INVENTORIES

FAUZIAH, SE., MM,

 THE REPORTING OF INVENTORY
Two important steps in the reporting of inventory at the end of the accounting period are the
classification of inventory based on its degree of completeness and the determination of
inventory amounts.

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 CLASSIFYING INVENTORY

MERCHANDISING COMPANY MANUFACTURING COMPANY

The merchandisers company The manufacturers company
need only one inventory usually classify inventory into
classification, merchandise three categories: finished
inventory, to describe the many goods, work in process, and
different items that make up the raw materials.
total inventory.

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 DETERMINING INVENTORY QUANTITIES
Determining inventory quantities involves two steps:
A complication in determining ownership is goods in
transit at the end of the period. The company may have
TAKING A PHYSICAL INVENTORY purchased goods that have not yet been received, or it
may have sold goods that have not yet been delivered.
When the terms are FOB (free on board) shipping point,
Taking a physical inventory involvegs actually counting, ownership of the goods passes to the buyer when the
weighing, or measuring each kind of inventory on hand, at public carrier accepts the goods from the seller.
the end of the accounting period. When the terms are FOB destination, ownership of the
Companies using a perpetual system take a physical goods remains with the seller until the goods reach the
inventory for two reasons: buyer.
1. To check the accuracy of their perpetual inventory
records.
2. To determine the amount of inventory lost due to
wasted raw materials, shoplifting, or employee theft.
Companies using a periodic inventory system take a
physical inventory for two different purposes:
DETERMINING OWNERSHIP OF
1. To determine the inventory on hand at the balance GOODS
sheet date.
2. To determine the cost of goods sold for the period. 4
INVENTORY COST FLOW
METHODS
Inventory is accounted for at cost. Cost
includes all expenditures necessary to
acquire goods and place them in a
condition ready for sale.
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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THE COST OF GOODS SOLD
FORMULA
DATA FOR INVENTORY COSTING EXAMPLE

Cost of goods sold will differ depending on which two TVs the company sold. For
example, it might be $1,470 ($720 + $750), or $1,520 ($720 + $800), or $1,550
($750 + $800).

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ALTERNATIVE COSTING METHODS

Specific Identification
• Specific identification requires that companies keep records of the original cost of each individual
inventory item. Historically, specific identification was possible only when a company sold a
limited variety of high-unit-cost items that could be identified clearly from the time of purchase
through the time of sale. Examples of such products are cars, pianos or expensive antiques.

Cost Flow Assumptions

• First-In, First-Out (FIFO) Method: assumes that the earliest goods purchased are the first to be
sold. The costs of the earliest goods purchased are the first to be recognized in determining cost
of goods sold.
• Last-In, First-Out (LIFO) Method: assumes that the latest goods purchased are the first to be
sold. the costs of the latest goods purchased are the first to be recognized in determining cost of
goods sold.
• Average-Cost Method: allocates the cost of goods available for sale on the basis of the
weighted-average unit cost incurred. The average-cost method assumes that goods are similar in
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EXAMPLE OF SPECIFIC IDENTIFICATION

If the company sold the TVs it purchased on February 3 and May 22, then its cost
of goods sold is $1,520 ($720 + $800), and its ending inventory is $750.

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EXAMPLE OF FIFO METHOD (PERIODIC SYSTEM)
Houston Electronics had a total of 1,000 units available to sell during the period (beginning inventory
plus purchases). The total cost of these 1,000 units is $12,000 (cost of goods available for sale). A
physical inventory taken determined that there were 450 units in ending inventory. Houston sold 550
units (1,000 - 450) during the period. The allocation of the cost of goods available for sale at Houston
Electronics under FIFO is as below.

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EXAMPLE OF LIFO METHOD (PERIODIC SYSTEM)
Houston Electronics had a total of 1,000 units available to sell during the period (beginning inventory
plus purchases). The total cost of these 1,000 units is $12,000 (cost of goods available for sale). A
physical inventory taken determined that there were 450 units in ending inventory. Houston sold 550
units (1,000 - 450) during the period. The allocation of the cost of goods available for sale at Houston
Electronics under LIFO is as below.

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EXAMPLE OF AVERAGE-COST METHOD (PERIODIC SYSTEM)
Houston Electronics had a total of 1,000 units available to sell during the period (beginning inventory plus
purchases). The total cost of these 1,000 units is $12,000 (cost of goods available for sale). A physical
inventory taken determined that there were 450 units in ending inventory. Houston sold 550 units (1,000
- 450) during the period. The allocation of the cost of goods available for sale at Houston Electronics
under Average-cost method is as below.

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INCOME STATEMENT EFFECTS DUE TO DIFFERENCES IN
COSTING METHODS

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PERPETUAL
SYSTEM
EXAMPLE OF FIFO METHOD (PERPETUAL SYSTEM)

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EXAMPLE OF LIFO METHOD (PERPETUAL SYSTEM)

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EXAMPLE OF AVERAGE-COST METHOD (PERPETUAL SYSTEM)

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TWO METHODS OF
ESTIMATING
INVENTORIES:
1. The gross profit method
2. The retail inventory method
GROSS PROFIT METHOD
The gross profit method estimates the cost of ending inventory by applying a gross
profit rate to net sales. This method is relatively simple but effective. To use this
method, a company needs to know its net sales, cost of goods available for sale, and
gross profit rate. The company then can estimate its gross profit for the period.

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EXAMPLE OF GROSS PROFIT METHOD
Assume that Kishwaukee Company wishes to prepare an income statement for the month of
January. Its records show net sales of $200,000, beginning inventory $40,000, and cost of goods
purchased $120,000. In the preceding year, the company realized a 30% gross profi t rate. It
expects to earn the same rate this year. Given these facts and assumptions, Kishwaukee can
compute the estimated cost of the ending inventory at January 31 under the gross profit method
as follows.

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RETAIL INVENTORY METHOD
A retail store has thousands of different types of merchandise at low unit costs. In such cases, it is
difficult and time-consuming to apply unit costs to inventory quantities. An alternative is to use
the retail inventory method to estimate the cost of inventory. Under the retail inventory method,
a company’s records must show both the cost and retail value of the goods available for sale.

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EXAMPLE OF RETAIL INVENTORY METHOD

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THE EFFECTS OF INVENTORY
ERRORS ON THE FINANCIAL
STATEMENTS
Unfortunately, errors occasionally occur
in accounting for inventory. In some
cases, errors are caused by failure to
count or price the inventory correctly. In
other cases, errors occur because
companies do not properly recognize the
transfer of legal title to goods that are in
transit. When errors occur, they affect
both the income statement and the
balance sheet.
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 in two periods. 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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EXAMPLE OF INVENTORY ERRORS EFFECTS ON
TWO YEARS’ INCOME STATEMENTS

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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 as below.

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