CHAPTER ONE

ACCOUNTING FOR INVENTORIES

Introduction
1.1 Nature and definitions of inventory
Merchandise on hand (not sold) at the end of the period is a current asset called merchandise
inventory. Inventory sold becomes the cost of merchandise sold. Merchandise inventory is a
large asset for most merchandising companies.
The term inventory refers to an asset items held for sale in the ordinary course of business or
items in the process of production for sale or items held for use or consumption in the production
of goods and services to be made available for sale. In the merchandise company, items have two
common characteristics: (1) They are owned by the company, and (2) they are in a form ready
for sale to customers in the ordinary course of business. Thus, merchandisers need only one
inventory classification, merchandise inventory, to describe the many different items that make
up the total inventory. In a manufacturing company, some inventory may not yet be ready for
sale. As a result, manufacturers usually classify inventory into three categories: finished goods,
work in process, and raw materials. Raw materials are the basic goods that will be used in
production but have not yet been placed into production. Work in process is that portion of
manufactured inventory that has been placed into the production process but is not yet complete.
Finished goods inventory is manufactured items that are completed and ready for sale. When the
finished goods are sold, the costs are transferred to cost of goods sold on the income statement.
Manufacturers normally use the term cost of goods sold rather than cost of merchandise sold to
describe the cost of products sold. Manufacturing inventories are normally disclosed in the notes
to the financial statements. The accounting concepts discussed in this chapter apply to the
inventory classifications of both merchandising and manufacturing companies. Our focus here is
on merchandise inventory.

1.2. Internal Control of Inventories

Inventory is used to indicate (1) merchandise held for sale in the normal course of business and
(2) materials in the process of production or held for production. Not only must the cost
inventory be determined, but good internal control over inventory must also be maintained. Two
primary objectives of internal control over inventory are safeguarding the inventory and properly
reporting it in the financial statements. These internal controls can be either preventive or
detective in nature. A preventive control is designed to prevent errors or misstatements from
occurring. A detective control is designed to detect an error or misstatement after it has occurred.
Control over inventory should begin as soon as the inventory is received. Pre-numbered
receiving reports should be completed by the company’s receiving department in order to
establish the initial accountability for the inventory. To make sure the inventory received is what

1
was ordered, each receiving report should agree with the company’s original purchase order for
the merchandise. Likewise, the price at which the inventory was ordered, as shown on the
purchase order, should be compared to the price at which the vendor billed the company, as
shown on the vendor’s invoice. After the receiving report, purchase order, and vendor’s invoice
have been reconciled, the company should record the inventory and related account payable in
the accounting records.
Controls for safeguarding inventory include developing and using security measures to prevent
inventory damage or employee theft. For example, inventory should be stored in a warehouse or
other area to which access is restricted to authorized employees. The removal of merchandise
from the warehouse should be controlled by using requisition forms, which should be properly
authorized. The storage area should also be climate controlled to prevent damage from heat or
cold. Further, when the business is not operating or is not open, the storage area should be
locked.
Using a perpetual inventory system for merchandise also provides an effective means of control
over inventory. The amount of each type of merchandise is always readily available in a
subsidiary inventory ledger. In addition, the subsidiary ledger can be an aid in maintaining
inventory quantities at proper levels. Frequently comparing balances with predetermined
minimum and maximum levels allows for timely reordering and prevents ordering excess
inventory.
To ensure the accuracy of the amount of inventory reported in the financial statements, a
merchandising business should take a physical inventory (i.e., count the merchandise). In a
perpetual inventory system, the physical inventory is compared to the recorded inventory in
order to determine the amount of shrinkage or shortage. If the inventory shrinkage is unusually
large, management can investigate further and take any necessary corrective action. Knowledge
that a physical inventory will be taken also helps prevent employee thefts or misuses of
inventory. How does a business “take” a physical inventory? The first step in this process is to
determine the quantity of each kind of merchandise owned by the business. A common practice
is to use teams of two persons. One person determines the quantity, and the other lists the
quantity and description on inventory count sheets. Quantities of high-cost items are usually
verified by supervisors or a second count team.
 Goods Flows and Cost Flows
Goods flow refers to the actual physical movement of goods in the operations of a company.
Cost flow refers to the association of costs with their assumed flow. The assumed cost flow may
or may not be the same as the actual goods flow. A difference arises because several choices of
assumed cost flow are available under generally accepted accounting principles. In fact, it is
sometimes preferable to use an assumed cost flow that bears no relationship to goods flow
because it results in a better estimate of income, which is the main goal of inventory accounting.

2
The first stage in the process of taking inventory is to determine the quantity of each kind of
merchandise owned by an enterprise. The physical count of inventory is needed under both
inventory systems.
What merchandise should be included in inventory? All the merchandise owned by the business
on the inventory date should be included. A complication in determining ownership is goods in
transit (on board a truck, train, ship, or plane) at the end of the period. The company may have
purchased goods that have not yet been received, or it may have sold goods that have not yet
been delivered. To arrive at an accurate count, the company must determine ownership of these
goods. For merchandise in transit, the party (the seller or the buyer) who has title to the
merchandise on the inventory date is the owner. To determine who has title, it may be necessary
to examine purchases and sales invoices of the last few days of the current period and the first
few days of the following period. Goods in transit should be included in the inventory of the
company that has legal title to the goods. Legal title is determined by the terms of the sale.
a) When the terms are FOB (free on board) shipping point, ownership of the goods passes to the
buyer when the public carrier accepts the goods from the seller.
b) When the terms are FOB destination, ownership of the goods remains with the seller until the
goods reach the buyer.
If goods in transit at the statement date are ignored, inventory quantities may be seriously
miscounted. Assume, for example, that XYZ Company has 20,000 units of inventory on hand on
December 31. It also has the following goods in transit:
1) Sales of 1,500 units shipped December 31 FOB destination.
2) Purchases of 2,500 units shipped FOB shipping point by the seller on December 31.
XYZ has legal title to both the 1,500 units sold and the 2,500 units purchased. If the company
ignores the units in transit, it would understate inventory quantities by 4,000 units (1,500 +
2,500).
As we will see later in the chapter, inaccurate inventory counts affect not only the inventory
amount shown on the balance sheet but also the cost of goods sold calculation on the income
statement.
Consigned Goods
In some lines of business, it is common to hold the goods of other parties and try to sell the
goods for them for a fee, but without taking ownership of the goods. These are called consigned
goods.
For example, you might have a used car that you would like to sell. If you take the item to a
dealer, the dealer might be willing to put the car on its lot and charge you a commission if it is
sold. Under this agreement, the dealer would not take ownership of the car, which would still
belong to you. Therefore, if an inventory count were taken, the car would not be included in the
dealer’s inventory. Many car, boat, and antique dealers sell goods on consignment to keep their
inventory costs down and to avoid the risk of purchasing an item that they won’t be able to sell.

