Chapter-4

Inventory
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 Contents
• Nature and classification of inventory
• Physical goods and costs included in inventory
• Valuation of inventories: A cost-basis approach
• Special inventory valuation methods
Lower-of-cost-or-net realizable value (LCNRV) method
Gross profit method
Retail-inventory method
Nature and classification of inventory-Definition of Inventory

Inventories are:
» Assets held for sale in the ordinary course of business;

» Assets in the process of production for such sale; or

» Assets in the form of materials or supplies to be

consumed in the production process or in the rendering
of services.
» The investment in inventories is frequently the largest
current asset of merchandising (retail) and manufacturing
businesses

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 Classification
Businesses with Inventory

Merchandising or Manufacturing
Company Company
Classification of Inventory
Classification of inventory in merchandise business
 Usually purchases its merchandise in a form ready for
sale.
 It reports the cost assigned to unsold units left on hand
as merchandise inventory.
 Only one inventory account, Merchandise Inventory,
appears in the financial statements.

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 Cont…

 One inventory
account.
 Purchase
merchandise in a
form ready for sale.
Classification of inventory in manufacturing business
• Manufacturing concerns, on the other hand, produce
goods to sell to merchandising firms.
• Although the products they produce may differ,
manufacturers normally have three inventory accounts
– Raw Materials,
– Work in Process, and
– Finished Goods.

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 Cont…

Three accounts
 Raw Materials
 Work in Process
 Finished Goods
9
Inventory Cost Flow

Companies use one of two types of systems for maintaining

inventory records - perpetual system or periodic system.
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1. Perpetual System
 A perpetual inventory system continuously tracks changes
in the Inventory account.
 The perpetual inventory system provides a continuous record of
Inventory and Cost of Goods Sold.
 The accounting features of a perpetual inventory system are
as follows.
1. Purchases of merchandise for resale or raw materials for production
are debited to Inventory rather than to Purchases.
2. Freight-in is debited to Inventory. Purchase returns and allowances
and purchase discounts are credited to Inventory.
3. Cost of goods sold is debited and Inventory is credited for each sale.
4. Subsidiary records show quantity and cost of each type of inventory
on hand.
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2. Periodic System
Under a periodic inventory system, a company determines
the quantity of inventory on hand only periodically, as the
name implies.
It records all acquisitions of inventory during the accounting
period by debiting the Purchases account.
A company then adds the total in the Purchases account at
the end of the accounting period to the cost of the
inventory on hand at the beginning of the period.
This sum determines the total cost of the goods available
for sale during the period.

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Periodic system
1. Purchases of merchandise are debited to Purchases.
2. Ending Inventory determined by physical count.
3. At the time of sale no need of recording CGS
4. Calculation of Cost of Goods Sold:

Beginning inventory $ 100,000

Purchases, net 800,000
Goods available for sale 900,000
Ending inventory 125,000
Cost of goods sold $ 775,000

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 Comparing Perpetual and Periodic Systems

Illustration: Fesmire Company had the following

transactions during the current year.

Record these transactions using the Perpetual and

Periodic systems.

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Solution

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Illustration: Assume that at the end of the reporting period,
the perpetual inventory account reported an inventory balance
of $4,000. However, a physical count indicates inventory of
$3,800 is actually on hand. The entry to record the necessary
write-down is as follows.

Inventory Over and Short 200

Inventory 200

Note: Inventory Over and Short adjusts Cost of Goods Sold. In

practice, companies sometimes report Inventory Over and
Short in the “Other income and expense” section of the
income statement.

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Inventory Control
All companies need periodic verification of the inventory
records by actual count, weight, or measurement, with the
counts compared with the detailed inventory records.

Companies should take the physical inventory near the end

of their fiscal year, to properly report inventory quantities
in their annual accounting reports.

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 Basic Issues in Inventory Valuation
Goods sold (or used) during an accounting period rarely
correspond exactly to the goods bought (or produced)
during that period.
As a result, inventories either increase or decrease during
the period.
Companies must allocate the cost of all the goods available
for sale (or use) between the goods that were sold or used
and those that are still on hand.

