INVENTORIES

Definition: Inventory refers to items accumulated for a particular purpose. It is an ideal

resource of any kind, provided that such a resource has economic value.
Inventory control system includes
1. Determining the optimal level of inventory
2. Timing of its order
3. Its constant review

Depending up on the purpose why these items are accumulated, different types of
inventories are identified. The following are the frequently encountered terms in
accounting.
Merchandise inventory: this refers to items or commodities bought for reselling
purpose in the normal activities of the business enterprise.
Manufacturing inventory: For manufacturing firms Inventory refers to raw materials
inventory, goods in process inventory, finished goods inventory, and supplies inventory.
-Raw materials inventories- are items acquired and being held for use in the
fabrication process. Raw materials are held as inputs of the manufacturing
process.
-Working process inventory - goods in the fabrication process but not yet
completed. They are also known as work in process or partially processed
goods.
-Finished Goods Inventory- these are goods that are completed and ready for
sale.
Supplies Inventory- these are various consumable items held for use in the
normal course of business. Supplies are not parts of the finished product.
Thus, inventory means different things for different establishments, but in all
cases it represents an asset item held for different purposes. However, in this
course inventory is used to mean merchandise inventory.
o Cost of Inventory: What is cost of inventory? Cost of inventory items includes all
costs necessary to acquire the item and to bring it in the location and conditions in
which it is ready for use. The cost of inventories includes;
-the item’s purchase price less discount
-Transportation-in (freight-in)
-handling charges
-cost of insurance while merchandise is in transit
-storage costs
o Why are inventories and their valuation important? From the standpoint of
management, inventories constitute an extremely important asset. Reasons:
1. The investment in inventories is frequently the largest current asset in
manufacturing and retail establishments, and also may be a material portion of the
company's total assets. In other words the company’s resources are tied up in the
form of inventories.
2. To maintain optimum level of inventories. Sales and customers may be lost if
products ordered by customers are not available in the desired style, quality and
quantity. An inefficient purchasing procedure, faulty manufacturing techniques
or inadequate sales efforts all may saddle a firm with excessive inventories.

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 Also, it becomes important for business to monitor inventory levels carefully to limit
the financing costs of carrying large inventories.
3. Merchandise is one of the most active elements in the operation of wholesale and
retail business. The sale of merchandise provides the principal sources of revenue for
such enterprises. When the net income is determined, the cost of merchandise sold is
the largest deduction from sales. In fact, it is usually larger than all others deductions
combined.
The misstatement in identifying the ending inventory will have the following effect:
o Understatement in identifying the ending inventory will result in overstatement of the
cost of good sold, in turn the overstatement of cost of good sold will understate the
gross profit, the as a result the net income of the period will be understated by the
same amount.
o The understatement of the period net income will result in understatement of the
owner’s equity for the period.
o The understated ending inventory for this period will be the beginning inventory for
the next period which still is understated. The understatement of beginning inventory
in the subsequent period will understate the cost of good sold for the period.
o The understated cost of goods in the subsequent period will overstate the period’s net
income. The overstated net income will in turn over state the period’s owner’s equity
which was understated in the previous period; thus the understated owner’s equity in
the previous period will be compensated by the overstated owner’s equity of this
period.
o Thus the amount of misstatement will be equal in two subsequent periods but of
opposite direction, therefore, these two misstatements will cancel each other, these
means if the effect in the net income of an incorrectly stated inventory is not
corrected, it is limited only to the period of the error and the following period.
Example: Assume that the correct ending inventory is Br 20,000but let us assume that in
assumption number 01 we have misstated the ending inventory as 25,000 while in
assumption number 02 we have misstated the ending inventory as 15,000. And let us see
now the effect of the misstatement in the balance sheet and income statement items,
If the ending inventory is correctly determined as 20,000:
Beginning inventory Br 18,000 Beginning owner’s equity 44,000
Add Purchase 190,000 Add Additional investment 0
Available for sale 208,000 Net income 6,000
Less Ending inventory 20,000 Less Withdrawal 0
Cost of goods sold 188,000 Ending owner’s equity 50,000

Income statement Balance sheet

Net sales Br 200,000 Merchandise inventory 20,000
Less Cost of goods sold 188,000 other asset 60,000
Gross Profit 12,000 Total Assets 80000
Expenses 6,000
Net Income 6,000 Liabilities 30,000
Owners’ equity
50000
Total Liab. &Cap. 80,000
If the ending inventory is incorrectly determined as 25,000.00:
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Beginning inventory Br 18,000 Beginning owner’s equity 44,000
Add Purchase 190,000 Add Additional investment 0
Available for sale 208,000 Net income 11,000
Less Ending inventory 25,000 Less Withdrawal 0
Cost of goods sold 183,000 Ending owner’s equity 55,000
Income statement Balance sheet
Net sales Br 200,000 Merchandise inventory 25,000
Less Cost of goods sold 183,000 other asset 60,000
Gross Profit 17,000 Total Assets 85,000
Expenses (6,000
Net Income 11,000 Liabilities 30,000
Owners equity 55,000
Total lab. + Capital 85,000
If the ending inventory is incorrectly determined as 15,000.00:
Beginning inventory Br 18,000 Beginning owner’s equity 44,000
Add Purchase 190,000 Add Additional investment 0
Available for sale 208,000 Net income 1,000
Less Ending inventory 15,000 Less Withdrawal 0
Cost of goods sold 193,000 Ending owner’s equity 45,000
Income statement Balance sheet
Net sales Br 200,000 Merchandise inventory 15,000
Less Cost of goods sold 193,000 other asset 60,000
Gross Profit 7,000 Total Assets 75,000
Expenses (6,000)
Net Income 1,000 Liabilities 30,000
Owners equity 45,000
Total Liab. + Capital 75,000
Analyzing the effects of error(s) in Reporting Inventory
To illustrate the effects of different cost flow methods on income statement and balance
sheet, we use the following data for ABC company for the month ended Sene, 1992:
All assets excluding merchandise inventory on Sene 30, 1992…. Birr 234,000
All liabilities on Sene 30, 1992….………………………………. Birr 124,000
ABC capital on Sene 1, 1992 (Beginning) ……………………… Birr 155,000
Net sales for Sene, 1992 ………………………………………… Birr 150,000
Total operating expenses during Sene 1992 ……………………… Birr 80,000
The following income statement and balance sheet show the effect of different
methods of cost assignments on net income, end capital, and total assets. [The periodic
inventory system is used and tax is assumed to be zero.]

ABC Company
Income Statement
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 For the month ended Sene 30, 1992
FIFO LIFO Weighted Average
Sales (Net) …………………… 150,000 150,000 150,000
Cost of goods sold [earlier section] 40,000 51,000 45,970
Gross profit …………………… 110,000 99,000 104,030
Operating expenses …………… 80,000 80,000 80,000
Net income …………………… 30,000 19,000 24,030

ABC Company
Balance Sheet
As of Sene 30, 1992
FIFO LIFO Weighted Average
Merchandise inventory……….. 75,000 64,000 69,030
All other assets ……………… 234,000 234,000 234,000
Total assets …………………. 309,000 298,000 303,030
Total liabilities …………….. 124,000 124,000 124,000
ABC capital (155,000+net income) 185,000 174,000 179,030
Total liability & capital…………. 309,000 298,000 303,030
The three methods show different figures on the income statement and the balance sheet
for inventory, total assets, total liabilities & capital, cost of goods sold, gross profit and
net income.
Errors in reporting inventory
Companies must take care in both computing and taking the physical count of inventory.
If inventory is reported in error, it causes misstatements in cost of goods sold, gross
profit, net income, current assets, and capital account. It also means misstatements will
exist in the next period’s statements. This is because of the ending inventory on one
period is the beginning inventory of the next period. An error carried forward causes
misstatements in the next period are cost of goods sold, gross profit, and net income.
Misstatements will reduce the usefulness of financial statements.

