Chapter One

Accounting for Inventories

1.1. Introduction

Inventories are asset items held for sale in the ordinary course of business or goods that will be
used or consumed in the production of goods to be sold. They are mainly divided into two major:
 Inventories of merchandising businesses
 Inventories of manufacturing businesses
i. Inventories of merchandising businesses are merchandise purchased for resale in the
normal course of business. These types of inventories are called merchandise
inventories.
ii. Inventories of manufacturing businesses manufacturing businesses are businesses that
produce physical output. They normally have three types of inventories. These are:
 Raw material inventory
 Work in process inventory
 Finished goods inventory
a) Raw material inventory -is the cost assigned to goods and materials on hand but not yet
placed into production. Raw materials include the wood to make a chair or other office
furniture’s, the steel to make a car etc.
b) Work in process inventory- is the cost of raw material on which production has been
started but not completed, plus the direct labor cost applied specifically to this material
and allocated manufacturing overhead costs.
c) Finished goods inventory- is the cost identified with the completed but unsold units on hand at
the end of each period.

In this unit only the determination of the inventory of merchandise purchased for resale
commonly called merchandise inventory will be discussed.

1.2 Importance of Inventories

Merchandise purchased and sold is the most active elements in merchandising business, i.e. in
wholesale and retail type of businesses. This is due to the following reasons:

a) The sale of merchandise is the principal source of revenue for them.

b) The cost of merchandise sold is the largest deductions from sales.
c) Inventories (ending inventories) are the largest current assets

Because of the above reasons inventories, have effects on the current and the following period’s
financial statements. If inventories are misstated(understated or overstated), the financial
statements will be distorted.
1.3 The Effects of inventories on current and following period’s financial statements.

Any errors in merchandise inventory will affect the balance sheet and income statement.Some
reasons that inventory errors may occur include the following:
Physical inventory on hand was miscounted.
Costs were incorrectly assigned to inventory. For example, the FIFO, LIFO, oraverage
cost method was incorrectly applied.
Inventory in transit was incorrectly included or excluded from inventory.

1.3.1 Effect of ending inventory on current period’s financial statements

Ending inventory is the cost of merchandise on hand at the end of accounting period. Let us see
its effect on current period’s financial statements.

Income statement

a. Cost of goods (merchandise) sold =Beginning inventory + Net

purchase – Ending inventory
As you see, ending inventory is a deduction in calculation 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.

b. 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.

c. 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).

Balance Sheet
1. 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.
2. Liabilities- No effect on liabilities. Inventory misstatement has no effect on liabilities.
3. 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-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).
1.3.2 Effects of beginning inventory on current period’s financial statements
Beginning inventory is inventory balance that was left on hand in the previous period and
transferred to the current period. Its effect is summarized below:
Income Statement

1. Cost of merchandise sold= Beginning inventory + Net Purchases – Ending inventory

As you see, beginning inventory is an addition in determining cost of goods sold. It has
direct effect on cost of merchandise sold. That is, if the beginning inventory is
understated (Overstated), the cost of merchandise sold will be understated (Overstated)

2. Gross Profit= Net Sales – Cost of merchandise sold

The effect of beginning inventory on gross profit is the opposite of the effect on cost of
merchandise sold, i.e. indirect (negative) relationship. If the beginning inventory is
understated, the gross profit will be overstated and if it is overstated, the gross profit will
be understated.

3. Net income = Gross Profit – Operating expenses

The effect of beginning inventory on net income is the same as its effect on gross profit.

Balance sheet
1. Current assets – The inventory included in current assets is the ending inventory. So,
beginning inventory has no effect on current assets.
2. Owners’ equity- If the effect comes from the previous year, the beginning inventory will
not have an effect on ending owners’ equity since the positive or negative effect of the
previous year will be netted off by the negative or positive effect of the current year. But
if the error is made in the current period, it will have indirect effect on ending owners’
equity.
1.3.3 Effect of ending inventory on the following period’s financial statements
The ending inventory of the current period will become the beginning inventory for the
following period. So, it will have the same effect as beginning inventory of the current period.
Let us summarize it.
Income statement of the following period
Cost of merchandise sold direct relationship
Gross profit indirect relationship
Net income indirect relationship
Balance sheet of the following period
The ending inventory of the current period will not have an effect on the following period’s
balance sheet items.
To illustrate, we use the income statements of Sami Company shown below. On December 31,
2009, assume that Sami Company incorrectly records its physical inventoryas $50,000 instead of
the correct amount of $60,000. Thus, the December 31,2009, inventory is understated by
$10,000 ($60,000 _ $50,000). As a result, the cost ofmerchandise sold is overstated by $10,000.
The gross profit and the net income for theyear will also be understated by $10,000.