3
Today even some manufacturers are making consignment agreements with their suppliers in
order to keep their inventory levels low.
No matter whether they are using a periodic or perpetual inventory system, all companies need to
determine inventory quantities at the end of the accounting period. If using a perpetual system,
companies take a physical inventory for two reasons:
a) To check the accuracy of their perpetual inventory records.
b) To determine the amount of inventory lost due to wasted raw materials, shoplifting, or
employee theft.
Companies using a periodic inventory system take a physical inventory to determine the
inventory on hand at the balance sheet date, and to determine the cost of goods sold for the
period. Determining inventory quantities involves two steps:
1) Taking a physical inventory of goods on hand and
2) Determining the ownership of goods.
Illustration 1.1
Beza Company completed its inventory count. It arrived at a total inventory value of Br.200,
000. As a new member of Beza’s accounting department, you have been given the information
listed below. Discuss how this information affects the reported cost of inventory.
a) Beza included in the inventory goods held on consignment for Jacob Co., costing Br.15, 000.
b) The company did not include in the count purchased goods of Br.10, 000 which were in
transit (terms: FOB shipping point).
c) The company did not include in the count sold inventory with a cost of Br.12, 000 which was
in transit (terms: FOB shipping point).
Solution:
The goods of Br.15, 000 held on consignment should be deducted from the inventory count. The
goods of Br.10, 000 purchased FOB shipping point should be added to the inventory count. Sold
goods of Br.12, 000 which were in transit FOB shipping point should not be included in the
ending inventory. Thus, inventory should be carried at Br.195, 000 (Br.200, 000 -Br.15, 000 +
Br.10, 000

1.3. The Effect of Inventory Errors on the Financial Statements

Unfortunately, errors occasionally occur in accounting for inventory. In some cases, errors are
caused by failure to count or price the inventory correctly. In other cases, errors occur because
companies do not properly recognize the transfer of legal title to goods that are in transit. When
errors occur, they affect both the income statement and the balance sheet.
1.3.1. Income Statement Effects
Under a periodic inventory system, both the beginning and ending inventories appear in the
income statement. The ending inventory of one period automatically becomes the beginning
inventory of the next period. Thus, inventory errors affect the computation of cost of goods sold
and net income in two periods. The effects on cost of goods sold can be computed by entering

4
incorrect data in the formula (beginning inventory + cost of goods purchased - ending inventory
= cost of goods sold) and then substituting the correct data.
1) Cost of goods (merchandise) sold =Beginning inventory + Net purchase - Ending
inventory
As you see, ending inventory is a deduction in the computation of cost of merchandise sold. So,
it has an indirect (negative) relationship to cost of merchandise sold, i.e. if ending inventory is
understated, the cost of merchandise sold will be overstated, and if ending inventory is
overstated, the cost of merchandise sold will be understated.
2) Gross Profit = Net sales – Cost of merchandise sold
Here, the cost of merchandise sold had indirect relationship to gross profit. So, the effect of
ending inventory on gross profit is the opposite of the effect on cost of merchandise sold. That is,
if ending inventory is understated, the gross profit will be understated and if ending inventory is
overstated, the gross profit will be overstated. This is a direct (positive) relationship.
3) Operating income = Gross Profit – Operating Expenses
Gross profit and operating income have direct relationships. Thus, the effect of ending inventory
on net income is the same as its effect on gross profit, i.e. direct (positive) effect (relationship).If
the error understates beginning inventory, and cost of goods sold will be understated. If the error
understates ending inventory, cost of goods sold will be overstated. The effects of inventory
errors will be illustrated using the periodic system. This is because it is easier to see the impacts
of inventory errors on the income statement using the periodic system. The effects of inventory
errors would be the same under the perpetual inventory system.
Inventory errors will misstate the income statement amounts for cost of merchandise sold, gross
profit, and net income. The effects of inventory errors on the current period’s income statement
are summarized.
Table 1
Table 1: Effects of inventory errors on current year’s income statement
Income Statement Effect
Inventory Error Cost of Merchandise Sold Gross Profit Net Income
Beginning Inventory
Understate Understate Overstate Overstate
Overstate Overstate Understate Understate
Ending Inventory
Understate Overstate Understate Understate
Overstate Understate Overstate Overstate

An error in the ending inventory of the current period will have a reverse effect on net income of
the next accounting period.
For example: A Br. 3000 understatement of ending inventory of the current year and no other
error was made, results understatement of total asset, owner’s equity, and net income of the

5
current year by Br.3000, and results overstatement of net income of the following period by Br.
3000 without affecting total assets.
Recall that one period’s ending inventory is the next period’s beginning inventory. Thus, an error
in ending inventory carries over into the next period.
Illustration 1.2
The following table illustrates the effect of an inventory error. Period 1’s ending inventory is
overstated by Br.10, 000. The error carries over to Period 2. Period 3 is correct. In fact, both
Period 1 and Period 2 should look like Period 3.
Table 2 Effects of Inventory Errors for different periods

The correct gross margin is Br.50, 000 for each period.

