ECSU Mubarek S.

UNIT ONE: INVENTORIES

Introduction
The other current asset owned by the business is inventory. Therefore this unit will
identify and explain the accounting principles and concepts applicable to inventory
account and methods of valuing inventory
The term inventory is used to express merchandises held for sale in the normal
course of the business. Inventory is considered as a current asset because it is
normally expected to be sold within a year’s time or within a company’s operating
cycle. Merchandise inventory consists of all goods owned and held for sale in the
regular course of business. Manufacturing entities maintain other types of
inventories: Raw Materials inventory, Work in Process inventory and Finished
Goods inventory.

Management of inventory is one of the most complex and challenging tasks.

Inventory represents one of the largest assets of a merchandising business. The
amount of money tied up in inventory must be controlled because of the high costs
of borrowing funds and storing inventory.

A major objective of accounting for inventories is the proper determination of

income through the process of matching appropriate costs against revenues. Its
emphasis is on proper determination of income through the matching of costs and
revenues, though the determination of the most realistic inventory value is also
important.

Learning objectives
At the end of this chapter, you will be able to:
 Define inventory ,
 Value inventory under both periodic and the perpetual inventory systems,
using average-cost method, first in, first-out (FIFO) method; and last-in,
first-out (LIFO) method,
 State the effects of inventory methods and misstatements of inventory on
income determination and income taxes,
 Apply the lower-of-cost-or-market (LCM) rule to inventory valuation, and
 Estimate the cost of ending inventory using the retail and gross profit
method of inventory estimation.

The Effect of Ending Inventory on Financial Statements

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The amount assigned to ending inventory has a direct effect on the net income. In
effect, the value assigned to the ending inventory determines what portion of cost
of goods available for sale is assigned to cost of goods sold and what portion is
assigned to the balance sheet as inventory to be carried over into the next
accounting period. Decisions made regarding inventory usually result in different
amounts of reported income. For instance, if ending inventory is overstated in year
1, it will have effect on the following accounts in year 2:
 Beginning inventory is over stated
 Cost of goods sold is over stated
 Net income is understated
To prepare the proper financial statement, due care has to be given while
determining inventory. If we have failed to determine the inventory properly, its
effect distorts all financial statements.

Inventory systems
Inventory systems are alternative ways of collecting and recording information
about cost of goods sold and cost of goods available for sale. There are two types
of inventory systems:
o Periodic inventory system.
o Perpetual inventory system.

1. Periodic inventory system

This method requires updating the inventory account only at the end of the year to
reflect the quantity, and cost of goods available for sale and sold. It does not
require continual updating of the inventory account. The cost of merchandise is
recorded in temporary purchase account.

When company sells merchandise, it records revenue only, not both revenue and
cost of goods sold. Instead, when it prepares financial statements, the company
takes a physical count of inventory by counting the quantities of merchandise
available. Then, the cost of existing merchandise is computed by linking the
quantities counted to the purchase records that show each item’s original cost.
The cost of merchandise available is then used to compute cost of goods sold. The
inventory account is then adjusted to reflect the amount computed from the
physical count of inventory.

2. Perpetual inventory system

It keeps continual record of the amount of inventory available. It accumulates the
net cost of merchandise purchase in inventory account and subtracts the cost of

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each sale from the same inventory account. When a company sales an item, both
its revenue and cost are recorded. Under this system at any time, the balance of
inventory is known just by referring to the inventory account i.e. no need to count
as we need to do under periodic system. Similarly, the balance of cost of goods
sold is determined any time by looking at cost of goods sold account.

An inventory valuation involves two major consecutive activities. These are:

A. Taking physical inventory
B. Costing the physical inventory.

A. Taking physical inventory

This includes activities of counting, measuring and weighting to determine quantity
of inventory. Dear student! While counting, the all inventory that the company
owns as of inventory date should be incorporated in the counting. Goods in transit
and on consignments should be properly considered while taking physical
inventory.

Merchandises in Transit
Inventories, which are not in the physical possession of the buyer or seller, are said
to be merchandises in transit. These merchandises should be incorporated in the
inventory of the party that has ownership right on it. Ownership of goods in transit
is determined based on the shipping agreement, which indicates whether title has
passed.
• Outgoing goods (sold and in transit):
• Shipped under FOB destination would be included in the inventory.
• Shipped under FOB shipping point would not be included in the
inventory.
• Incoming goods (purchased and in transit):
• Shipped under FOB destination would not be included in the inventory
• Shipped under FOB shipping point would be included in the inventory

In addition to this, if the company (consignor) has sales agent (consignee), unsold
goods on the hands of consignees have to be incorporated in the inventory of the
company (consignor).