Sami Company
Income Statement
For the Years Ended December 31, 2009 and 2010
2009 2010
Correct Incorrect Incorrect Correct
Net sales $980,000 $980,000 $1,100,000 $1,100,000
M. inventory, Jan. 1 $ 55,000 $ 55,000 $ 50,000 $ 60,000
Purchases 650,000 650,000 700,000 700,000
Merchandise available for sale $705,000 $705,000 $750,000 $760,000
Less merchandise inventory,
December 31 60,000 50,000 70,000 70,000
Cost of merchandise sold 645,000 655,000 680,000 690,000
Gross profit $335,000 $325,000 $ 420,000 $ 410,000
Operating expenses 100,000 100,000 120,000 120,000
Net income 235,000 225,000 300,000 290,000

$10,000 $10,000
Understatement Overstatement
of Net Income of Net Income

Net Effect Is Zero for Two Yearsthe inventory errors reverse (or cancel) so that the combined
netincome for the two years of $525,000 ($225,000 + $300,000) is correct.

The December 31, 2009, merchandise inventory becomes the January 1, 2010, inventory.Thus,
the beginning inventory for 2010 is understated by $10,000. As a result,the cost of merchandise
sold is understated by $10,000 for 2010. The gross profit andnet income for 2010 will be
overstated by $10,000.
As shown above, since the ending inventory of one period is the beginninginventory of the next
period, the effects of inventory errors carry forward to thenext period. Specifically, if
uncorrected, the effects of inventory errors reversethemselves in the next period. In the
illustration above, the combined net income for the twoyears of $525,000 is correct even though
the 2009 and 2010 income statements wereincorrect.

For the Sami Company illustration shown above, the December 31, 2009, endinginventory was
understated by $10,000. As a result, the merchandise inventory, currentassets, and total assets
would be understated by $10,000 on the December 31, 2009,balance sheet. Because the ending
physical inventory is understated, the cost of merchandisesold for 2009 will be overstated by
$10,000. Thus, the gross profit and the netincome for 2009 are understated by $10,000. Since the
net income is closed to owner’sequity (capital) at the end of the period, the owner’s equity on the
December 31, 2009,balance sheet is also understated by $10,000.

1.4 Inventory Systems: periodic Vs perpetual

There are two principal systems of inventory accounting periodic and perpetual.

1.4.1 Periodic inventory system

Under this system there is no continuous record of merchandise inventory account. The
inventory balance remains the same throughout the accounting period, i.e. the beginning
inventory balance. This is because when goods are purchased, they are debited to the purchases
account rather than merchandise inventory account.
The revenue from sales is recorded each time a sale is made. No entry is made for the cost of
goods sold. So, physical inventory must be taken periodically to determine the cost of inventory
on hand and goods sold.

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 merchandise such as
groceries, drugstores, hardware etc.

The journal entries to be prepared 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 allowance:
Accounts payable or cash XX
Purchase returns and allowance XX
4. To record adjusting entry or closing entry for merchandise inventory:
 Income Summary XX
Merchandise inventory (beginning) XX
To close beginning inventory
Merchandise inventory (ending) XX
Income summary XX
To record ending inventory

1.4.2 Perpetual inventory system

Under this system the accounting record continuously disclose the amount of inventory. So, the
inventory balance will not remain the same in the accounting period. All increases are debited to
merchandise inventory account and all decreases are credited to the same account. There are no
purchases and purchase returns and allowances accounts in this system. At the time of sale, the
cost of goods sold is recorded in addition to Journal entry for the sale. So, we can determine the
cost of inventory as well as goods sold from the accounting record. No need of physical counting
to determine their costs.