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 Cont…
 Valuation requires determining the following three points
properly.

1. The physical goods to include in inventory (who owns

the goods?)—goods on hand, goods in transit,
consigned goods, special sales agreements.

2. The costs to include in inventory (product vs. period

costs).

3. The cost flow assumption to adopt (average cost,

FIFO).
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 1. Physical Goods Included in Inventory
» A company should record purchases when it obtains legal title to
the goods.

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 a. Goods in Transit
Example: ABC determines ownership by applying the “passage of
title” rule.
 If a supplier ships goods to ABC FOB shipping point, title passes
to ABC when the supplier delivers the goods to the common
carrier, who acts as an agent for ABC.
 If the supplier ships the goods FOB destination, title passes to
ABC only when it receives the goods from the common carrier.
“Shipping point” and “destination” are often designated by a particular
location, for example, f.o.b. Addis Abeba.
b. Consigned Goods
Example: Williams Art Gallery (the consignor) ships various art
merchandise to ABC (the consignee), who acts as Williams’ agent
in selling the consigned goods.
 ABC agrees to accept the goods without any liability, except
to exercise due care and reasonable protection from loss or
damage, until it sells the goods to a third party.
 When ABC sells the goods, it remits the revenue, less a
selling commission and expenses incurred, to Williams.

NB: Goods out on consignment remain the property of

the consignor (Williams).
c. Sales with Repurchase Agreements
Example: Hill Enterprises transfers (“sells”) inventory to Chase,
Inc. and simultaneously agrees to repurchase this merchandise
at a specified price over a specified period of time. Chase then
uses the inventory as collateral and borrows against it.
 Essence of transaction is that Hill Enterprises is financing
its inventory—and retains control of the inventory—even
though it transferred to Chase technical legal title to the
merchandise.
 Often described in practice as a “parking transaction.”
 Hill should report the inventory and related liability on
its books.
 d. Sales with Rights of Return
Example: XYZ Company sells textbooks to Campus Bookstores
with an agreement that Campus may return for full credit any
books not sold. XYZ should recognize:
a) Revenue from the textbooks sold that it expects will not be
returned.
b) A refund liability for the estimated books to be returned.
c) An asset for the books estimated to be returned which
reduces the cost of goods sold.
If xyz is unable to estimate the level of returns, it should not
report any revenue until the returns become predictive.
 Effect of Inventory Errors
• Failing to include some items in ending inventory will have the
following effects on the financial statements at the end of the
period.

• If ending inventory is understated, working capital and the current

ratio are understated.
• If cost of goods sold is overstated, then net income is understated.

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The effect of an error on net income in one year (2011) will be
counterbalanced in the next (2012), however the income statement
will be misstated for both years.
Illustration: Jay Weiseman Corp. understates its ending inventory
by $10,000 in 2011; all other items are correctly stated.

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 2. Costs Included in Inventory
 Product Costs
 Product costs are those costs that “attach” to the inventory.
 As a result, a company records product costs in the inventory
account.
 These costs are directly connected with bringing the goods to
the buyer’s place of business and converting such goods to a
salable condition.
• Cost of purchase includes all of:
1. The purchase price.
2. Import duties and other taxes.
3. Transportation costs.
4. Handling costs directly related to the acquisition of the goods.
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 Cont….
 Period Costs
 Period costs are those costs that are indirectly related to
the acquisition or production of goods. Generally selling,
general, and administrative expenses, not included as part
of inventory cost.
 Purchase Discounts
 Purchase or trade discounts are reductions in the selling
prices granted to customers.
 IASB requires these discounts to be recorded as a
reduction from the cost of inventories.
 Gross vs. Net Method

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 Treatment of Purchase Discounts