Effects on the Income statements

The income statement effects of an inventory error are evident by looking at the
components of the cost of goods sold as shown below:
Beginning Cost of Ending Cost of
Plus Minus Equals
inventory goods inventory goods sold
purchased
The effect of an inventory error on the cost of goods sold is determined by computing it
with the incorrect component amount and comparing it to cost of goods sold when using
the correct component amount. We can see, for example, that understating ending
inventory will overstate cost of goods sold. An overstatement in cost of goods sold yields
an understatement in gross profit and hence on the net income. We can do the same
analysis with overstating ending inventory and for an error in beginning inventory. The
following is the summary of inventory errors on the current period’s income statement
amount.
Inventory error Cost of goods sold Net income
Understate ending inventory Overstated Understated
Understate beginning inventory Understated Overstated
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Overstate ending inventory Understated Overstated
Overstated beginning inventory Overstated Understated

Notice that inventory errors yield opposite effects in the cost of goods sold and net
income. Inventory errors also carry over to the next period, yielding a reverse effect.

Income Statement
1990 1991 1992
Sales [Given] 100,000 100,000 100,000
Cost of goods sold:
Beginning inventory 20,000 16,000 20,000
Add: Purchases 60,000 60,000 60,000
Cost of goods available for sales 80,000 76,000 80,000
Less: ending inventory 16,000 20,000 20,000
Cost of goods sold 64,000 56,000 60,000
Gross profit 36,000 44,000 40,000
Operating expenses (assumed) 10,000 10,000 10,000
Net income 26,000 34,000 30,000
Effects on Balance Sheet
Balance sheet effects of an inventory error are evident by looking at the components of
the accounting equation:
Assets = Liabilities + Capital
We can see, for example, that understating the ending inventory will understate both the
current assets and the total assets. An understating in ending inventory also yields an
understatement in capital because of the understatement of the net income. We can do the
same analysis with overstating the ending inventory. The following will summarize the
effects of the error on balance sheet:
Inventory error Asset Capital
Understating ending inventory Understated Understated
Overstating ending inventory Overstated Overstated
Errors in beginning inventory do not yield misstatements in the year-end balance sheet,
but they do affect the net income.

BASIC ISSUES IN INVENTORY VALUATION

The valuation of inventories can be a complex process that requires determination of:
1. The physical goods to be included in inventory (also owns the goods? Goods is
transit, consigned goods, special sales agreement)
2. The costs to be included in inventory (product verses period costs)
3. The cost flow assumption to be adopted (specific identification, average cost,
FIFO, LIFO, retail, etc.)

1. PHYSICAL GOODS TO BE INCLUDED IN INVENTORY

Technically, purchase should be recorded when legal title to the goods passes to the
buyer. General practice, however, is to record the acquisitions when the goods are
received, because it is difficult for the buyer to determine the exact time of legal passage
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of title for every purchase. In addition, no material error is likely to resort from such a
practice if it is consistently applied.

Goods in Transit
Are goods purchased but not yet received, at the end of a fiscal period. The accounting
for these shipped goods depends on who owns them on the unitary date. That can be
determined by application of the “passage of title” rule.
If the goods are slipped f.o.b. shipping point, title passes to the buyer when the seller
delivers the goods to the common carrier, who acts as an agent for the buyer. (the
abbreviation f.o.b. stands for free on board.)
If the goods are shipped f.o.b. destination, title does not pass units the buyer
receives the goods from the common currier “shipping point” and destination are often
designated by a particular location, for example, f.o.b. legal.
The accounting rule is that goods to which legal title has passed should be recorded as
purchase of the fiscal period. Otherwise a series of misstatement may be included in the
FS.
Consigned Goods - Under this arrangement, the consignor ships merchandise to the
consignee, who acts as the consigner’s agent in selling the goods. The consignee agrees
to accept the goods without any liability, except to exercise due care and reasonable
protection from loss or damage, until the goods are said to a third party. When the
consignee sells the goods, the revenue less a selling commission and expenses incurred in
accomplishing the rate is remitted to the consigner.
Goods out on consignment remain the property of the consignor and must be
included in the consigner’s inventory at purchase price or production cost.
The consignee must no entry to the inventory account to goods received because
they are the property of the consignor.
Sales on Installment – “Goods sold on installment” describes any types of sale in which
payment is required in periodic installments over an extended period of time. Because
the risk of loss from Uncollectible is higher in installment sale situations than in other
sales transactions, the seller often withholds legal title to the merchandise until all the
payments have been made. The question is whether the inventory should be considered
sold, even though legal title has not passed. The answer is that the goods should be
excluded from the seller’s inventory if the percentage of bad debts can be reasonably
estimated. Installment sales are discussed here to show that in some cases, the goods
should be removed from inventory, although legal title may not have period.
Damaged or obsolete goods
It is possible that some goods could be damaged or obsolete on the date of physical
count. Damage refers to physical destruction on goods. Obsolescence refers to the
deterioration of importance [acceptability of a product] for the users [purchasers]. Such
goods are not salable at the usual selling price. Therefore, care must be taken not to
include the cost of such goods at their purchase price.
If such items do not have a sales value, they should be excluded from the physical
counting. If they are salable at reduced price, their cost is determined by taking the net
realizable value. The net realizable value is sales price minus the cost of making the
sales.

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Physical count of merchandise inventory
The merchandise inventory account under a perpetual inventory system is always up to
date. Yet events can occur where the book balance [merchandise inventory account
balance] may differ from the actual count. Such events include:
- Thefts,
- Losses,
- Damages, and
- Errors.
This means that nearly all companies take a physical count of inventory at least once each
year. Under the periodic inventory system, it is a must to take a physical count to know
the actual account balance of the merchandise inventory account any time. This is
because the merchandise inventory account is not up dated every time purchases and
sales are made. We determine the Birr amount for the physical count of inventory on
hand at the end of the period by following the steps indicated below:
(1) count the units of each item on hand,
(2) multiply the count for each item by its cost per unit, and
(3) add the costs for all items.
Example: Assume that ABC Company had reported the physical count of the inventory
on Sene 30, 1993 as follows:
Inventory item physical count unit cost
Sugar 1,000 kg Birr 4 per kg
Salt 2,000 kg Birr 1.40 per kg
Macaroni 3,000 kg Birr 3 per kg
Required: Compute the total inventory cost to be reported on the balance sheet on
Sene 30, 1993.

When taking a physical count, care must be taken not to count items more than once or
omit an item in the counting process. There are different methods to avoid such errors.
One of the methods is to use pre-numbered inventory tickets. This ticket may have the
following format.

Inventory ticket No. 10001

Quantity counted ________ Purchase date _______

Sales price per unit Birr_______
Cost price per unit Birr _______
Counted by ___________________ Signature ____
Checked by ___________________ Signature ____

The process of physical count is fairly standard. It means all companies use the same
procedure or steps in the physical count process. The following procedures are usually
followed by most merchandising companies:
(1) Decide the date and period of inventory counting [for example, inventory count will
start on Sene 25 and shall end in one-week time].
(2) Assign individuals who will conduct the physical count [for example, Abebe,
Tesema, and Alemu are assigned to take the count with specific responsibility, i.e., Abebe
will count, Alemu will measure, and Tesema will check the count].
(3) Prepare at least one inventory ticket for each product on hand.