Companies that sell items of high unit value, such as appliances or automobiles, tended to use the
perpetual inventory system. Given the number and diversity of items contained in the
merchandise inventory of most businesses, the perpetual inventory system is usually more
effective for keeping track of quantities and ensuring optimal customer service. Management
must choose the system or combination of systems that is best for achieving the company's goal.

Journal entries to be prepared are:

1. At the time of purchase of merchandise

Merchandise inventory XX at cost
Accounts payable/cash XX
To record cost of goods sold
2. At the time of sale of merchandise
Accounts receivable or cash XX at retail price
Sales XX
To record cost of goods sold
To record the sales
Cost of goods sold XX
Merchandise inventory XX at cost
To record the cost of merchandise sold
3. To record purchase returns and allowances
Accounts payable or cash XX
Merchandise inventory XX
4. No adjusting entry or closing entry for merchandise inventory is needed at the end of
each accounting period.
1.5 Determining actual quantities in the inventory
The physical count of inventory is needed under both inventory systems. Under periodic
inventory system, it is needed to determine the cost of inventory and goods sold. The inventory
account under perpetual inventory systems is always up to date. Yet events can occur where the
inventory account balance is different from inventory on hand. Such events include theft,, loss,
damage, and errors. The physical count (some times called “taking an inventory”) is used to
adjust the inventory account balance to the actual inventory on hand.

We determine a birr (dollar) amount for physical count of inventory on hand at the end of a
period by:
(1) Counting the units of each product on hand
(2) Multiplying the count for each product by its cost per unit
(3) Adding the cost for all products

At the time of taking an inventory, all the merchandise owned by the business on the inventory
date, and only such merchandise, should be included in the inventory. The merchandise owned
by the business may not necessarily be in the warehouse. They may be in transit.

The legal title to the merchandise in transit on the inventory date is known by examining
purchase and sales invoices of the last few days of the current accounting period and the first few
days of the following accounting period. This legal title depends on shipping terms (agreements).

There are two main types of shipping terms. FOB shipping point and FOB destination
a) FOB shipping point- the ownership title passes to the buyer when the goods are shipped
(when the goods are loaded on the means of transportation, i.e. at the seller’s point). The
purchaser is responsible for freight charges.
b) FOB destination – the title passes to the buyer when the goods arrive at their destination,
i.e. at the buyer’s point.

So, in general, goods in transit purchased on FOB shipping point terms are included in the
inventories of the buyer and excluded from the inventories of the buyer and excluded from the
inventories of the seller. And goods in transit purchased on FOB destination terms are included
in the inventories of the seller and excluded from the inventories of the buyer.

There are also a problem with goods on consignment at the time of taking and inventory. Goods
on consignment to another party (agent) called the consignee. A Consignee is to sell the goods
for the owner usually on commission are included in the consignor’s inventories and excluded
from the consignee’s inventories.

1.6 DETERMINING THE COST OF INVENTORY

Costs included in merchandise inventory are those expenditures necessary, directly or indirectly,
to bring an item to a salable condition and location. In other words, cost of an inventory item
includes its invoice price minus any discount, plus any added or incidental costs necessary to put
it in a place and condition for sale. Added or incidental costs can include import duties,
transportation-in, storage, insurance against losses while the goods are in transit, and costs
incurred in an aging process(for example, aging of wine and cheese).

Minor costs that are difficult to allocate to specific inventory items may be excluded from
inventory cost and treated as operating expenses of the period. This is based on materiality
principle or the cost-to –benefit constraint.

1.7 INVENTORY COSTING METHODS UNDER PERIODIC INVENTORY SYSTEM

One of the most important decisions in accounting for inventory is determining the per unit costs
assigned to inventory items. When all units are purchased at the same unit cost, this process is
simple since the same unit cost is applied to determine the cost of goods sold and ending
inventory. But when identical items are purchased at different costs, a question arises as to what
amounts are included in the cost of merchandise sold and what amounts remain in inventory. A
periodic inventory system determines cost of merchandise sold and inventory at the end of the
period. We must record cost of merchandise sold and reductions in inventory as sales occur using
a perpetual inventory system. How we assign these costs to inventory and cost of merchandise
sold affects the reported amounts for both systems.