Ending inventory is subtracted in computing cost of goods sold in one period and the same
amount is added as beginning inventory the next period. An error in the ending inventory of the
current period will have a reverse effect on net income of the next accounting period.
Therefore, an inventory error cancels out after two periods. The overstatement of cost of goods
sold in Period 2 counterbalances the understatement for Period 1. Thus, the total gross margin for
the two periods combined is correct.
1.3.2. Balance Sheet Effects
Companies can determine the effect of ending inventory errors on the balance sheet by using the
basic accounting equation: Assets = Liabilities + Owner’s Equity.
i. Current assets: - Ending inventory is part of current assets, even the largest. So, it has a
direct (positive) relationship to current assets. If ending inventory balance is understated
(overstated), the total current assets will be understated (overstated). Since current assets are
part of total assets, ending inventory has direct relationship to total assets.
ii. Liabilities: - No effect on liabilities. Inventory misstatement has no effect on liabilities.
6
iii. Owners’ equity: - The net income will be transferred to the owners’ equity at the end of
accounting period. Closing income summary account does this. So, net income has direct
relationship with owners’ equity at the end of accounting period. The effect of ending
inventory on owners’ equity is the same as its effect on net income, i.e. if ending inventory
is understated (overstated), the owners’ equity will be understated (overstated).
Table 3: Effect of Inventory Errors on Current Period’s Balance Sheet

Balance Sheet Effect

Inventory Merchandise Current Asset Total Asset Owner’s Equity
Error Inventory (Capital)
Understate Understate Understate Understate Understate
Overstate Overstate Overstate Overstate Overstate
Illustration 1.4
The following amounts were reported in ABC Company’s financial statements for three
consecutive fiscal year ended December 31.
2016 2015 2014
a) Cost of merchandise sold Br. 360,000 Br.288, 000 Br. 150,000
b) Net income 140,000 105,000 51,000
c) Total Current assets 320,000 285,000 195,000
d) Owner’s equity 425,000 365,000 220,000
In making the physical counts of inventory, the following errors were made:
© Inventory on December 31, 2014, understated by Br. 10,000
© Inventory on December 31, 2015, overstated by Br. 15,000
Required:
Determine the correct amount of the items listed above.
Solution

2016 2015 2014

a) Cost of Goods Sold:
Reported Br. 360,000 Br. 288,000 Br. 150,000
Adjustment of
2014 error _ 10,000 (10,000)
2015 error (15,000) 15,000 -__
Corrected Bal. Br. 345,000 Br. 313,000 Br. 140,000
b) Net Income:

Reported Br. 140,000 Br. 105,000 Br. 51,000

Adjustment of
2014 error _ (10,000) 10,000
2015 error 15,000 (15,000) -_
7
Corrected Bal Br. 155,000 Br. 80,000 Br. 61,000

c) Total Current Assets:

Reported Br. 320,000 Br. 285,000 Br. 195,000
Adjustment of
2014 error - - 10,000
2015 error -___ (15,000) -__
Corrected Bal. Br. 320,000 Br. 270,000 Br. 205,000
d) Owner’s Equity:
Reported Br. 425,000 Br. 365,000 Br. 220,000
Adjustment of
2014 error - - 10,000
2015 error - (15,000) -__
Corrected Bal. Br. 425,000 Br. 350,000 Br. 230,000

1.4. Inventory Cost Flow Assumptions

Inventory is accounted for at cost. Cost includes all expenditures necessary to acquire goods and
place them in a condition ready for sale.

Specific Identification
Specific identification requires that companies keep records of the original cost of each
individual inventory item. Historically, specific identification was possible only when a company
sold a limited variety of high-unit-cost items that could be identified clearly from the time of
purchase through the time of sale. Examples of such products are cars, pianos, or expensive
antiques. A major disadvantage of the specific identification method is that management may be
able to manipulate net income. For example, it can boost net income by selling units purchased at
a low cost, or reduce net income by selling units purchased at a high cost.

Illustration 1.5
To illustrate, assume that three identical units of item X are purchased during May, as shown
below.
Date Item X Units Cost
May 10 Purchase 1 Br. 9
May 18 Purchase 1 13
May 24 Purchase 1 14
Total 3 Br.36
Br .36
Average cost per unit ………………………….. = Br.12
3

8
Assume that one unit is sold on May 30 for Br.20. If this unit can be identified with a specific
purchase, the specific identification method can be used to determine the cost of the unit sold.
For example, if the unit sold was purchased on May 18, the cost assigned to the unit is Br.13 and
the gross profit is Br.7 (Br.20 -Br.13). If, however, the unit sold was purchased on May 10, the
cost assigned to the unit is Br.9 and the gross profit is Br.11 (Br.20 -Br.9).The specific
identification method is not practical unless each unit can be identified accurately.

 Cost Flow Assumptions

Because specific identification is often impractical, other cost flow methods are permitted. These
differ from specific identification in that they assume flows of costs that may be unrelated to the
physical flow of goods. There are three assumed cost flow methods:

1. First-in, first-out (FIFO)

2. Last-in, first-out (LIFO)
3. Average-cost

There is no accounting requirement that the cost flow assumption be consistent with the physical
movement of the goods. Company management selects the appropriate cost flow method.