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(4) Issue the pre-numbered tickets to the assigned employees who will conduct the count.
(5) An employee will count the quantity of the product and obtain information on its
purchase date, selling price, and cost. [This information is sometimes included with the
product but must often be obtained from accounting records or invoices].
(6) Once the necessary information is collected, the employee records it on the ticket,
signs the ticket and attach it to the counted inventory so that it will be checked and avoid
double counting and omitting it from the count.
(7) Another employee often recounts and rechecks information on the ticket, signs the
ticket, and returns it to the inventory manager.
(8) To insure no ticket is lost or missed, internal control procedures verify that all pre-
numbered tickets are returned.
(9) The quantity and cost data on the inventory tickets are aggregated by multiplying the
number of units for each product by its unit cost. This gives us the Birr amount for each
product in inventory. The total of all products is the Birr amount reported for inventory
on the balance sheet. The above procedures are commonly used. However, do not
conclude that all companies must follow all the steps. A company can devise its own way
of taking physical count procedures.
Example: If NIKE sells goods to TARGET with terms FOB shipping point, which will
report these goods in its inventory while they are in transit?
1. An art gallery [painter] purchases a painting for Birr 11,400 on terms FOB shipping
point. Additional costs in obtaining and offering the artwork for sale includes Birr
130 for transportation-in, Birr 150 for import duties, Birr 100 for insurance during
shipment, Birr 180 for advertising and Birr 800 for sales salaries. For computing
inventory, what cost is assigned to the painting?

The Functions of Inventory Taking

Inventory taking is an activity which is used to determine cost and quantity of unsold or
unused items. A firm needs inventories as a protection against uncertainty and to have a
smooth and continuous operation. It is known that no business can operate without
inventories and company’s basic need of inventories can better be understood by
examining the prime functions of inventories. These functions of inventories are the
following:
1. To meet anticipated customer demand: Inventories are on hand to ensure good
customer service. It is only when inventories get out of hand that they
become unnecessary burden. If they are managed properly, they permit
quick and economical customer service.
2. To smoothen production requirements: Firms that experience seasonal patterns
in demand often build up inventories during off-season periods in order to
meet overly high requirements that exist during certain seasonal periods.
Therefore, inventories are used to smoothen out seasonal demands by
leveling out production.
3. To Protect against stock outs: Delayed deliveries and unexpected increases in
demand increase the risk of shortages. Delays can be due to weather
conditions, suppliers’ stock outs, and deliveries of wrong materials,
quality problems, and so on. Holding safety stocks.
4. To take advantage of stock order cycles: In order to minimize purchasing and
inventory costs, it is often necessary to buy quantities that exceed
immediate usage requirements. This necessitates storing some or all of the
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 purchasing amount for later use. Similarly, it is usually economical to
produce in large, rather than small quantities..
5. To hedge against price increases: Occasionally a firm may suspect that a
substantial price increase is about to be made and purchases larger than
normal amounts to achieve some saving.
6. To permit operations: The fact that production or operations take a certain amount
of time, that is they are not instantaneous/ immediate, means that there
will generally be some work in process inventory. In addition,
intermediate stocking of goods at production sites as well as goods stored
in warehouses leads to pipe production sites as well as goods stored in
warehouses leads to pipe line inventories throughout a production
distribution system.

While determining or taking physical inventory, first the quantity of each kind of
Merchandise owned by an enterprise is identified, when periodic system is adopted,
counting, weighting or measuring is made at the end of the period.
Only merchandise owned by the business at the inventory date is included in inventory.
This is to say it is necessary to examine purchase and sales invoice of the last few days to
determine the legal ownership title of merchandise in transit.
In general inventory should include all (but only) those goods which the business has
legal ownership at the date of the balance sheet. For example merchandise could be
purchased on following terms, FOB shipping point or FOB Destination.
FOB Shipping point (Free on board shipping point) title will pass to the purchaser at the
shipping point, thus if these goods are in transit, they are fully owned by the enterprise
and should be included in the inventory even though they are not available for physical
count /measurement or weight/. It is must that the transaction should also be recorded as:
Purchase XXXXX
Account Payable XXXXX
The above transaction should be recorded in the current period rather than recording the
transaction in the following period.
FOB Destination (free on board destination point) means title will pass to the purchaser
at the destination point. In this case the merchandises in transit are not owned by the
buyer enterprise, thus these merchandise will not be included in the inventory.
In some cases manufacturers ship their product (merchandises) on consignment basis to
the retailers who act as the manufacturer’s (consigner’s) agent when selling the
merchandise. In this case the manufacturer is the legal owner of the merchandise
consigned, thus these consigned merchandise should be included in the inventory of the
manufacture. Even though the manufacturer does not have a physical possession, title is
still retained by the manufacturer. The retailer should not include consigned
merchandises in inventory because the consignee (the retailer) does not have a legal right
of ownership (title).
Inventory System
It is the process of designing and maintaining inventory for controlling the planned
balance between inventory and sales.

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 Periodic inventory system
Under this system, the Merchandise Inventory account is updated only once. This is done at
the end of the fiscal period. This means that the Merchandise Inventory account balance
will not change until the updating process takes place. When goods are purchased, they are
recorded in the Purchase Account. Similarly, the cost of goods sold will not be recorded
each time the goods are sold. Instead, the total cost of goods sold will be computed at the
end of the fiscal period.
Note that the following formula applies in computing the cost of goods sold.
The cost of goods sold for the period = Beginning merchandise inventory …. Birr xx
Plus: net purchases…………………… xx
Equals: cost of goods available for sales...
Xx
Less: end merchandise inventory ……… xx
Equals: cost of good sold
………………… xx
In periodic inventory systems, a separate temporary account is opened for each purchase,
purchase discount, purchase return and allowances and transportation-in transactions. The
following example will explain the recording process of these transactions in a general
journal form.

(a)purchase ABC merchandising firm purchases goods for reselling purpose for Birr
1,200 on credit. The terms of purchases are 2/10, n/30 on Sene 20, 1992. The journal
entry will be:
1992 Purchases ……………………….. 1,200
Sene 20 Accounts payable ………………..1,200
The periodic system uses a temporary Purchases account that accumulates the cost of all
purchase transactions during the period.
b) Purchase discounts:
ABC Merchandising paid the supplier for the above purchase in (a) on Sene 30, 1992.
The required payment is Birr 1,176 (1200 x 98%) and is recorded as:
1992 Accounts payable ………………..1,200
Sene 30 Purchase discount ……………… 24
Cash …………………………… 1,176
The periodic system uses a temporary account that accumulates discounts taken on
purchase transactions during the period
(c) Purchase returns and allowances
ABC returned goods purchased on (a) above because of defects on Hamle 2, 1992. The
cost of defects is Birr 300 (net of the discount). ABC records the return as:
1992 Accounts payable ………………… 300
Hamle 2 Purchase returns and allowances ……... 300
This entry is the same if ABC merchandising is given a price reduction [allowance]
instead of returning the merchandise. In periodic system, the temporary purchase returns
and allowances account is used to accumulate the cost of all returns and allowances
transactions during a period.
(d) Transportation-in
ABC paid Birr 75 to transport the merchandise to its store on the date of purchase. The
entry will be as follows:

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 1992 Freight-in 75
Sene 20 Cash 75
(e) Sales
ABC sold merchandise on credit basis for Birr 1,400 on Hamle 1, 1992. The cost of this
merchandise is Birr 1000. The terms of sales is 2/10, n/30. The journal entry will be:
1992 Accounts receivable ……………….1, 400
Hamle 1 Sales ……………………… 1,400
Under the periodic system the cost of goods sold is not recorded at the time of sales.
(f) Sales returns
A customer returned part of the merchandise sold in (e) above on Hamle 5, 1992. The
returned items sell for Birr 600 and the cost of this item is Birr 400. The journal entry to
record this transaction is:
1992 Sales returns and allowances ……….. 600
Hamle 5 Accounts receivable …………. 600
The periodic system records only the revenue reduction.
Perpetual inventory system