The title of ownership on goods held on consignment remains with the consignor
until the consignee sells the goods and the goods must not be included in the

3 DEPARTMENT OF ACCOUNTING
physical inventory of the consignee; rather they have to be included in the
inventory of consignor.

B. Costing the physical inventory

The primary basis of accounting for inventories is cost, which is generally defined
as the price paid to acquire the assets. Inventory cost includes:
– Invoice price less purchase discounts.
– Freight or transportation cost.
– Taxes and tariffs.
– Insurance while in transit
Prices of merchandise purchased vary throughout the year. Many identical
products are be purchased at different prices. It is often impossible to determine
which products have been sold and which are still in inventory. It is necessary to
make an assumption about the order in which items have been sold. The
assumption is about the flow of costs rather than the flow of physical inventory.
These assumptions will be discussed in the following part.

Methods of Inventory costing (Inventory flow assumption):

Dear learner, we have said that the first activity in the inventory determination is
taking physical inventory or determining goods available in terms of quantity. Then
to prepare financial statements, the determined quantities have to be costed.
Therefore, inventory-costing methods are all about converting determined
quantities to costs. There are four possible inventory cost flow assumptions:
a) Average-cost method.
b) First-in, first-out method.
c) Last in, first-out method.
d) Specific identification method.

Average-Costing Method
It assumes that cost should be charged against revenue according to the weighted
average unit cost of the goods sold. The same unit cost or average unit cost is
computed for all inventory items available for sale during the period. As per the
assumption, cost of goods sold is computed by multiplying the number of units
sold by the average unit cost. Similarly, the cost of ending inventory is computed
by multiplying the number of units in ending inventory by the average unit cost.

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Average unit cost is computed by dividing total cost of goods available for sale for
total quantities available for sale.

First-In, First-Out (FIFO) Method

It assumes that inventory items purchased first are sold first. Therefore,
inventories (unsold merchandises) are from recent purchases and earliest
purchases are transferred to cost of goods sold. To obtain cost of ending inventory,
take the unit cost of most recent purchase and go upward until all units of
inventory are fully costed.

Last In, First-Out (LIFO) Method

It assumes that last purchases are the one to be sold first. Thus, inventories of
earliest purchases are kept as ending inventory and costs of goods sold are from
recent purchases. To determine the cost of ending inventory, take the unit cost of
earliest purchase and go downward until all units of inventory are fully costed.

Illustrative Data for the three Methods:

Assume the following information for WW Trading.

Data –for the month of June

June1: Inventory 50 units @ Br 1.0 = Br 50
June 6: Purchase 50 units @ Br 1.10 = 55
June 13: Purchase 150 units @ Br 1.20 = 180
June 20: Purchase 100 units @ Br 1.30 = 130

5 DEPARTMENT OF ACCOUNTING
 June 25: Purchase 150 units @ Br 1.40 = 210
GAFS * 500 units Br 625
Sales (280) units
June 30: 220 units on hand

* Goods available for sale (GAFS)

Periodic Average method

Average unit cost → 500 units @1.25 per unit=br. 625

Ending Inventory:
220 units @ br 1.25 = Br 275

Cost of goods sold (CGS):

280 units @ Br 1.25 per unit = Br 350
Or
CGS = Cost of goods available for sale - Ending Inventory

Cost of goods available for sale (COGAFS) Br 625

Less: June 30 inventory (275)
CG S Br 350

Periodic First-In, First-Out (FIFO) Method

Ending Inventory
150 units @ Br 1.40 from June 25 purchase Br 210
70 units @ Br Br1.30 from June 20 purchase 91
220 units @ a cost of-------------------------------Br 301

Cost of goods sold

Cost of goods available for sale Br 625
Less: June 30 inventory ( 301)
CGS Br 324

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Periodic Last-In, First-Out (LIFO) Method

Ending Inventory
50 units @ Br 1.00 from June 1 inventory Br 50
50 units @ Br 1.10 from June 6 purchase 55
120 units @ Br 1.20 from June 13 purchase 144
220 units Br 249

Cost of goods sold

Cost goods available for Br 625
Less: June 30 inventory 249
COGS Br 376

Costing Inventory under the Perpetual Inventory System

Use the following data to illustrate inventory costing under perpetual inventory
system using three cost flow assumptions.

Inventory Data for the month of June.

June 1: Inventory 50 units @ Br 1.00
6: Purchase 50 units @ Br 1.10
10: Sale 70 units
13: Purchase 150 units @ Br Br1.20
20: Purchase100 units @ Br Br1.30
25: Purchase150 units @ Br 1.40
30: Sale 210 units
30: Inventory 220 units

Perpetual Average method

Under perpetual system costing system, since continual record is kept for
merchandise transactions, new average cost is computed after each purchase,
rather than at the end of the period. This average unit cost is then used to
determine the cost of each sale until another purchase is made and new average
cost is computed. Thus the method is also called moving average method.