To demonstrate the three cost flow methods, we will use a periodic inventory system. We
assume a periodic system for two main reasons. First, many small companies use periodic rather
than perpetual systems. Second, very few companies use perpetual LIFO, FIFO, or average-cost
to cost their inventory and related cost of goods sold. Instead, companies that use perpetual
systems often use an assumed cost (called a standard cost) to record cost of goods sold at the
time of sale. Then, at the end of the period when they count their inventory, they recalculate cost
of goods sold using periodic FIFO, LIFO, or average-cost and adjust cost of goods sold to this
recalculated number

Illustration 1.6

To illustrate the three inventory cost flow methods, we will use the data for Change Electronics’,
shown in the following illustration.

Date Description Units Unit Cost Total Cost

Jan. 1 Beginning inventory 100 Br.10 Br. 1,000

Apr. 15 Purchase 200 11 2,200

Aug. 24 Purchase 300 12 3,600

Nov. 27 Purchase 400 13 5,200

Total units available for sale 1,000 Br.12,000

9
Units in ending inventory 450

Units sold 550

The cost of goods sold formula in a periodic system is:

(Beginning Inventory + Purchases) - Ending Inventory = Cost of Goods Sold

Change Electronics had a total of 1,000 units available to sell during the period (beginning
inventory plus purchases). The total cost of these 1,000 units is Br.12, 000, referred to as cost of
goods available for sale. A physical inventory taken at December 31 determined that there were
450 units in ending inventory. Therefore, Houston Change sold 550 units (1,000 - 450) during
the period. To determine the cost of the 550 units that were sold (the cost of goods sold), we
assign a cost to the ending inventory and subtract that value from the cost of goods available for
sale. The value assigned to the ending inventory will depend on which cost flow method we
use. No matter which cost flow assumption we use, though, the sum of cost of goods sold plus
the cost of the ending inventory must equal the cost of goods available for sale-in this case,
Br.12,000.

1.5. Inventory Costing Methods Under a Perpetual and Periodic Inventory System
Before looking more closely at the accounting for cost of goods sold, you need to understand the
difference between the periodic and the perpetual inventory systems. All businesses use one of
these two distinct approaches to account for inventory. Perpetual system is a system in which the
Inventory account is increased at the time of each purchase and decreased at the time of each
sale. Periodic system a system in which the Inventory account is updated only at the end of the
period.
With the perpetual system, the Inventory account is updated perpetually after each sale or
purchase of merchandise. Conversely, with the periodic system, the Inventory account is updated
only at the end of the period.
In a perpetual system, every time goods are purchased, the Inventory account is increased. When
that inventory is sold, the accountant records an entry to recognize the cost of the goods sold and
the decrease in the cost of inventory on hand.

1.5.1. Inventory Costing Methods under a Perpetual Inventory System

In a perpetual inventory system, all merchandise increases and decreases are recorded in a
manner similar to recording increases and decreases in cash. The merchandise inventory account
at the beginning of an accounting period indicates the merchandise in stock on that date.
Purchases are recorded by debiting Merchandise Inventory and crediting Cash or Accounts
Payable. On the date of each sale, the cost of the merchandise sold is recorded by debiting Cost
of Merchandise Sold and crediting Merchandise Inventory.

10
Journal entries to be made are:
1. At the time of purchase of merchandise
Merchandise inventory XX at cost
Accounts payable/cash XX
To record cost of Merchandise purchased
 At the time of sale of merchandise
Accounts receivable or cash XX at retail price
Sales XX
To record the sale
Cost of goods sold XX at cost
Merchandise inventory XX
To record the cost of merchandise sold or cost of sale
 To record purchase returns and allowances
Accounts payable or cash XX
Merchandise inventory XX
 No adjusting entry or closing entry for merchandise inventory is needed at the end of each
accounting period.
When identical units of an item are purchased at different unit costs during a period, a cost flow
must be assumed. In such cases, the FIFO, LIFO, or average cost method is used.
1. First-In, First-Out (FIFO) Method
The first-in, first-out (FIFO) method assumes that the earliest goods purchased are the first to be
sold. FIFO often parallels the actual physical flow of merchandise. Under the FIFO method,
therefore, the costs of the earliest goods purchased are the first to be recognized in determining
cost of goods sold. (This does not necessarily mean that the oldest units are sold first, but that the
costs of the oldest units are recognized first.

Under FIFO, since it is assumed that the first goods purchased were the first goods sold, ending
inventory is based on the prices of the most recent units purchased. That is, under FIFO,
companies obtain the cost of the ending inventory by taking the unit cost of the most recent
purchase and working backward until all units of inventory have been costed.

2. Last-In, First-Out (LIFO) Method

The last-in, first-out (LIFO) method assumes that the latest goods purchased are the first to be
sold. Under the LIFO method, the costs of the latest goods purchased are the first to be
recognized in determining cost of goods sold.

Under LIFO, since it is assumed that the first goods sold were those that were most recently
purchased, ending inventory is based on the prices of the oldest units purchased. That is, under
LIFO, companies obtain the cost of the ending inventory by taking the unit cost of the earliest
goods available for sale and working forward until all units of inventory have been costed.

3. Average Cost Method

When the average cost method is used in a perpetual inventory system, an average unit cost for
each type of item is computed each time a purchase is made. This unit cost is then used to
11
determine the cost of each sale until another purchase is made and a new average is computed.
This averaging technique is called a moving average. Since the average cost method is rarely
used in a perpetual inventory system.