**

ILLUSTRATION 8-11 * $4,000 x 2% = $80 ** $10,000 x 98% = $9,800

Entries under Gross and
Net Methods
 3. Cost Flow Assumption
• During any given fiscal period, companies typically purchase
merchandise at several different prices.
• If a company prices inventories at cost and it made
numerous purchases at different unit costs, which cost price
should it use?
• Conceptually, a specific identification of the given items sold
and unsold seems optimal.
• But this measure often proves both expensive and
impossible to achieve.
• Consequently, companies use one of several systematic
inventory cost flow assumptions.
 The three method of cost flow assumption are
1. Specific Identification
2. Average Cost
3. Firs in, First out (FIFO) 30
 Illustration
Assume that Call-Mart Inc. had the following transactions in its first
month of operations.

Calculate Goods Available for Sale

Beginning inventory (2,000 x €4) € 8,000
Purchases:
6,000 x €4.40 26,400
2,000 x €4.75 9,500
Goods available for sale €43,900
1.Specific Identification

 Cost of goods sold includes costs of the specific items

sold.
 Used when handling a relatively small number of
costly, easily distinguishable items.
 Matches actual costs against actual revenue.
 Cost flow matches the physical flow of the goods.
 May allow a company to manipulate net income.
Illustration:
Call-Mart Inc.’s 6,000 units of inventory consists of 1,000 units from the
March 2 purchase, 3,000 from the March 15 purchase, and 2,000 from the
March 30 purchase. Compute the amount of ending inventory and cost of
goods sold.
2. Weighted-Average Method
 Prices items in the inventory on the basis of
the average cost of all similar goods available
during the period.
 Not as subject to income manipulation.
 Measuring a specific physical flow of
inventory is often impossible.
Illustration:
 cont,….

Moving-Average Method

In this method, Call-Mart computes a new average unit cost each

time it makes a purchase.
3. First-In, First-Out (FIFO)
 Assumes goods are used in the order in
which they are purchased.
 Approximates the physical flow of goods.
 Ending inventory is close to current cost.
 Fails to match current costs against current
revenues on the income statement.
Illustration:
Periodic Inventory System

Determine cost of ending inventory by taking the cost of

the most recent purchase and working back until it
accounts for all units in the inventory.
 Illustration:
Perpetual Inventory System

In all cases where FIFO is used, the inventory and cost

of goods sold would be the same at the end of the
month whether a perpetual or periodic system is used.
 Special valuation:
1. Lower-of-Cost-or-Net Realizable Value (LCNRV)
• A company abandons the historical cost principle when
the future utility (revenue-producing ability) of the asset
drops below its original cost.
Net Realizable Value
Estimated selling price in the normal course of business less
 estimated costs to complete and
 estimated costs to make a sale.

Illustration

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Illustration of LCNRV:

ABC computes its inventory at LCNRV (amounts in

thousands).
Methods of Applying LCNRV
Recording Net Realizable Value

Illustration: Data for Ricardo Company

Cost of goods sold (before adj. to NRV) €108,000
Ending inventory (cost) 82,000
Ending inventory (at NRV) 70,000

Loss
Loss Loss Due to Decline to NRV 12,000
Method
Method Inventory (€82,000 - €70,000)

12,000
COGS
COGS Cost of Goods Sold 12,000
Method
Method Inventory

12,000
Use of an Allowance

Instead of crediting the Inventory account for net realizable

value adjustments, companies generally use an allowance
account.

Loss
Loss Method
Method

Loss Due to Decline to NRV 12,000

Allowance to Reduce Inventory to NRV
12,000
Agricultural Inventory NRV
Biological asset (classified as a non-current asset) is a living
animal or plant, such as sheep, cows, fruit trees, or cotton
plants.
 Biological assets are measured on initial recognition and at
the end of each reporting period at fair value less costs to sell
(NRV).
 Companies record gain or loss due to changes in NRV of
biological assets in income when it arises.
Agricultural Inventory NRV
Agricultural produce is the harvested product of a biological
asset, such as wool from a sheep, milk from a dairy cow, picked
fruit from a fruit tree, or cotton from a cotton plant.
 Agricultural produce are measured at fair value less costs to
sell (NRV) at the point of harvest.
 Once harvested, the NRV becomes cost.
 Illustration:
Bancroft Dairy produces milk for sale to local cheese-makers.
Bancroft began operations on January 1, 2015, by purchasing 420
milking cows for €460,000. Bancroft provides the following
information related to the milking cows.
 Agricultural Accounting at NRV

Bancroft makes the following entry to record the change in

carrying value of the milking cows.