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

Three commoncost flow assumptions and related inventory cost flow methods are shown below:
First-in first-out(FIFO)
Last-in first-out (LIFO)
Weighted average
Specific identification

To illustrate, assume that three identical units of merchandise are purchased duringMay, as
follows:
Units Cost
May 10 Purchase 1 $9
18 Purchase 1 13
24 Purchase 114
Total 3 $36
Average cost per unit: $12 ($36/3 units)
Assume that one unit is sold on May 30 for $20. Depending upon which unit wassold, the gross
profit varies from $11 to $6 as shown below.
May 10 May 18 May 24
Unit Sold unit soldUnitSold
Sales $20 $20 $20
Cost of merchandise sold 9 13 14
Gross profit $11 $7$ 6
Ending inventory $27 $23 $22
($13 + $14) ($9 + $14) ($9 + $13)

Under the specific identification inventory cost flow method, the unit sold isidentified with a
specific purchase. The ending inventory is made up of the remainingunits on hand. Thus, the
gross profit, cost of merchandise sold, and endinginventory can vary as shown above. For
example, if the May 18 unit was sold,the cost of merchandise sold is $13, the gross profit is $7,
and the ending inventoryis $23.
The specific identification method is not practical unless each inventory unit canbe separately
identified. For example, an automobile dealer may use the specific identificationmethod since
each automobile has a unique serial number. However, mostbusinesses cannot identify each
inventory unit separately. In such cases, one of the followingthree inventory cost flow methods is
used.
Under the first-in, first-out (FIFO) inventory cost flow method, the first unitspurchased are
assumed to be sold and the ending inventory is made up of the mostrecent purchases. In the
preceding example, the May 10 unit would be assumed to havebeen sold. Thus, the gross profit
would be $11, and the ending inventory would be$27 ($13 + $14).
Under the last-in, first-out (LIFO) inventory cost flow method, the last unitspurchased are
assumed to be sold and the ending inventory is made up of the firstpurchases. In the preceding
example, the May 24 unit would be assumed to havebeen sold. Thus, the gross profit would be
$6, and the ending inventory would be$22 ($9 + $13).
Under the average inventory cost flow method, the cost of the units sold and inending
inventory is an average of the purchase costs. In the preceding example, thecost of the unit sold
would be $12 ($36/3 units), the gross profit would be $8 ($20 - $12), and the ending inventory
would be $24 ($12 x 2 units).

Let us see these costing methods under periodic inventory system based on the following
illustration

Illustration:
Beza Company began the year and purchased identical units of merchandise as follows:
Jan-1 Beginning inventory 80 units@ Br. 60 = Br. 4,800
Feb. 16 Purchase 400 units@ 56 = 22,400
Sep.2 Purchase 160 units @ 50 = 8,000
Nov. 26 Purchase 320 units@ 46 = 14,720
Dec. 4 Purchase 240 units@ 40 = 9,600
 Total 1200 units Br.59, 520

The ending inventory consists of 300 units, 100 from each of the last three purchases.

1.7.1 Specific Identification Method

When each item in inventory can be directly identified with a specific purchase and its invoice,
we can use specific identification (also called specific invoice pricing) to assign costs. This
method is appropriate when the variety of merchandise carried in stock is small and the volume
of sales is relatively small. We can specifically identify the items sold and the items on hand.

Example
From the above illustration, the ending inventory consists of 300 units, 100 from each of the last
purchases. So, the items on hand are specifically known from which purchases they are:

Cost of ending inventories under specific identification method

Br. 40 x 100 = Br. 4,000
Br. 46 x 100 = 4,600
Br. 50 x 100 = 5,000
300units Br. 13,600

 Cost of Ending inventory cost = Br. 13,600

 The cost of merchandise sold = Cost of goods available for sale - Ending inventory
= Br. 59,520 – Br. 13,600
= Br. 45,920

1.7.2 First-in, First-out (FIFO)

This method of assigning cost to inventory and the goods sold assumes inventory items are sold
in the order acquired. This means the cost flow is in the order in which the expenditures were
made. So, to determine the cost of ending inventory, we have to start from the most recent
purchase and continue to the next recent. Because the first purchased items (old purchases) are
the first to be sold they are used (included) in the computation of cost of goods sold.