Illustration 1.7
Now let’s see how to compute inventory amounts under the FIFO, LIFO and weighted-average-
cost methods. Begging inventory, purchase and sales for commodity B are as follows. Assume
that the units are sold for Br.30 each on account.
Date Item B Quantity Cost
Jan. 1 Inventory 10 Br.20
4 Sale 7
10 Purchase 8 21
22 Sale 4
28 Sale 2
30 Purchase 10 22
Required: Find the cost of merchandise sold in each sale, gross profit, the merchandise
inventory balance after each sale and journalize the transactions during the month by using
FIFO, LIFO and methods. If company uses perpetual inventory system

Solution

 Entries and Perpetual Inventory Account (FIFO)

Item B
Purchase Cost of Goods Sold Inventory
Date Qty Unit Total Qty Unit Cost Total cost Qt Unit Total
Cost cost y Cost cost
Jan 1 10 20 200
4 7 20 140 3 20 60
10 8 21 168 3 20 60
8 21 168
22 3 20 60 7 21 147
1 21 21
28 2 21 42 5 21 105
30 10 22 220 5 21 105
10 22 220
31 Balance 263 325
You should note that after the 7 units were sold on January 4, there was an inventory of 3 units at
Br.20 each. The 8 units purchased on January 10 were acquired at a unit cost of Br.21, instead of
Br.20. Therefore, the inventory after the January 10 purchase is reported on two lines, 3 units at
Br.20 each and 8 units at Br.21 each. Next, note that the Br.81 cost of the 4 units sold on January
22 is made up of the remaining 3 units at Br.20 each and 1 unit at Br.21. At this point, 7 units are

12
in inventory at a cost of Br.21 per unit. The remainder of the illustration is explained in a similar
manner.
Notice that you can use the familiar cost of goods sold model to check the accuracy of the
inventory record, as follows:
Beginning inventory…………………… Br.200

+Net purchases ……………………. 388

=Cost of goods available for sale…... Br.588

- Ending inventory…………………. (325)

=Cost of goods sold………………… Br.263

The ending inventory results using periodic inventory system under FIFO method is:

Date Quantity Unit Cost Total Cost

Jan 30 10 Br.22 Br.220
Jan 10 5 21 105
Ending Inventory 15 Br.325
Marchandise avalable for sale = 200 ([email protected]) + 168 ([email protected]) + 220 ([email protected]) Br.588
Deduct ending inventor……………………………………………………… 325

Cost of merchandise sold...........................................................................…...Br.263

Here, the ending inventory is Br.325, and the cost of goods sold is Br.263. Notice that in these
two FIFO examples, the cost of goods sold (Br.263) and ending inventory (Br.325) are the same.
Journal Entries Under FIFO
The journal entries under FIFO costing for the perpetual inventory system follow the data in the
FIFO inventory valuation table above. For example, on Jan 4, B Company sold 7 units of goods
for sales price of Br.30 each. B Company recorded the sale Br.210 (7 @ Br.30) and the cost of
goods sold (Br.140) and made the first journal entry. On Jan 10 purchased Br.168 of inventory
and made the second journal entry. The remaining journal entries (January 22 to January 30)
follow the inventory data in the FIFO inventory valuation table above.
FIFO Journal Entries: (All purchases and sales on account. The sale price is Br.30 per unit.)

Jan 4. Accounts Receivable 210

Sale 210
4 Cost of Merchandise Sold 140
Merchandise Inventory 140
10 Merchandise Inventory 168
Accounts Payable 168

13
22 Accounts Receivable 120
Sales 120
22 Cost of Merchandise Sold 81
Merchandise Inventory 81
28 Accounts Receivable 60
Sales 60
28 Cost of Merchandise Sold 42
Merchandise Inventory 42
30 Merchandise Inventory 220 220
Accounts Payable

Item B
Purchase Cost of Goods Sold Inventory
Date

Qty Unit Total Qt Unit Total cost Qty Unit Total

Cost cost y Cost Cost cost
Jan 1 10 20 200
4 7 20 140 3 20 60
10 8 21 168 3 20 60
8 21 168
22 4 21 84 3 20 60
4 21 84
28 2 21 42 3 20 60
2 21 42
30 10 22 220 3 20 60
2 21 42
10 22 220
31 Balance 266 322
 Entries and Perpetual Inventory Account (LIFO)

If you compare the ledger accounts for the FIFO perpetual system and the LIFO perpetual
system, you should discover that the accounts are the same through the January 10 purchase.
Using LIFO, however, the cost of the 4 units sold on January 22 is the cost of the units from the
January 10 purchase (Br.21 per unit). The cost of the 7 units in inventory after the sale on
January 22 is the cost of the 3 units remaining from the beginning inventory and the cost of the 4
units remaining from the January 10 purchase. The remainder of the LIFO illustration is
explained in a similar manner. The results using periodic inventory system under LIFO method
is:

14
Date Quantity Unit Cost Total Cost

Jan 1 10 Br.20 Br.200

Jan 10 5 21 105

Ending Inventory 15 Br.305

Marchandise avalable for sale = 200 ([email protected]) + 168 ([email protected]) + 220 ([email protected])Br.588

Deduct ending inventory …………………………………………………… 305

Cost of merchandise sold…………………………………………………. Br.283

Use of the LIFO method results in different ending inventory and cost of goods sold amounts
than the amounts calculated under the periodic method.

The month-end periodic inventory computation presented in the above illustration

(InventoryBr.305 and cost of goods sold Br.283) shows a different amount from the perpetual
inventory computation (inventory Br.322 and cost of goods sold Br.266).

The periodic system matches the total withdrawals for the month with the total purchases for the
month in applying the last-in, first-out method. In contrast, the perpetual system matches each
withdrawal with the immediately preceding purchases.