Biological Asset (milking cows) 33,800

Unrealized Holding Gain or Loss—Income 33,800
Agricultural Accounting at NRV

Biological Asset (milking cows) 33,800

Unrealized Holding Gain or Loss—Income

33,800
Reported on the Statement of financial position as a non-
current asset at fair value less costs to sell (net realizable
value).

Reported as “Other income and expense” on the income

statement.
Agricultural Accounting at NRV

Illustration: Bancroft makes the following summary entry to

record the milk harvested for the month of January.
Inventory (milk) 36,000
Unrealized Holding Gain or Loss—Income
36,000
Assuming the milk harvested in January was sold to a local
cheese-maker for €38,500, Bancroft records the sale as follows.
Cash 38,500
Sales Revenue 38,500

Cost of Goods Sold 36,000

Inventory (milk) 36,000
2. Gross Profit Method
Illustration-1: Cetus Corp. has a beginning inventory of €60,000
and purchases of €200,000, both at cost. Sales at selling price
amount to €280,000. The gross profit on selling price is 30
percent. Cetus applies the gross margin method as follows.

LO 5
Illustration-2

Astaire Company uses the gross profit method to estimate inventory

for monthly reporting purposes. Presented below is information for the
month of May.
Inventory, May 1 € 160,000 Sales € 1,000,000
Purchases (gross) 640,000 Sales returns 70,000
Freight-in 30,000 Purchases discounts 12,000

Instructions:
Compute the estimated inventory at May 31, assuming that the gross
profit is 25% of sales.

LO 5
Solution
Compute the estimated inventory at May 31, assuming that the
gross profit is 25% of sales.

Inventory, May 1 (at cost) € 160,000

Purchases (gross) (at cost) 640,000
Purchase discounts (12,000)
Freight-in 30,000
Goods available (at cost) 818,000
Sales (at selling price) € 1,000,000
Sales returns (at selling price) (70,000)
Net sales (at selling price) 930,000
Less: Gross profit (25% of €930,000) 232,500
Sales (at cost) 697,500
Approximate inventory, May 31 (at cost) € 120,500

LO 5
3. Retail Inventory Method
Method used by retailers to compile inventories at retail prices.
Retailer can use a formula to convert retail prices to cost.
Requires: retailers to keep a record of:
1) Total cost and retail value of goods purchased.

2) Total cost and retail value of the goods available for sale.

3) Sales for the period.

LO 6
RETAIL INVENTORY METHOD

Illustration: The following data pertain to a single department for

the month of October for Fuque Inc. Prepare a schedule computing
retail inventory using the Conventional and Cost methods.

COST RETAIL
Beg. inventory, Oct. 1 £ 52,000 £ 78,000
Purchases 272,000 423,000
Freight in 16,600
Purchase returns 5,600 8,000
Additional markups 9,000
Markup cancellations 2,000
Markdowns (net) 3,600
Normal spoilage and breakage 10,000
Sales 390,000
LO 6
Solution

Cost to
COST RETAIL Retail %
Beginning inventory £ 52,000 £ 78,000
Purchases 272,000 423,000
Purchase returns (5,600) (8,000)
Freight in 16,600
Markups, net 7,000
Current year additions 283,000 422,000
Goods available for sale 335,000 500,000 67.0%
Markdowns, net (3,600)
Normal spoilage and breakage (10,000)
Sales (390,000)
Ending inventory at retail £ 96,400

Ending inventory at Cost:

£ 96,400 x 67.0% = £ 64,588

LO 6
I thank you
All!
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