For example, grocerystores shelve milk and other perishable products by expirationdates.
Products with early expiration dates are stocked in front.In this way, the oldest products (earliest
purchases) are sold first.

The cost of ending inventory under FIFO method

= Br. 40 x 240 Br. 9,600
= Br. 46 x 60 2,760
300 units Br. 12,360
  Cost of Ending inventory Br. 12,360
 Cost of merchandise sold = Br. 59,520 – Br. 12,360
Br. 47,160

1.7.3 Last-in first-out (LIFO)

When the LIFO method is used, the cost of the units sold is the cost of the most recent purchases.
The LIFO method was originally used in those rare cases where the units sold were taken from
the most recently purchased units. However, for tax purposes, LIFO is now widely used even
when it does not represent the physical flow of units. The cost flow is in the reverse order in
which expenditures were made. In calculating the cost of goods sold, we will start from the
earliest purchases.

As an example, take the previous illustration

The cost-ending inventory under LIFO method
=Br.60 x 80 = Br. 4,800
=Br. 56 x 220 = 12,320
300 units
Ending inventory cost = Br. 17,120
Cost of merchandise sold = Br. 59,520 – Br. 17,120
= Br. 42,400

1.7.4 Weighted Average Method

This method of assigning cost requires computing the average cost per unit of merchandise
available for sale. That means the cost flow is an average of the expenditures. To calculate the
cost of ending inventory, we will calculate first the cost per unit of goods available for sale.

Average cost per unit = Cost of goods available for sale

Total units available for sale

Then the weighted average unit cost is multiplied by units on hand at the end of the period to
calculate the cost of ending inventory. Also, the same average unit cost is applied in the
computation of cost of goods sold.

As an example, take the previous illustration

Weighted average unit cost = Br. 59,520 = Br. 49.60
1,200

 Ending inventory cost = Br. 49.60x 300

= Br. 14,880

 Cost of merchandise sold = Br. 59,520-Br. 14,880

 = Br. 44,640

1.8 Comparison of Inventory costing methods

If the cost of units and prices at which they are sold remains stable, all the four methods yield the
same results. But if prices change, the three methods usually yield different amounts for:

- Ending inventory
- Cost of merchandise sold
- Gross profit or net income

In periods of rising (increasing) prices: (or if there is inflationary trend):

FIFO yields – higher ending inventory

_ Lower cost of merchandise sold
_ higher gross profit (net income)

LIFO yields_ Lower ending inventory

_ Higher cost of merchandise sold
_ Lower gross profit (net income)

 Weighted average yields the results between the two.

In periods of declining (decreasing) prices:

FIFO yields _ Lower ending inventory

_ Higher cost of merchandise sold
_ Lower gross profit or net income

LIFO yields_ higher ending inventory

_ Lower cost of merchandise sold
_ Higher gross profit or net income
 Weighted average- between the two

1.9 Inventory costing methods under perpetual inventory system

Under perpetual inventory systems we will apply the inventory costing methods each time sale of
merchandise is made. We calculate the cost of goods (merchandise) sold and inventory on hand
at the time of each sale. This means the merchandise inventory account is continually updated to
reflect purchase and sales.
Illustration:
 The beginning inventory, purchases and sales of Nile Company for the month of January are as
follows:
Units Cost
Jan. 1 Inventory 15 Br. 10.00
6 Sale 5
10 purchase 10 Br. 12.00
20 Sale 8
25 purchase 8 Br. 12.50
27 Sale 10
30 purchase 15 Br. 14.00

1.9.1 First-in first-out Method

The assignment of costs to goods sold and inventory using FIFO is the same for both the
perpetual and periodic inventory systems Because each withdrawal of goods is from the oldest
stock on hand. The oldest is the same whether we use periodic inventory system or perpetual
inventory system. Let us calculate the cost of goods sold and ending inventory under perpetual
inventory system from the above illustration.

