08 x 25 = Br. 302

 Cost of merchandise sold = Br. 580 – Br. 302 = Br. 278

• So, the result is different under periodic and perpetual inventory systems.

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 Valuation of inventory at other than cost

Valuation at Lower of Cost or Market

• Under LCM rule, the current market price is compared with historical cost derived under one of the
four primary methods: specific identification, FIFO, LIFO or average.
• The Lower of the two, current market value or historical cost, is selected as the basis for the
evaluation of ending inventory.
• LCM is applied in one of three ways:
 Separately to individual item
 To major categories of items
 To the whole of inventory
Illustration
The following are the inventory of ABC motor sports, retailer
per unit
Inventory Items Units on hand
cost market

Cycles:
Roadster 50 Br.15,000 Br. 14,000
Sprint 20 9,000 9,500
Cars
Toyota 10 10,000 11,200
Mercedes
Required: Let us see 6 under the three ways:16,000
LCM computation 14,500

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 Solution

• Separately to each individual item

Inventory Items Total cost Total market LCM
Roadster 750,000 Br. 700,000 700,000
Sprint 180,000 190,000 180,000
Categories sub total 930,000 890,000
Toyota 100,000 112,000 100,000
Mercedes 96,000 87,000 87,000
Categories sub total 196,000 199,000
Totals 1,126,000 1,089,000 1,067,000

• Major categories of items

Inventory Items Categories Total cost Categories Total market LCM
Cycles 930,000 890,000 890,000
Cars 196,000 199,000 196,000
Totals 1,126,000 1,089,000 1,086,000

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 Cont….

• To the whole of inventory

 When LCM is applied to the whole of inventory, the market cost is Br. 1,089,000
and the recorded cost is Br. 1,126,000. Since this market cost is Br. 37,000 lower
than Br. 1,126,000 recorded cost, it is the amount reported for inventory on the
balance sheet.
 When LCM is applied to individual items of inventory, the marked cost is Br.
1,067,000. Since market is again less than Br. 1,126,000 cost, it is the amount
reported for inventory.
 When LCM is applied to the major categories of inventories, the market is Br.
1,086,000 which is also lower than cost.

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 Estimating inventory costs

• Taking a physical inventory every month would be very expensive and time
consuming.
• Moreover, taking physical counting may be impossible when the inventory has
destroyed such as by fire.
• Therefore, if a business using a periodic inventory system usually estimates the
amounts of its inventory and cost of goods sold.
• approach for making these estimates are
 gross profit method and

 retail method

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 Gross profit method

• This method uses an estimate of the gross profit realized during the period to estimate the cost
of inventory.
• The steps are as follows:
 Determine the cost of goods available for sale from the general ledger records of
beginning inventory and net purchases
 Estimate the cost of goods sold by multiplying the net sales by the cost ratio. Cost ratio
is determined by deducting the gross profit rate from 100%
 Deduct the cost of goods sold from the cost of goods available for sale to find the
estimated ending inventory.

Illustration

Assume that metro company has a beginning inventory of Birr 50,000 on January1. During

the month of January, net purchases amount to Birr20,000 and net sales totaled Birr 30,000

Assume that the company’s normal gross profit rate is 40% of net sales; it follows that the

cost ratio is 60%. Using these facts the inventory on January 31 may be estimated as follows:
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 Cont….

Goods available for sale:

Beginning Inventory, Jan.1------------------------Birr 50,000

Add: Purchases--------------------------------------------20.000

Cost of goods available for sale----------------------------------------Birr 70,000

Deducts: Estimated cost of goods sold:

Net sales ---------------------------------------------Birr 30,000

Cost ratio (100% - 40%)------------------------------------60%

Estimated cost of goods sold -------------------------------------------

(18,000)

Estimated ending inventory, Jan.31 ---------------------------------------Birr 52,000

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 Retail method
• The retail method of estimating inventory and the cost of goods sold are quite similar to
the gross profit method.
• The basic difference is that the retail method is based upon the cost ratio of the currents
period, rather than that of the prior year.
• Determination of inventory by the retail method is illustrated as follows:

Illustration
The following information is for XYZ-Company

Cost Retail

Merchandise Inventory, Jan. 1---------------------Birr 38,800.00 Birr 72,000.00

Purchases in January (net)-------------------------------85,200.00 128,000.00
Sales for January (Net) Birr 140,000.00
Required: determine ending inventory?

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 Solution

Cost Retail

Merchandise Inventory, Jan. 1---------------------Birr 38,800.00 Birr 72,000.00

Purchases in January (net)-------------------------------85,200.00 128,000.00

Merchandise available for sale -------------------Birr 124,000.00 Birr 200,000.00

Cost ratio= 124,000 = 0.62 or 62%

200,000

Sales for January (Net) -----------------------------------------------------------------Birr 140,000.00

Merchandise inventory, Jan. 31, at retail -----------------------------------------Birr 60,000.00

Merchandise inventory, Jan. 31, at estimated cost (60,000 x 62%) ---------------Birr 37,200.00

 The version of retail method approximates valuation of the inventor at average cost.

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