A perpetual book inventory system refers to a system of inventory taking and information
gathering on a continuous or ongoing basis using various accounting records to compute
stock on hand at any given time. The purchase and sales figures needed to calculate stock
on hand are derived from internal accounting records that must be kept current if the
computed book inventory is to correctly reflect the seller's true stock position. To
summarize it, a perpetual book inventory represents an up-to-then minute,-date, or-week
accounting system in which all transactions that affect inventory are considered as they
occur or shortly thereafter. Its major advantage is that the seller can determine stock on
hand as required by operating conditions and the need for inventory information.
A perpetual book inventory system for unit control involves continuous recoding of all
transactions (number of units sold or purchased), which changes the unit status of the
seller's merchandise inventory. Each unit transaction is posted as it occurs or shortly
thereafter (on daily basis). Perpetual unit control provides
In perpetual inventory systems, each purchase, purchase return and allowance, purchase
discount, and transportation-in transaction is recorded in the merchandise inventory
account. This means any change made on merchandise is immediately shown on the
merchandise inventory account. The cost of goods sold account is opened to record all
cost of items sold on the date of sales. Under perpetual system, the Merchandise
Inventory account shows the correct balance of goods available for sales on any date.
The following example will explain the recording process of transactions in a general
journal form using the perpetual inventory systems. The transactions are copies of the
transactions you have seen in the earlier example. Try to compare how the recording
process differ and make a note of it.
(a) Purchases:
ABC merchandising firm purchases goods for reselling purpose for Birr 1,200 on credit
on Sene 20, 1992. The terms of purchases are 2/10, n/30. The journal entry will be:
Sene 20 Merchandise inventory …………….. 1,200
Accounts payable …………………..1,200
The perpetual system does not use a temporary purchases account. Rather it will record
the cost of items purchased on the merchandise inventory account directly.
(b) Purchase discounts:
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ABC merchandising paid the supplier for the above purchase in (a) on Sene 30, 1992.
The required payment is Birr 1,176 (1200 x 98%) and is recorded as:
1992 Accounts payable ………………..1,200
Sene 30 Merchandise inventory ……… 24
Cash …………………………… 1,176
The perpetual system uses the merchandise inventory account itself to record the
purchase discounts taken on purchase transactions during the period. If payment is
delayed until after the discount period [10 days] expires, the entry is to debit the accounts
payable and credit cash for Birr 1,200.
(c) Purchase returns and allowances
ABC returned goods purchased on (a) above because of defects on Hamle 2, 1992. The
cost of defects is Birr 300 (net of the discount). ABC records the return as:
1992 Accounts payable ………………… 300
Hamle 2 Merchandise inventory ……... 300
The above entry [1992 Hamle 2] is the same if ABC merchandising is given a price
reduction [allowance] instead of returning the merchandise. In perpetual system, the
temporary purchase returns and allowances account is not needed. The merchandise
inventory account will be reduced for the return and allowance amount during a period.
(d) Transportation-in
ABC paid Birr 75 to transport the merchandise to its store on the date of purchase. The
entry will be as follows:
1992 Merchandise inventory 75
Sene 20 Cash 75
In perpetual system, the transportation-in cost is charged to the merchandise inventory
account since it is part of the cost of goods purchased.
(e) Sales
ABC sold merchandise on credit basis for Birr 1,400 on Hamle 1, 1992. The cost of this
merchandise is Birr 1000. The terms of sales is 2/10, n/30. The journal entry will be:
1992 Accounts receivable ……………….1, 400
Hamle 1 Sales ……………………… 1,400

1992 Cost of goods sold ……………….1, 000

Hamle 1 Merchandise inventory………. 1,000
Under the perpetual system, the cost of goods sold is recorded at the time of sales.
(f) Sales returns
A customer returned part of the merchandise sold in (e) above on Hamle 5,1992. The
returned items sell for Birr 600 and the cost of this item is Birr 400. The journal entries to
record this transaction are:
1992 Sales returns and allowances ……….. 600
Hamle 5 Accounts receivable …………. 600
1992 Merchandise inventory ……….. 400
Hamle 5 Cost of goods sold …… ……. 400
The perpetual system records reduction on both the cost of goods sold and the revenue.

Assigning Costs to Inventory (Cost Flow Assumptions)

Activities of merchandising companies involve frequent purchase and resell
transactions. You have seen in the earlier sections how periodic and perpetual inventory
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systems account for the merchandise inventory and how to determine the physical count
of the merchandise inventory. In this section, you will see what unit cost is assigned to
the inventory. There are about four methods of assigning costs to inventory.
Assume purchases will be made from:
(a) Different sellers and at different times, and
(b) The same seller using different unit prices at different period of time.
This fact consequently brings the question of which price to use in determining the cost
of ending inventory and cost of goods sold.
Specific identification method
The specific identification method of assigning costs to ending inventory requires that
each item and unit be numbered and coded. This will tell us that at what price a particular
item is purchased on specific date. The company will keep a record that shows which
item is sold. When a sale is made, the cost assigned will be the actual cost of that item.
Thus, actual costs can be assigned to the specific items on hand when inventory is
counted.
Cost of goods sold for the period could be obtained by subtracting the ending inventory
from goods available for sale. This method has only a limited use. If the company is
engaged in buying and selling of different items in bulk quantity, it will be difficult to
follow the track of records. Theoretically, it may be possible but practically it is almost
impossible.
However, if the company is dealing with very few items and very high unit cost, it will be
wise and economical to use the specific identification method. For example, a car dealer
can use this method. Each car will be given a code number on the date of purchase.
Corresponding to the code number, the purchase price will be indicated in the record.
When a car is sold, the unit cost will be identified using the code number. If the car is still
on hand on the date of reporting, its unit cost will be used to determine the cost of the car
[which is the end inventory for the car dealer].
Assume Toyota car dealer has the following data for the year ended Sene 30,
1993. The inventory item is the Pick-Up Toyota cars.
Code number Purchase price per car Status of the car on Sene 30
002001 Birr 50,000 Sold for Birr 65,000
002003 Birr 54,000 Still on hand on Sene 30
002006 Birr 78,000 Sold for Birr 87,000
002007 Birr 80,000 Sold for Birr 81,000
002009 Birr 70,000 Still on hand on Sene 30
002010 Birr 90,000 Sold for Birr 89,000
The ending inventory in Birr will be computed as follows:
Code number Cost of the car
002003 Birr 54,000
002009 Birr 70,000
Total cost Birr 124,000
Therefore, the ending inventory will be Birr 124,000.
The First-In-First-Out [FIFO] cost flow assumption
The First-In-First-Out [FIFO] method of assigning cost to inventory and the cost of goods
sold assumes inventory items are sold in the order of they are acquired. When sales
occur, costs of the earliest units acquired are charged to the cost of goods sold. This
13
leaves the costs from the most recent purchases in the end inventory. This method
assumes that the order of inventory movement is in the same way as expenditure is made.
That means, the item purchased first must be sold before selling an item from the next
purchase. For example, if ABC Company purchased 400 units at Birr 3 each on Sene 3,
1992 and 300 units at Birr 4 each on Sene 6, it must sell all the 400 units before it sells
any item from the 300 units. This is the assumption in the FIFO method. If 200 units are
sold from the total purchases of the 700 units [400 + 300], it is assumed that these units
are from the 400 units. Thus, the cost of sales will be Birr 600 [200 units @Birr 3].
Consider the following data for ABC Company to further illustrate how the FIFO method
works.
Date Purchases sold units Balance in units
Sene 10, 1992 4,000 units @Birr 6 no sales 4,000 units
Sene 15, 1992 8,000 units @Birr 8 no sales 12,000 units [4,000 + 8,000]
Sene 20, 1992 no purchases 6,000 units 6,000 units [12,000 – 6,000]
Sene 25, 1992 3,000 units @Birr 9 no sales 9,000 units [6,000 + 3,000]
Under periodic inventory system, the end inventory is counted at the end of the period. In
the example above, the end period is Sene 30, 1992. On this date the end inventory in
units is 9,000 units. The cost of these units shall be the most recent cost. Therefore, the
cost of the 9,000 units will be:
The most recent purchase [Sene 25] = 3,000 units @ Birr 9 = Birr 27,000
The next recent purchase [Sene 15] = 6,000 units @ Birr 8 = Birr 48,000
Total cost of the end inventory is …………………… Birr 75,000
The total cost of goods available for sales Birr 115,000
Thus, the cost of goods sold (Birr 115,000 – Birr 75,000) Birr 40, 000.
This amount can be computed using the unit cost data.
(1) The cost of goods sold for the earliest purchase [Sene 10] =4,000x 6 = Birr 24,000
(2) The cost of goods sold for the next earliest purchase [Sene 15]=2,000x8 = Birr 16,000
The total cost of goods sold during Sene 1992 [(1) + (2)]…………………….Birr 40,000
Under perpetual inventory system, the inventory account is updated whenever
there is a change due to either purchase or sales transactions. For each item, there is a
subsidiary ledger that shows the changes made [decreases and increases] and the account
balance continuously. The following will be the ledger card for the above example:

Date Purchases Cost of sales End Balance

Unit Total cost Unit Total Unit Total
Month Date Units cost Units cost cost Units cost cost
Sene 10 4,000 6 24,000 - - - 4,000 6 24,000
Sene 15 8,000 8 64,000 - - - 4,000 6 24,000
8,000 8 64,000
12,000 88,000
4,000 6 24,000
Sene 20 - - - 2,000 8 16,000 6,000 8 48,000
6,000 8 48,000
Sene 25 3,000 9 27,000 - - - 3,000 9 27,000
9,000 75,000

You can see that the perpetual system keeps the end inventory balance continuously
updated whenever there is a change in the inventory due to purchases or sales
14
transactions. As it is indicated in the above ledger card, there may be a need to use more
than one line to update the record. In FIFO method, it is not possible to mix up the unit
costs since we are not using average figures. The unit costs appear in the ledger card. The
concept of FIFO is applied in the perpetual system and periodic system strictly.

The Last-In-First-Out [LIFO] cost flow assumption

The Last-In-First-Out (LIFO) method of cost assignment assumes that the most recent
purchases are sold first. The most recent costs are assigned to the cost of goods sold and
the earliest costs are assigned to the end inventory.

The method assumes that inventory flows in the reverse order of expenditure
made. That means the item purchased recently must be sold before selling items from the
earlier purchase. For example, if ABC Company purchased 400 units at Birr 3 each on
Sene 3, 1992 and 300 units at Birr 4 each on Sene 6, ABC must sell all the 300 units
before it sells any item from the 400 units. This is the assumption in the LIFO method. If
200 units are sold from the total purchases of the 700 units [400 + 300], it is assumed that
these units are from the 300 units. Thus, the cost of sales will be Birr 800 [200 units
@Birr 4].

Consider the following data to further illustrate how the LIFO method works.
[The same data were used to illustrate the FIFO method. You may compare and contrast
as you proceed with the illustration. This will assist you to understand the two methods
properly.]
Date Purchases Sold units Balance in units
Sene 10, 1992 4,000 units @Birr 6 no sales 4,000 units
Sene 15, 1992 8,000 units @Birr 8 no sales 12,000 units [4,000 + 8,000]
Sene 20, 1992 no purchases 6,000 units 6,000 units [12,000 – 6,000]
Sene 25, 1992 3,000 units @Birr 9 no sales 9,000 units [6,000 + 3,000]
Assume that these are the only transactions regarding purchases and sales during Sene.
How much is the cost of end inventory on Sene 30,1992 and the cost of goods sold during
Sene 1992 using the LIFO cost flow assumption under the periodic and the perpetual
inventory systems?
Under periodic inventory system, the end inventory is counted at the end of the period
and will be valued using the unit costs. In the example above, the end period is Sene 30,
1992. On this date, the end inventory in units is 9,000 units [assume there is no loss or
damage]. The cost of these units shall be the earliest cost. Therefore, the cost of the 9,000
units will be:
The earliest purchase [Sene 10] = 4,000 units @ Birr 6 = Birr 24,000
The next earliest purchase [Sene 15] = 5,000 units @ Birr 8 = Birr 40,000
Total cost of the end inventory is …………………… Birr 64,000
The total cost of goods available for sales is Birr 115,000 = [(4,000 x 6) + (8,000 x 8) +
(3,000 x 9)]. The total cost of goods available for sales will not differ from the FIFO
method. Thus, the cost of goods sold will be the total cost of goods available for sales
minus the end inventory balance, i.e., Birr 115,000 – Birr 64,000 = Birr 51,000. This
amount can be computed using the unit cost data as follows:
(1) The cost of goods sold from the most recent purchase [Sene 25]=3,000x9=Birr 27,000
(2) The cost of goods sold for the next recent purchase [Sene 15]=3,000x 8 = Birr 24,000
The total cost of goods sold during Sene 1992 [(1) + (2)]…………………….Birr 51,000
15
Under perpetual inventory system, we have seen that the inventory account is updated
whenever there is a change due to either purchases or sales transactions. For each item, there
is a subsidiary ledger that shows the changes made [decreases and increases] and the account
balance continuously. The following will be the ledger card for the above example using the
LIFO method of cost flow assumption. Compare how each transaction is recorded in the
ledger card here and the record using the FIFO method, which is done earlier.

Date Purchases Cost of sales End balance

Unit Total cost Unit Total Unit Total
Month Date Units cost Units cost cost Units cost cost
Sene 10 4,000 6 24,000 - - - 4,000 6 24,000
Sene 15 8,000 8 64,000 - - - 4,000 6 24,000
8,000 8 64,000
12,000 88,000
Sene 20 - - - 6,000 8 48,000 4,000 6 24,000
2,000 8 16,000
6000 40,000
4,000 6 24,000
2,000 8 16,000
Sene 25 3,000 9 27,000 - - - 3,000 9 27,000
9,000 67,000
You can see that the perpetual system keeps the end inventory balance continuously updated
whenever there is a change in the inventory due to purchases or sales transactions. As it is
indicated in the above ledger card, there may be a need to use more than one line to update
the record, which is similar to the FIFO method. Moreover, we will not mix up the unit costs
since we are not using average figures. The unit costs appear in the ledger card. You need to
notice that the concept of FIFO is applied in the perpetual system and periodic system
strictly. However, this is not the case for LIFO method when it is coupled with perpetual
inventory system.