Perpetual - FIFO
Date Purchase Cost of merchandise sold Inventory
Qty. Unit cost Total cost Qty Unit Total cost Qty Unit cost Total cost
cost
Jan. 1 15 Br. 10.00 Br. 150.00
6 5 Br. Br. 50.00 10 10.00 100.00
10.00
10 10.00 100.00
10 10 Br. 12.00 Br.120.00 10 12.00 120.00

20 8 10.00 80.00 2 10.00 20.00

10 12.00 120.00
2 10.00 20.00
25 8 12.50 100.00 10 12.00 120.00
8 12.50 100.00
27 2 10.00 20.00 2 12.00 24.00
8 12.00 96.00 8 12.50 100.00
2 12.00 24.00
30 15 14.00 210.00 8 12.50 100.00
5 14.00 210.00
23 Br. 246.00 25 Br. 334.00
So, the cost of merchandise sold and ending inventory under perpetual- FIFO method are Br. 246
and Br. 334 respectively.
 Let us see them under periodic - FIFO method:
Units on hand = units available for sale – units sold
= (15 + 10 + 8 + 15) – (5+ 8 + 10)
= 48 - 23 = 25
Cost of ending inventory = Br. 14 x 15 = Br. 210
Br. 12.50 x 8 = 100
Br. 12 x 2 = 24
Br. 334
Cost of goods available for sale = Br. 120 + Br. 100 + Br. 210 = Br. 580
Cost of goods sold = Br. 580 – Br. 334
Br 246
So, the same results of cost of gods sold and ending inventory under both periodic inventory
systems.

1.9.2 Last in, First-Out method

Unlike FIFO method, different results may occur under periodic and perpetual inventory system.
The most recent purchases change when new purchase occurs. Let us calculate first the cost of
goods sold and ending inventory for the above illustration under perpetual inventory system.
Then, we will see the results under periodic inventory system.

Perpetual - LIFO
Date Purchase Cost of merch. Sold Inventory
Qty Unit cost Total cost Qty Unit cost Total cost Qty Unit cost Total cost
Jan. 1 15 Br. 10.00 Br. 150.00
6 5 Br. 10.00 Br. 50.00 10 10.00 100.00
10 10 Br. 12.00 Br. 120.00 10 10.00 100.00
10 12.00 120.00
20 8 Br. 12.00 Br. 96.00 10 10.00 100.00
2 12.00 24.00
25 8 12.50 100.00 10 10.00 100.00
2 12.00 24.00
8 12.50 100.00
27 8 12.50 100.00 10 10.00 100.00
2 12.00 24.00
30 15 14.00 210.00 10 10.00 100.00
15 24.00 210.00
23 Br. 270.00 25 Br. 310.00

So, the cost of merchandise sold and ending inventory under perpetual inventory system are Br.
270 and Br. 310 respectively.
The results under periodic inventory system are:
 Cost of ending inventory = Br. 10 x 15 = Br. 150
Br. 12 x 10 = 120
25
Br. 310
Cost of merchandise sold = Br. 580 - 310
= Br. 270
As you see, the results are different under periodic & perpetual inventory systems.

1.9.3 Weighted average cost method.

When the average cost method is used in a perpetual inventory system, an average unitcost for
each item is computed each time a purchase is made. This unit cost is then usedto determine the
cost of each sale until another purchase is made and a new averageis computed. This averaging
technique is called a moving average. The results may be different under periodic and perpetual
inventory system. Let us calculate the cost of merchandise sold and ending inventory comes out
from the previous illustration under perpetual inventory system.

Average Cost Method (Moving Average)

Purchase Cost of merchandise sold Inventory
Date Qty Unit cost Total cost Qty Unit cost Total cost Qty Unit cost Total cost

Jan. 15 Br. 10.00 Br. 150.00

1
6 5 Br. 10.00 Br. 50.00 10 10.00 100.00
20 11.00 220.00
10 10 12.00 Br. 120.00 =
100+120
10+10
20 8 11.00 88.00 12 11.00 132.00
20 11.60 + 232.00
25 8 12.00 100.00 132+100
12+8

27 10 11.60 116.00 10 11.60 116.00

30 15 14.00 210.00 15 13.04 326.00
116+210
10+15
23 Br. 254.00 25 Br. 13.04 Br 326.00
So, the cost of goods sold and ending inventory under perpetual inventory system are Br. 254.00
and Br. 326.00, respectively.