Did you identify periodic average and perpetual average methods of costing
inventory? Good! Let us proceed with the above illustration under perpetual
average costing method.

Dat Purchase Cost of goods sold Inventory

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 e Quantit Uni Tot Quantit Uni Total Quantit Unit Total
y t al y t cost y cost cost
Dat Purchase cos cost Post of goodscos
sold Inventory
e t t
quantit unit total quantit unit total quantit unit total
Jun1 y cos cost y cost cost y50 1
cost 50
cost
6 50 t
1.1 55 100 1.05* 105
jun1
10 70 1.05 73.5 50
30 1 1.05 50 31. 5
13 150 1.2 180 180
50 1 1.17550 211.5
206 100
50 1.3
1.1 130
55 280
50 1.21 55 341.5
1.1
25 150 1.4 210 430 1.28 551.5
10 50 1 50 30 1.1 33
30 210
20 1.1
1.28 22268.8 220 1.28 281.6
*
30 1.1 33
13 150 1.2 180 150 1.2 180

20 30 1.1 33
150 1.2 180 150 1.2 180
100 1.3 130 100 1.3 130
25 30 1.1 33
150 1.2 180
100 1.3 130
150 1.4 210 150 1.4 210
30 30 1.1 33 70 1.3 91
150 1.2 180 150 1.4 210
30 1.3 99

50+55 = 1.05
10
0+50
Cost of goods sold (268.8 +73.5) = Br Br342.3
Cost of Ending inventory = Br 281.6

Perpetual FIFO method

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Cost of goods sold (50+22+33+180+39) =Br324

Ending inventory (91+210) =Br301

9 DEPARTMENT OF ACCOUNTING
Dat Purchase Cost of goods sold Inventory
e Quantit Uni Tot Quantit Uni Tot Quantit Uni Total
y t al y t al y t cost
cos cost cos cost cos
t t t
Jun1 50 1.00 50.00
50 1.00 50.00
6 50 1.10 55 50 1.10 55.00
10 50 1.10 55 30 1.00 30.00
20 1.00 20
13 30 1.00 30.00
150 1.20 180 150 1.20 180.00
20 30 1.00 30.00
150 1.20 180 150 1.20 180.00
100 1.30 130 100 1.30 130.00
25 30 1.00 30.00
150 1.20 180.00
100 1.30 130.00
150 1.40 210 150 1.40 210.00
30 150 1.40 210 30 1.00 30.00
60 1.30 78 150 1.20 180.00
40 1.30 520.00
Cost of goods sold will be (55+20+210+78) =Br363

Cost of ending inventory will be (30+180+52) =Br262

Specific Identification Method

Unlike other cost flow assumptions Specific Identification Method is the method
where each item of inventory is identified with its actual cost any time. In other
words, each unit sold and unit on hand at the end of the period matches with its
actual cost. Although such a method might be possible for a business enterprise
handling a small number of items, for example, an automobile dealer, it becomes

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completely impossible in a complex manufacturing enterprise when the identity of

the individual item is lost. This method identifies unit cost of both item sold on the
date of sale and items remaining in inventory. Therefore, specific identification
method relates physical flow with the cost flow.

Even when specific identification is a feasible method of valuation, it may be

desirable from theoretical point of view. The method permits income manipulation
when there are identical items acquired at different unit price. In other words by
choosing to sell the items that were acquired at specific cost, the management
may cause material distortions in income.

Comparison of inventory costing methods

Each of the four methods of inventory costing is acceptable and used to prepare
financial statements. However, a business must be consistent in its use of a
method once it has made a choice. Using FIFO costing method in the periods of
rising prices may cause a business to report more than their true profit and pay
more income taxes. Because as per FIFO assumption ending inventories are from
the recent purchases that are of higher price .Therefore during inflation FIFO
resulted to higher ending balance of inventory. The higher is the ending inventory,
the lower is the cost of goods sold, and the lower is the cost of goods sold, the
higher is the net income. The higher is the net income the higher the income tax.
Hence, during inflation the business may have a tendency of using LIFO to value
inventory for its lower income tax. The reverse is true during the period of
declining price or deflation.