Under the FIFO method, the end inventory balance and the cost of goods sold
figure is the same in both the periodic and perpetual inventory systems. [Check the
figures for your self]. But this is not the case for LIFO method. The cost of goods sold
figure is Birr 51,000 under the periodic inventory system and Birr 48,000 under the
perpetual system. The cost of end inventory is Birr 64,000 under the periodic system and
Birr 67,000 under the perpetual system. This difference is because of inconsistency in
applying the LIFO cost flow assumption. In perpetual system, you do not wait until the
end of the fiscal period to assign the cost to the cost of goods sold and the end inventory.
Rather you have to use the recent unit cost data available on the date the change occurred
on the inventory balance.
LIFO method is not recommended in companies dealing with perishable items
[items that will be spoiled within a short period of time]. For such items the FIFO method
is most appropriate to match the cost with the revenue generated. Some companies may
not want to consider such a strict cost flow. They prefer to use the average method since
there is no as such corresponding cost flow for physical movement of inventories.
The Weighted Average (WA) method

16
 In this method there is no need to worry about how cost flows and physical flows
of inventories are related. This method suggests using a single unit cost in assigning cost
to cost of goods sold and ending inventory. When this method is coupled with the
periodic inventory system, there is only one unit cost to be computed for the fiscal period.
When it is used in combination with the perpetual inventory system, the average unit cost
will be computed whenever there is a purchase transaction. In such situation, there is no
single unit cost. Rather, the unit cost will move and hence the method is called the
moving average method.
The unit cost is computed not by taking a simple average [i.e. the sum of unit costs
divided by the frequency]. This is not correct! Individual unit costs must be weighted by
the total quantities purchased.
Let us consider the following example. [This example is used in the FIFO and
LIFO methods. It is reproduced for comparison purpose].
ABC Company purchased 400 units at Birr 3 each on Sene 3, 1992 and 300 units
at Birr 4 each on Sene 6, and it may sell any combination of the two purchases from the
total units available for sales. There is no cost flow assumption that corresponds with the
physical flow. If 200 units are sold from the total purchases of the 700 units [400 + 300],
it is assumed that these units are from the total mix of the 700 units. Thus, the cost of
sales will be computed using an average unit cost. The average unit cost is not Birr 3.5
[Birr 3 plus Birr 4 then divided by 2]. The average unit cost will be computed as follows:
Average unit cost = Total cost of goods available for sales.
Total quantity available for sales
= Birr (400 x 3) + (300 x 4)
400 units + 300 units
= Birr 2,400  Birr 3.43
700 units

Therefore, the cost of goods sold will be Birr 686 [Birr 3.43 x 200 units].
Consider the following data to further illustrate how the weighted average method works.
[The same data were used to illustrate the FIFO & LIFO methods. You may compare and
contrast as you proceed with the illustration. This will assist you to understand the three
methods properly.]
Date Purchases Sold units Balance in units
Sene 10, 1992 4,000 units @Birr 6 no sales 4,000 units
Sene 15, 1992 8,000 units @Birr 8 no sales 12,000 units [4,000 + 8,000]
Sene 20, 1992 no purchases 6,000 units 6,000 units [12,000 – 6,000]
Sene 25, 1992 3,000 units @Birr 9 no sales 9,000 units [6,000 + 3,000]
Assume that these are the only transactions regarding purchases and sales during Sene. If
ABC prefers to use the average method, how much is the cost of end inventory on Sene
30,1992 and the cost of goods sold during Sene 1992 [using the average method] under
the periodic and the perpetual inventory systems?
Under periodic inventory system, the end inventory is counted at the end of the
period and will be valued using a single average unit cost. In the example above, the end
period is Sene 30, 1992. On this date, the end inventory in units is 9,000 units [assume
there is no loss or damage]. The cost of these units shall be the average unit cost
multiplied by 9,000 units. Therefore, the unit cost must be computed first i.e,

Average unit cost = Total cost of goods available for sales.

17
 Total quantity available for sales
= Birr (4,000 x 6) + (8,000 x 8) + (3000 x 9)
4,000 units + 8,000 units + 3,000 units
= Birr 115,000
15,000 units
 Birr 7.67
The cost of the 9,000 units = Birr 7.67 x 9,000 units
= Birr 69,030
The total cost of goods available for sales is Birr 115,000]. The total cost of goods available
for sales will not differ from the FIFO & the LIFO methods. Thus, the cost of goods sold will
be the total cost of goods available for sales minus the end inventory balance; i.e., Birr
115,000 – Birr 69,030 = Birr 45,970. This amount can be computed by multiplying the total
units sold [15,000 units minus 9,000 units = 6,000 units] by the average unit cost [Birr 7.67].
That is, the cost of goods sold = 6,000 x Birr 7.67
=Birr 46,020*
 There is a difference of Birr 50 [Birr 46,020 – Birr 45,970]. This is due to the
rounding made in computing the average unit cost.
Under perpetual inventory system, we have said that the average unit cost will
change. But the computation is done using the same formula. The unit cost is called
as moving average as it changes whenever new items are purchased. The subsidiary
ledger that shows the changes made [decreases and increases] and the account
balance is shown below using the moving average unit cost. Compare how each
transaction is recorded in the ledger card here and the records made using the FIFO &
LIFO methods.
Date Purchases Cost of sales End Balance
Unit Total cost Unit Total Unit Total
Month Date Units cost Units cost cost Units cost* cost
Sene 10 4,000 6 24,000 - - - 4,000 6 24,000
Sene 15 8,000 8 64,000 - - - 12,000 7.33 88,000
Sene 20 - - - 6,000 7.33 43,980 6000 7.33 44,020
Sene 25 3,000 9 27,000 - - - 9,000 7.89 71,020

*Unit costs are used to determine the cost of goods sold amount, not for the end
balance. The end balance is always the remainder amount. The unit costs are
computed as follows:
- On Sene 10, the average unit cost is Birr 6 since we have only one purchase.
- On Sene 15, Average unit cost = (Birr 24,000 + Birr 64,000)
4,000 units + 8,000 units
- On Sene 20, there is no purchase. So the unit cost will not change.
- On Sene 25, Average Unit cost = (Birr 44,020 + Birr 27,000)
6,000 units + 3,000 units
There are rounding made and check for your self.
You can see that in the perpetual system the unit costs move in the direction of actual
costs incurred. The cost of goods sold and end inventory balance are different compared
to the periodic system, as the unit cost used is not the same. If the actual cost increases
from time to time, the average cost also increases [as it is in the example]. If the actual
cost decreases from time to time, the average cost moves downwards. The average unit
18
 cost will be computed whenever new purchases are made. As it is indicated in the above
ledger card, there is no need to use more than one line to show the end balance. This will
save space and avoids possible errors of recording on the ledger card.

FIFO will yield the lowest amount for the cost of merchandise sold, and the highest
amount of gross profit (net income). And it also provides the highest amount of inventory
that is reported in balance sheet.
On the other hand LIFO yields the highest cost of goods (merchandise) sold and lowest
gross profit. It also yields lowest inventory reported n the balance sheet. The average cost
method yields result that is between the two methods (i.e. between FIFO and LIFO).
The uses of three cost flow assumptions are revised under the inflation and deflation period as follows:

Cost follow assumption Inflation Period Defilation Period

Ending inventory High Low
FIFO Cost of goods sole Low High
Gross profit High Low
Ending inventory Average Average
Average Cost of goods sole Average Average
Gross profit Average Average
Ending inventory Low High
LIFO Cost of goods sole High Low
Gross profit Low High

At a time of inflation, most portions of the gross profits is from sale of the inventory is
attributed to inflation effects, and are referred as inventory profits or illusory profits.
o The major criticism in FIFO method is that it has a tendency to maximize the
effect of inflation and defilation trends on amounts reported as gross profit.
o But the advantage of FIFO method is that the merchandise reported in inventory
on the balance sheet is usually at about the same as the current replacement cost.
o The major criticism on LIFO is that the birr amount reported for merchandise
inventory in balance sheet may be quit far from the current replacement cost.
o But those organizations which use LIFO usually disclose or attach a note to the
financial statement stating the difference between LIFO inventory amount and the
inventory amount if FIFO had been used.
LIFO provides tax advantage in the inflationary periods because most recent costs will
be included in the cost of good sold, and as a result the revenues are in effect matched
against current costs and the gross profit is low in relation to FIFO.
Average cost method compromises between FIFO and LIFO. The effect of price trend is
averaged, both in cost of good sold or cost of inventory. Weather in deflation or inflation
period, average costing method provides the same cost.
Valuation of inventory by other method than cost

19
So far inventories have been valued at cost which is the purchase price of merchandise..
Under certain circumstance, however, inventory is valued at other than cost. Two
commonly identified circumstances arise when:
For example:
1. When the cost of replacing the item is below recorded cost.
2. When the inventory is not salable at normal price because of imperfection,
style change, shops wear …etc.