The results under periodic inventory system are:

Weighted average unit cost = Br. 580 = Br. 12.08
48
Ending inventory cost = Br. 12.08 x 25
= Br. 302
Cost of merchandise sold = Br. 580 – Br. 302
= Br. 278
So, the result is different under periodic and perpetual inventory systems
1.10 Valuation of Inventory at other than cost

1.10.1 Valuation at lower of cost or market (LCM)

As discussed in the first part, cost is the primary basis for the valuation of assets. This cost,
particularly of inventory is determined by using one of the four pricing methods (FIFO, LIFO,
Weighted-average, or specific identification). However, the cost of inventory is not necessarily
the amount that is reported on the balance sheet. Generally, accepted accounting principles
require the inventory be reported at market value whenever market is lower than cost. Thus, the
merchandise inventory is shown on the balance sheet at the lower of cost or market

For the purpose of assigning a value to merchandise inventory, market normally means
replacement cost. That is, the price a company would pay if it bought new items to replace those
in its inventory. When the cost to replace merchandise drops below original cost, the sales price
of the merchandise also is likely to fall. Therefore, the merchandise is worthless to the company
and should be written down to replacement cost (or market).

Lower of cost or market may be applied to:

 Each item in the inventory
 Major classes or categories
 The inventory as a whole

The principle of conservatism is the justification for the LCM rule. Conservatism in accounting
means that we should choose accounting methods that are least likely to overstate assets and
income. Valuing inventory at cost when its replacement cost is lower overstates that asset
merchandise inventory to a more realistic value and, at the same time recognizes the loss in value
that has occurred.

1.11 Estimating Inventory cost

A business may need to estimate the amount of inventory for the following reasons:
 Perpetual inventory records are not maintained.
 A disaster such as a fire or flood has destroyed the inventory records and the inventory.
 Monthly or quarterly financial statements are needed, but a physical inventory istaken
only once a year.
To estimate the cost of inventory, two methods are used. These are retail method and gross profit
method.
1.11.1 Retail method of inventory costing
This method is mostly used by retail business. The estimate is made based on the relationship
between the cost and the retail price of merchandise available for sale.
The steps to be followed are:
(1) Calculate the cost to retail ratio = Cost of merchandise available for sale
Retail Price of merchandise available for sale
(2) Calculate the ending inventory at retail price
Ending inventory at retail price = retail price of merchandise available for sale – Sales
(3) Calculate the estimated cost of ending inventory
Estimated cost of ending inventory = Cost to retail ration X Ending inventory at retail
Example
Cost Retail
Sep. 1, beginning inventory Br. 25,000 Br. 40,000
Purchases in September (net) 125,000 160,000
Sales in September (net) 140,000

(1) Cost retail ration = Br. 25,000 + Br. 125,000 = 0.75

Br. 40,000 + Br. 160,000
(2) Ending inventory at retail = (Br. 40,000 + Br. 160,000) – Br. 140,000 = Br. 60,000
(3) Estimated ending inventory at cost = 0.75 X Br. 60,000
= Br. 45,000

2.11.2 Gross profit method

This method uses an estimate of the gross profit realized during the period to estimate the cost of
inventory. The gross profit rate may be estimated based on the average of previous period’s gross
profit rates.
The steps are as follows:
(1) The gross profit rate is estimated and then estimated gross profit is calculated.
Estimated gross profit = Gross profit rate X Sales

(2) Cost of merchandise sold is estimated

Estimated cost of merchandise sold = Sales - Estimated gross profit

(3) Calculate the estimated cost of ending inventory

Estimated cost of ending inventory =
Cost of merchandise available for sale – Estimated cost of merchandise sold.

Example

Oct. 1, beginning inventory (cost) – Br. 36,000

 Net purchases during October (cost) 204,000
Net sales during October 220,000
Estimated gross profit rate is 40%

The ending inventory is estimated as follows:

(1) Estimated gross profit = 0.4 X 220,000
= Br. 88,000

(2) Estimated cost of merchandise sold

= Br. 220,000 – Br. 88,000
= Br. 132,000

(3) Estimated cost of ending inventory

= (Br. 36,000 + 204,000) – Br. 132,000
= Br. 240,000 – Br. 132,000
= Br. 108,000