Valuing Inventory at Other than Cost

 Lower-of-Cost-or-Market (LCM)
In the inventory valuation, cost is usually the most appropriate basis for valuation
of inventory. Nevertheless, the inventory may be valued at lower of cost or market
when inventories are declined in price level. This loss may be recognized by writing
the inventory down to market, or current replacement cost. As per the method,
both market value and cost of an item are compared and the item is valued at the
lower of the two.
Example:
Lower of cost
Descripti Market value Cost or market
on
Item A 3800 4100 3800
Item B 3000 2700 2700
Item C 4650 4800 4650
Item D 3920 3920 3920
The Total 15,370 15520 actual
cost of 15,070 the
inventory is Br 15,

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520, but as per the method, it is going to be reported at Br 15,070 and the
difference, Br Br450 is the declined market value of merchandise or holding loss.

 Valuing Inventory by Estimation

Under periodic inventory system, inventories are estimated when interim financial
statements are to be prepared. Since inventory counting and determining actual
inventory balance is time consuming, costly and difficult task, we may be forced to
estimate inventory on hand. In addition to this, if it is impossible to determine
actual inventory, again we may estimate inventory .This is the case where
inventories are lost by hazards like theft, fire and the like. There are two methods
of estimating inventory balance: these are the retail and gross profit methods of
valuing inventories.

i. Retail Method
This method estimates the cost of ending inventory by using the ratio of cost to
retail price. Inventory at retail is the amount of the inventory at the marked selling
prices of the inventory items. To estimate inventory using this method, the
following information is required:
• The beginning inventory at cost and at retail.
• The amount of goods purchased during the period both at cost and at
retail.
Estimated ending inventory is then, inventory at retail multiplied by cost to retail
ratio.

Example:
Dan’s Shoe Store uses the retail inventory estimation method to value its ending
inventory. The following were summarized on Dec31, 2000

Beginning inventory at cost …… Br Br 40,000

Cost of goods purchased at cost …….. 100,000
Net sales ……………………………. 165, 000
Beginning inventory at retail ………… 57,000
Cost of goods purchased at retail … 143, 000

Required:
Estimate ending inventory at cost using the retail method.

Solution
Cost Retail

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Beginning inventory …………………..Br 40,000 Br 57,000

Add: Cost of goods purchased ………… 100,000 143,000
Merchandise available for sale Br 140,000 Br 200,000
Cost to retail ratio: 140,000 =70%
200,000
Less: Net sales …………………………………………………………………….
…..165,000
Merchandise inventory at retail………………………………………….…Br 35,000
Estimated inventory at cost
(35,000 X0.7)…………………………… Br 24,500

ii. Gross Profit Method of Estimation

This method assumes that the ratio of gross margin for a business stays relatively
stable year-to-year. Usually, it is used in place of the retail method when records of
the retail prices of beginning and purchases are not kept. Inventory balance
estimated using this method is acceptable for interim financial statements, but not
acceptable for annual financial statements. In addition, it is used to estimate value
of inventory lost in cases of fire, theft, or other hazards.

Example:
Assume That on March 1 the entire inventory of Fraol Company was destroyed by
fire. The records of the company revealed the following data:
Sales Br 105,000, Sales Returns and Allowances Br 5,000, Purchases Br 62,000,
Freight-in Br 2,000, and Purchase Returns and Allowances Br 1,000.
Required:
Estimate the merchandise lost by fire, assuming:
(a) A beginning inventory of Br30,000 and a gross profit rate of 40% on net sales.

Solution:

Gross profit percentage = Gross profit

Net sale
Gross profit =( net sale) X (gross profit percentage)
Gross profit = net sale –cost of goods sold

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 Estimated ending inventory = cost of goods available - cost of goods sold

Beginning inventory................................................ Br 30,000

Purchase……………………………62,000
Less: purchase return……… (1000)
Net purchase………………………61,000
Add: fright in…………………………2000
Cost of goods purchased……………………………………..…… 63,000
Cost of goods available for sale…………………………. …. 93,000
Net sales…………………………..…… 100,000
Less: gross profit (100,000x.4)… (40,000)
Estimated cost of goods sold…………………………………. (60,000)
Estimated inventory destroyed by fire………………... Br 33,000

Have you understood how inventories are estimated using gross profit and retail methods? Good! Let us
now do the following exercise.
Exercise 3.3
Dobby Gillis Company reported the following information for the months of
November and December 2008.
November
December
Cost of goods purchased Br 600,000 Br 700,000
Inventory, beginning-of-month 140,000 100,000
Inventory, end-of-month 100,000 ????
Sales 1,000,000 1,200,000
The company’s ending inventory at December 31 was destroyed by fire.
Instructions
(a) Compute the gross profit rate for November.
(b) Using the gross profit rate for November, determine the estimated cost
of inventory by fire during the month of December.

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15 DEPARTMENT OF ACCOUNTING