Notice that you can use the familiar cost of goods sold model to check the accuracy of the
inventory record, as follows:

Beginning inventory…………………… Br.200

+ Net purchases ……………………. 388

= Cost of goods available for sale…... Br.588

- Ending inventory…………………….(305)

= Cost of goods sold………………… Br.283

 Journal Entries Under LIFO

Jan 4. Accounts Receivable ……………………….. 210

Sales ……………………………………. 210
4 Cost of Merchandise Sold…………………. 140
Merchandise Inventory………………… 140
10 Merchandise Inventory ……………………. 168

15
 Accounts Payable 168
22 Accounts Receivable ………………………. 120
Sales …………………………………… 120
22 Cost of Merchandise Sold ………………… 84
Merchandise Inventory …………………. 84
28 Accounts Receivable ……………………… 60
Sales……………………………………. 60
28 Cost of Merchandise Sold…………………. 42
Merchandise Inventory.………………….. 42
30 Merchandise Inventory …………………….. 220
Accounts Payable ………………………… 220
 Average Cost Method

When the average cost method is used in a perpetual inventory system, an average unit cost for
each type of item is computed each time a purchase is made. This unit cost is then used to
determine the cost of each sale until another purchase is made and a new average is computed.

 Perpetual Inventory Account Weighted Average (Moving Average)

Purchase Cost of Goods Sold Inventory
Date

Qt Unit Total Qt Unit Total Qt Unit Cost Total

y Cost cost y Cost cost y cost
Jan 1 10 20 200
4 7 20 140 3 20 60
10 8 21 168 11 60+168 228
=20.73
3+8
22 4 20.73 82.92 7 20.73 145.11
28 2 20.73 41.46 5 20.73 103.65
30 10 22 220 15 103.65+220 323.70
=¿2
5+10
1.58
264.38 15 21.58 323.70
So, the cost of goods sold and ending inventory under perpetual inventory system areBr.264.38
and Br.323.70, respectively.
The results under periodic inventory system are:
Marchandise avalable for sale = 200 ([email protected]) + 168 ([email protected]) + 220 ([email protected]) = Br.588
Br .588
Weighted average unit cost = =Br .21
28

16
 Ending inventory cost = 15 @ Br.21= Br.315
Cost of goods sold= 13 @ Br.21 = Br.273
Cost of goods sold = Merchandise available for sale – cost of ending inventory
= Br.588 – Br.315 =Br.273
So, the result is different under periodic and perpetual inventory systems.

1.5.2. Inventory Costing Methods under a Periodic Inventory System

When the periodic inventory system is used, only revenue is recorded each time a sale is made.
No entry is made at the time of the sale to record the cost of the merchandise sold. At the end of
the accounting period, a physical inventory is taken to determine the cost of the inventory and
the cost of the merchandise sold.

Like the perpetual inventory system, a cost flow assumption must be made when identical units
are acquired at different unit costs during a period. In such cases, the FIFO, LIFO, or average
cost method is used.

The periodic inventory system is less costly to maintain than the perpetual inventory system, but
it gives management less information about the current status of merchandise.

This system is often used by retail enterprises that sell many kinds of low unit cost merchandises
such as groceries, drugstores, hardware etc.
The journal entries to be made are:
1. At the time of purchase of merchandise:
Purchases XX at cost
Accounts payable or cash XX
2. At the time of sale of merchandise:
Accounts receivable or cash XX at retail price
Sales XX
3. To record purchase returns and allowances:
Accounts payable or cash XX
Purchase returns and allowances XX at cost
4. To record adjusting entry or closing entry for merchandise inventory:
Income Summary XX
Merchandise inventory (beginning) XX
To close beginning Merchandise inventory
Merchandise inventory (ending) XX
Income Summary XX
To record ending Merchandise inventory
The cost of goods sold formula in a periodic system is:
(Beginning Inventory + Purchases) - Ending Inventory = Cost of Goods Sold
Illustration 1.8
The beginning inventory and purchase of an item during the year were as follows:

17
 Jan. 1 Inventory: 200 units at Br.9 Br. 1,800

Mar. 10 Purchase: 300 units at 10 3,000

Sept. 21 Purchase: 400 units at 11 4,400

Nov. 18 Purchase: 100 units at 12 1,200

Available for sale during year 1,000 Br.10,400

The physical count on December 31 shows that 300 units have not been sold.

Required:

a. Find the cost of inventory and cost of merchandise sold using FIFO, LIFO and average
cost method. If a company uses periodic inventory system.
b. For the periodic inventory system, assume that net sales were Br.15, 000. Show the
effects of each method (FIFO, LIFO and average cost) when prices are rising or
declining.

 FIFO Method
Using the FIFO method, the cost of the 700 units sold is determined as follows:
Earliest costs, Jan. 1: 200 units at Br. 9 Br.1,800
Next earliest costs, Mar. 10: 300 units at 10 3,000
Next earliest costs, Sept. 21: 200 units at 11 2,200
Cost of merchandise sold: 700 Br.7,000

Deducting the cost of merchandise sold of Br.7, 000 from the Br.10, 400 of merchandise
available for sale yields Br.3, 400 as the cost of the inventory at December 31. The Br.3, 400
inventories is made up of the most recent costs incurred for this item.

 LIFO Method
When the LIFO method is used, the cost of merchandise sold is made up of the most recent costs.
Based on the given data, the cost of the 700 units of inventory is determined as follows:

Most recent costs, Nov. 18: 100 units at Br.12 Br.1,200

Next most recent costs, Sept. 21: 400 units at 11 4,400
Next most recent costs, Mar. 10: 200 units at 10 2,000
Cost of merchandise sold: 700 Br.7,600
Deducting the cost of merchandise sold of Br.7, 600 from the Br.10, 400 of merchandise
available for sale yields Br.2,800 as the cost of the inventory at December 31. The Br.2, 800
inventories is made up of the earliest costs incurred for this item

 Average Cost Method

18
The average cost method is sometimes called the weighted average method. When this method is
used, costs are matched against revenue according to an average of the unit costs of the goods
sold. The same weighted average unit costs are used in determining the cost of the merchandise
inventory at the end of the period. For businesses in which merchandise sales may be made up of
various purchases of identical units, the average method approximates the physical flow of
goods. The weighted average unit cost is determined by dividing the total cost of the units of
each item available for sale during the period by the related number of units of that item. Using
the same cost data as in the FIFO and FIFO examples, the average cost of the 1,000 units,
Br.10.40, and the cost of the 700 units, Br.7, 280, are determined as follows:

 Average unit cost: Br.10,400/1,000 units =Br.10.40

 Cost of merchandise sold: 700 units at Br.10.40 =Br.7,280
Deducting the cost of merchandise sold of Br.7, 280 from the Br.10,400 of merchandise
available for sale yields Br.3,120 as the cost of the inventory at December 31.