Valuation at Lower of Cost or Market

If market price, that is, the replacement price of an item in the inventory is lower than
its cost, the Lower of Cost or Market method is used to value inventory.
Mind you, cost of the merchandise inventory must be first identified, to be compared
with the market price. Market price means, the cost to replace the merchandise
inventory on the inventory date, based on the quantity typically purchased form
supplier.

If the replacement price of an item in the inventory is lower than its cost, the use of
the lower of cost or market method provides two advantages:
a. The gross profit (and net income) are reduced for the period in which the
decline occurred and,
b. An approximately normal gross profit is realized during the period in which
the item is sold.
Example:
Assume The sales price is Br 100.00
The cost of inventory is 70.00
Gross profit 30.00 30% of sales price
Assume the market price has declined to Br 60.00, if the costs of inventory declines,
the sales price will also declines.
Assume the sales price has become Br 90.00:

Thus Sales Price Br 90.00

Cost 63.00
Gross profit 27.00 which is also 30% of sales price.
Therefore, according to the lower of cost or market, if the cost of merchandise is not
reduced to Br. 63.00, the cost of merchandise as they are sold in subsequent period
will be:
Sales Price Br 90.00
Cost 70.00

20
 Gross profit 20.00 which is less by Br 7.00
because of market price decrease in the previous period. But matching states all cost
or expense of the period must be matched against the period’s revenue.
Thus it is important to identify a decrease in inventory if market is less than cost and
adjust the inventory to the market value in the period the decline occurred.
Example:

Description Total
Quantity UnitCost Unitmarket Cost Lower of cost
Price Price or Market
Commodity A 400 Br 10.25 Br 9.50 Br 4,100.00 Br 3,800.00
B 120 22.50 24.10 2,700.00 2,700.00
C 600 8.00 7.75 4,800.00 4,650.00
D 280 14.00 14.00 3,920.00 3,920.00
Total 15,520.00 15,070.00
Thus the decline in the cost that is Br 15,520.00 -15,070.00 = Br 450.00 will either be
included in cost of good sold, to reduce the gross profit, or it could be reported as
administration expenses reported separately.
1. Cost of Good Sole Br 450.00
Inventory Br 450.00
2. Unrealized Loss Br 450.00
Inventory Br 450.00
1. Valuation at Net Realizable Value
Obsolete, damaged, spoiled Merchandises and other merchandise that can be sold
only at a price below cost should be valued at net realizable value. For this purpose,
net realizable value is the estimated selling price less any direct cost of disposition,
such as sales commissions.
Net Realizable Value = Estimated sales value – Any direct cost to sell this
merchandises
Example:
Assume that damaged merchandises, which have a selling value of Br 1,500.00, could be
sold at Br 800.00 and to sell these proud we have direct expense (transportation,
brokerage fee, and the likes) of Br 150.00. Thus the inventory should be valued at Net
Realizable value (NRV).
NRV= Br 800.00- 150.00 =Br 650.00
Presentation of Merchandise inventory in the balance sheet
Merchandise inventory is usually reported next to receivable. Both the method of
determining the method of identifying the cost (Cost or Lower or Cost) and inventory
method (FIFO, LIFO, Average) should be stated either in parenthesis in the balance sheet
it self or we could attach a note to the financial statement.
Afro –Arts Company
21
 Balance Sheet
December 31,2002
Current Asset
Cash Br 19,400.00
Account Receivable Br 80,000.00
Less: Allowance for Doubt full accounts 3,000.00 77,000.00
Merchandise inventory – at lower of cost (FIFO) or Market 216,300.00
An enterprise could have various costing method and inventory method, like LIFO for
one type of merchandise inventory (Commodity Y) and anther FIFO for the other
(Commodity X). In such cases a note will be attached stating the costing method, and
inventory method for each segment of inventory, separately.

Estimating Inventory costs:

Estimating inventory cost may be essential
1. When it is impractical to take physical inventory, or impossible to maintain
perpetual inventory.
2. When catastrophic events happen, like fire or flood, and has destroyed the
total inventory.
In such cases, the inventory cost might be estimated for the use of preparing income
statement.
Two commonly used estimating inventory cost
1. The Retail Method
2. The Gross Method
Retail Method of inventory estimation: - is based on the relation ship of the cost of
merchandise available for sale to the retail price of the same merchandise.
The retail price of all merchandise acquired is accumulated in supplementary records,
and the inventory at retail is identified by deducting the sales at retail price form retail
price of the goods available for sale during the period.
Then the inventory at retail (selling) is then converted to cost on the bases of the ratio
of cost to selling.
Example:
Merchandise inventory Jan 01 19,400.00 36,000.00
Purchase in January (net) 42,600.00 64,000.00
Merchandise Available for sale 62,000.00 100,000.00
Ratio of cost to retail = 62,000.00/ 100,000.00 = 62%
Sales for January (net) 70,000.00
Merchandise inventory at Jan 31 at retail 30,000.00

22
This method is used mostly by department stores. Its main advantage is it will provide
inventory figure for use in preparing interim statements (With in the accounting
period statement).
This method could also be used in periodic inventory system to identify the cost of
inventory. This is done, when physical inventory is done, inventories will be recorded
at their retail price and to convert these inventories stated at retail we will multiply it
by the cost %age.

Example
If physical inventory taken on December 31, totaled Br 29,000.00, priced at retail, it
would be converted to cost rather than the above 30,000.00 Br, therefore,
29,000.00 X 62% = Br 17,980.00 which will be reported on the year-end
financial statement.
Gross profit method of estimating inventories
The gross profit method uses an estimate of the gross profit realized during the period
to estimate the inventory at the end of the period. By using the rate of gross profit, the
dollar amount of sales for a period can be divided in to its two components
1. Gross profit and
2. Cost of merchandise sold
The latter may then be deducted from cost of merchandise available for sale to yield
the estimated inventory of merchandise on hand.
Example:
Assume that the inventory on January 01 is Br 57,000.00, that net purchases during
the month are Br 180,000.00, that net sales during the month are Br 250,000.00, and
finally that the gross profit is estimated to be 30% of net sales. The inventory on
January 31 may be estimated as follows:
Merchandise inventory on January 01 Br 57,000.00
Purchase in January 180,000.00
Merchandise available for sale 237,000.00
Sales in January (net) 250,000.00
Less: estimated gross profit (250,000.00 * 30%) 75,000.00
Estimated cost of merchandise sold 175,000.00
Estimated merchandise inventory, Jan. 31 62,000.00

Inventories estimated in this manner are useful in preparing interim statements, and is
also useful in establishing an estimate of the cost of merchandise destroyed by fire or
other disaster.

23
Exercise-1
A list of error is shown below:

EXERCISES ON INVENTORIES Cost of goods Year end Working

Error Capital
Ending Inventory is overstated _____ _____
Beginning Inventory is overstated _____ _____
Ending Inventory is Understated _____ _____
Beginning Inventory is Understated _____ _____
Purchase is recorded twice _____ _____
Purchase is not recorded _____ _____
Required:
Show the effects of the errors on the indicted balance sheet and income statement
items.
Exercise-2 Alem Co. reported net income of Br. 20,000. However, the following errors
were made.
a) Purchases were understated by Br. 1000
b) Beginning Inventory was overstated by Br. 1, 500.
c) Ending Inventory was understated by Br. 1000.
Required: Compute the correct income that Alem. Co. should have reported.