Partial Income Statements

First-In First-Out Average Cost Last-In First-Out
Net sales Br.15, 000 Br.15, 000 Br.15,000
Cost of merchandise sold:
Beginning inventory Br.1, 800 Br.1,800 Br.1,800
Purchases 8,600 8,600 8,600
Merchandise available for sale Br.10, 400 Br.10,400 Br.10,400
Less ending inventory 3,400 3,120 2,800
Cost of merchandise sold 7,000 7,280 7,600
Gross profit Br.8, 000 Br.7, 720 Br.7, 400
As shown above table, the FIFO method yielded the lowest amount for the cost of merchandise
sold and the highest amount for gross profit (and net income). It also yielded the highest amount
for the ending inventory. On the other hand, the LIFO method yielded the highest amount for the
cost of merchandise sold, the lowest amount for gross profit (and net income), and the lowest
amount for ending inventory. The average cost method yielded results that were between those
of FIFO and LIFO.
Effects of Changing Costs (Prices): FIFO and LIFO Cost Methods

Increasing Cost Decreasing Costs

(Prices) (Prices)

Highest Lowest Highest Lowest

Amount Amount Amount Amount

Cost of merchandise sold LIFO FIFO FIFO LIFO

19
Gross profit FIFO LIFO LIFO FIFO

Net income FIFO LIFO LIFO FIFO

Ending merchandise inventory FIFO LIFO LIFO FIFO

During a period of increasing costs, LIFO matches more recent costs against sales on the income
statement. Thus, it can be argued that the LIFO method more nearly matches current costs with
current revenues. LIFO also offers an income tax savings during periods of increasing costs. This
is because LIFO reports the lowest amount of gross profit and, thus, taxable net income.
However, under LIFO, the ending inventory on the balance sheet may be quite different from its
current replacement cost. In such cases, the financial statements normally include a note that
estimates what the inventory would have been if FIFO had been used.

The weighted average cost method is, in a sense, a compromise between FIFO and LIFO. The
effect of cost (price) trends is averaged in determining the cost of merchandise sold and the
ending inventory.

1.6. Valuation of Inventory at Other Than Cost

As we indicated earlier, cost is the primary basis for valuing inventories. In some cases,
however, inventory is valued at other than cost. Two such cases arise when:

1. The cost of replacing items in inventory is below the recorded cost and
2. The inventory is not salable at normal sales prices. This latter case may be due to
imperfections, shop wear, style changes, or other causes.

1.6.1. Valuation at Lower of Cost or Market

The value of inventory for companies selling high-technology or fashion goods can drop very
quickly due to changes in technology or fashions. These circumstances sometimes call for
inventory valuation methods other than those presented so far. As you probably reasoned, this
situation requires a departure from the cost basis of accounting. When the value of inventory is
lower than its cost, companies can “write down” the inventory to its market value.

If the cost of replacing an item in inventory is lower than the original purchase cost, the lower-
of-cost-or-market (LCM) method is used to value the inventory. Market, as used in lower of cost
or market, is the cost to replace the merchandise on the inventory date. This market value is
based on quantities normally purchased from the usual source of supply. In businesses where
inflation is the norm, market prices rarely decline. In businesses where technology changes
rapidly (e.g., microcomputers and televisions), market declines are common. The primary

20
advantage of the lower-of-cost-or-market method is that gross profit (and net income) is reduced
in the period in which the market decline occurred. In applying the lower-of-cost-or-market
method, the cost and replacement cost can be determined in one of three ways. Cost and
replacement cost can be determined for (1) each item in the inventory, (2) major classes or
categories of inventory, or (3) the inventory as a whole. In practice, the cost and replacement
cost of each item are usually determined:

Illustration 1.9

The following are the inventory of ABC motor sports, retailer.

Inventory Per unit Total

Items Units Cost Market Cost Market
Category A:
Item 1 200 Br.80 Br. 70 Br.16,000 Br. 14,000
Item 2 100 40 50 4,000 5,000
Category B:
Item X 100 Br.30 Br. 30 Br. 3,000 Br. 3,000
Item Y 150 50 80 7,500 12,000
Required: Compute cost of inventory under lower of cost or market for;

A. Each item of inventory

B. Each category of inventory
C. Inventory as a whole
Lower of Cost or Market

Lower of Cost or Market

Individual Major Total
Inventory Items Cost Market Items Categories Inventory
Category A:
Item 1 Br. 16,000 Br. 14,000 14000
Item 2 4,000 5,000 4000 19000
Total of category
A 20,000 19,000
Category B:
Item X Br. 3,000 Br. 3,000 3000
Item Y 7,500 12,000 7500
Total of Category
B 10500 15000 10500 10500
Grand Total 30500 34000 28500 29500 30500

If ABC motor sports applied the lower-of-cost-or-market rule to individual items, the amount of
inventory is Br.28,500. If applying the rule to major categories, it jumps to Br.29,500. If
applying LCM to the total inventory, it totals Br.30, 500. Why this difference? When a company

21
uses a major categories or total inventory approach, market values higher than cost offset market
values lower than cost. For ABC motor sports, using the major categories approach partially
offsets the high market value for “item 1” and “item y”. Using the total inventory approach
totally offsets it.