Exercise 3- Information:
Year Net Income per books Error in Ending
Inventory

1992 Br. 30, 000 Br. 1, 500 overstatements

1993 20, 000 2, 000 over vestment
1994 35, 000 3, 500 Understatement.

Required: Assuming that no corrections were made in any year, compute the correct
income for 1993 and 1994.
Exercise-5- Indicate the effect of the following errors on cost of goods sold and
Accounts payable.
24
 Error CGS Effect on
Account payable
aa) Ending Inventory is overstated because
of a miscount
b) Merchandise received was not recorded in the
purchase account but it was included in the
physical count.
c) Merchandise shipped FOB shipping point was
not
included in purchases or the ending physical
count
Exercise-6- Novel Company reported Br. 140, 000 of inventory on December 31,
2002, based on a physical count. Additional information:
a) Included in the physical count were machines billed to a costumer FOB shipping
point on December 31, 2002. These machines had a cost of Br., 6,000 and had
been billed at Br. 10, 000. The shipment was on Novel loading dock waiting to
be picked by the carrier.
b) Goods were in transit from a vendor to Novel. The invoice cost was Br. 16, 000
and the goods were shipped FOB shipping point on December 29, 2002.
c) Goods out on consignment amount to Br. 9, 200 (Sales price) shipping costs, Br.
240. (Gross margin is 15% on cost)
Required:
Compute the correct amount of ending Inventory for Novel Company.
Exercise-7- The Company had the following inventory transactions in 2003:
Date Transactions Units Cost per Unit
Jan 1, 2003 Balance 50 Br. 30
Feb 14 Sale 25
May 23 Purchase 100 Br. 40
Aug. 21 Sale 50
Nov. 5 Purchase 25 Br. 60
Nov. 18 Sale 95
Required: Compute the cost of good sold and the ending inventory using the following
systems:
a. FIFO Periodic
b. FIFO Perpetual
c. LIFO Periodic
d. LIFO Perpetual
e. Weighted average
f. Moving average

Exercise-8
Jan 1. Beginning Inventory 180 Units at Br. 40 each
Purchase:
Jan. 7 120 Units at Br. 50 each
Jan. 17 100 Units at Br. 60 each
Sales:
Jan. 10 140 Units
Jan.19 40 Units.
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Required: Compute the cost of the inventory and cost of goods sold at the end of
January under the following alternatives:
a. FIFO periodic
b. FIFO Perpetual
c. LIFO Periodic
d. LIFO Perpetual
e. Weighted Average
f. Moving average
Exercise-9- On January 1 the Bea Company began business with the purchase of 250
Units of inventory for Br. 225, 000. During the month Bea had the following inventory
transactions.
Date
Janu-6- purchased 50 Units at Br. 1, 000 per Units.
11. Sold 220untis
17. Sold 60 units.
24. Purchase 80 units at Br. 1,250 per unit.
28. Sold 80 units
30. Purchased 200 units at Br. 1,100 per unit

Required: Compute the cost of goods sold and cost of the inventory at the end of
inventory at the end of January under the following inventory costing methods.

Exercise10- Answer each of the following questions by inserting one of these

abbreviations in the space provided:

(SI) Specific Identification (FIFO) Cirist-in, first -out

(WA) Weighted average (LIFO) Last -in, First-out
_____1. Which inventory cost method best matches current costs with current revenues
on the income statement.
_____2. Which inventory cost method yields the most realistic amount for inventory,
compared to replacement cost, on the balance sheet?
_____3. Which method is based on the assumption that inventory flow is “mixed" and
therefore “mixes all acquisition prices?

During a period of rising prices, which method yields the:

_____ 4. Lowest net income figure?
_____ 5. Lowest amount for inventory on the balance sheet?
_____ 6. Lowest cost of goods sold figure?
_____ 7. Lowest owners' equity figure?
_____ 8. Lowest income tax bill for the current year?

During a period of declining price, which method yields the:

_____9. Lowest net income figure?
_____ 10. Lowest amount for inventory on the balance sheet?
_____ 11. Lowest cost of goods sold figure?
_____ 12. Lowest owners' equity figure?
_____ 13. Best cash flow/

Exercise-11
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Central Company began operations in 2003 by Selling a single product. Data on
purchases and sales for the year were as follows:
Purchases:
Units purchased
Unit Cost Total Cost
Date
April 10 6, 000 Br. 20. 00 Br. 120, 000
May 10 6, 000 24. 00 144, 000
June 8 6, 000 28.00 168, 000
July 12 6, 000 28.50 171, 000
Sept. 10 2, 000 30.20 60, 000
Oct. 12 2, 000 31.00 62, 000
Nov. 9 1, 200 32.00 38, 400
Dec. 11 1, 200 34.00 40, 000
30, 400
Sales

April , 2, 000 units September, 3000units

may, 2, 400 units October, 2, 700unit
June, 2, 900 units November, 2, 800
July, 2, 600 units December,
August, 2, 500 units

Sales totaled Br. 960, 000

On January 2, 2004, the president of the company, JJ. central asked for your advice on
costing the 6, 400 unit physical inventory that was taken on Dec. 31, 2003. Also, since
the firm plans to expand its product line, he asked your advice on the use of a perpetual
inventory system in the future.
Instructions:
1). Determine the cost of the Dec, 2003 inventory by the periodic method, using the (a)
first -in, first-out method, (b0 last-in, first-out method, and (c) average cost method.
2). Determine the gross profit for the year under each of the three methods in (1).
3). (a) In Your opinion, which of the three inventory costing methods best reflects the
results of operations for 2003? Why?
(b) In Your opinion which of the three inventory costing methods best reflects the
replacement cost of the inventory on the balance sheet as of December
31, 2003? Why?
(c) Which Inventory costing method would you choose to use for income tax
purposes? Why?
4). Discuss the advantages and disadvantages of using a perpetual inventory system.
From the data presented in this case, is there any indication of hate adequacy of inventory
levels during the year?
5). In general terms mention and briefly explants major advantages and disadvantages of
inventory costing

Exercise-12
Consider the following data for ABC trading company for the month ended Sene 30,
1993. [This data are copied from Activity 6. You need to compare the answer of this
activity with that of Activities 6 and 7].
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 Date Purchases Sold units
Sene 1, 1993 2,000 units @Birr 16 no sales
Sene 5, 1993 3,000 units @Birr 18 no sales
Sene 12, 1993 no purchases 4,000 units
Sene 20, 1993 3,000 units @Birr 19 no sales
Sene 27, 1993 no purchases 2,000 units
Required:
[1] Compute the cost of end inventory in units and in Birr using Weighted Average
method under periodic inventory system.
[2] Prepare the ledger card that shows the movement of units and account balance using
Weighted Average method under perpetual inventory system.

Exercise-13
ABC Company uses a periodic inventory system and had the following beginning
inventory and purchases during the month Hamle, 1992 for item X.
Date Units unit cost
Hamle 1,1992 Beginning inventory 400 Birr 14
Hamle 10, 1992 Purchases 200 Birr 15
Hamle 19, 1992 Purchases 300 Birr 16
Hamle 22, 1992 Purchases 250 Birr 20
Hamle 28, 1992 Purchases 100 Birr 21
As of Hamle 30, 1992, there were 550 units of X on hand. Sale of units were as follows:
Hamle 12, 1992 200 units at Birr 30
Hamle 20, 1992 200 units at Birr 30
Hamle 25, 1992 300 units at Birr 35
Required:
(1) Calculate the cost of goods available for sales and
(2) Under the periodic inventory systems, compute the cost of end inventory, cost
of goods sold, and the gross profit using:
[a] FIFO method
[b] LIFO method
[c] The weighted average method.

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