1.6.2. Valuation at Net Realizable Value

Merchandise that is out of date, spoiled, or damaged or that can be sold only at prices below cost
should be written down. Such merchandise should be valued at net realizable value. Net
realizable value is the estimated selling price less any direct cost of disposal, such as sales
commissions. For example, assume that damaged merchandise costing Br.1,000 can be sold for
only Br.800, and direct selling expenses are estimated to be Br.150. This inventory should be
valued at Br.650 (Br.800 -Br.150), which is its net realizable value.

1.6. Estimating Inventory Cost

Two circumstances explain why companies sometimes estimate inventories. First, a casualty
such as fire, flood, or earthquake may make it impossible to take a physical inventory. Second,
managers may want monthly or quarterly financial statements, but a physical inventory is taken
only annually. The need for estimating inventories occurs primarily with a periodic inventory
system because of the absence of perpetual inventory records. There are two widely used
methods of estimating inventories: (1) the gross profit method, and (2) the retail inventory
method. Gross Profit Method The gross profit method estimates the cost of ending inventory by
applying a gross profit rate to net sales. This method is relatively simple, but effective.
Accountants, auditors, and managers frequently use the gross profit method to test the
reasonableness of the ending inventory amount. It will detect large errors. To use this method, a
company needs to know its net sales, cost of goods available for sale and gross profit rate. The
company then can estimate its gross profit for the period.

To illustrate, assume that Kishwaukee Company wishes to prepare an income statement for the
month of January. Its records show net sales of $200,000, beginning inventory $40,000, and cost
of goods purchased $120,000. In the preceding year, the company realized a 30% gross profit
rate. It expects to earn the same rate this year. Given these facts and assumptions, Kishwaukee

22
can compute the estimated cost of the ending inventory at January 31 under the gross profit
method as follows

The gross profit method is based on the assumption that the gross profit rate will remain
constant. But it may not remain constant, due to a change in merchandising policies or in market
conditions. In such cases, the company should adjust the rate to reflect current operating
conditions. In some cases, companies can obtain a more accurate estimate by applying this
method on a department or product-line basis. Note that companies should not use the gross
profit method to prepare financial statements at the end of the year. These statements should be
based on a physical inventory count.

Retail Inventory Method

A retail store such as Home Depot, Ace Hardware, or Wal-Mart has thousands of different types
of merchandise at low unit costs. In such cases it is difficult and time-consuming to apply unit
costs to inventory quantities. An alternative is to use the retail inventory method to estimate the
cost of inventory. Most retail companies can establish a relationship between cost and sales
price. The company then applies the cost-to-retail percentage to the ending inventory at retail
prices to determine inventory at cost. Under the retail inventory method, a company’s records
must show both the cost and retail value of the goods available for sale. Illustration 6B-3
presents the formulas for using the retail inventory method.

We can demonstrate the logic of the retail method by using unit-cost data. Assume that Ortiz Inc.
has marked 10 units purchased at $7 to sell for $10 per unit. Thus, the cost-to-retail ratio is 70%
($70/ $100). If four units remain unsold, their retail value is $40 (4 x $10), and their cost is $28
($40 x 70%). This amount agrees with the total cost of goods on hand on a per unit basis (4x $7).

23
The retail inventory method also facilitates taking a physical inventory at the end of the year.
Valley West can value the goods on hand at the prices marked on the merchandise, and then
apply the cost-to-retail ratio to the goods on hand at retail to determine the ending inventory at
cost. The major disadvantage of the retail method is that it is an averaging technique. Thus it
may produce an incorrect inventory valuation if the mix of the ending inventory is not
representative of the mix in the goods available for sale. Assume, for example, that the cost-to-
retail ratio of 75% for Valley West Co. consists of equal proportions of inventory items that have
cost-to-retail ratios of 70%, 75% and 80%. If the ending inventory contains only items with a
70% ratio, an incorrect inventory cost will result. Companies can minimize this problem by
applying the retail method on a department or product-line basis.

Statement Presentation and Analysis

Inventory is classified in the balance sheet as a current asset immediately below receivables. In a
multiple-step income statement, cost of goods sold is subtracted from sales. There also should be
disclosure of (1) the major inventory classifications (2) the basis of accounting (cost or lower-of
or-market) and (3) the cost method (FIFO, LIFO or average).

Analysis

The amount of inventory carried by a company has significant economic consequences. And
inventory management is a double-edged sword that requires constant attention. On the one
hand, management wants to have a great variety and quantity on hand so that customers have a
wide selection and items are always in stock. But such a policy may incur high carrying costs
(e.g., investment, storage, insurance, obsolescence, and damage). On the other hand, low
inventory levels lead to stock outs and lost sales. Common ratios used to manage and evaluate
inventory levels are inventory turnover and a related measure, days in inventory. Inventory
turnover measures the number of times on average the inventory is sold during the period. Its
purpose is to measure the liquidity of the inventory. The inventory turnover is computed by
dividing cost of goods sold by the average inventory during the period.

24
For example, Wal-Mart reported in its 2008 annual report a beginning inventory of $33,685
million, an ending inventory of $35,180 million, and cost of goods sold for the year ended
January 31, 2008, of $286,515 million. The inventory turnover formula and computation for
Wal-Mart are shown below a variant of the inventory turnover ratio is days in inventory. These
measures the average number of day’s inventory is held. It is calculated as 365 divided by the
inventory turnover ratio. For example, Wal-Mart’s inventory turnover of 8.3 times divided into
365 is approximately 44 days. This is the approximate time that it takes a company to sell the
inventory once it arrives at the store. There are typical levels of inventory in every industry.
Companies that are able to keep their inventory at lower levels and higher turnovers and still
satisfy customer needs are the most successful.

25