Fundamentals of Accounting II Chapter One August, 2022

CHAPTER ONE: INVENTORIES

1.1 Introduction
Inventories are those assets Held for sale in the ordinary course of business or in the process of
production for such sale; in the form of materials or supplies to be consumed in the production
process or in the rendering of services. They are mainly divided into two major groups:
Inventories of merchandising businesses: are merchandise purchased for resale in the normal
course of business. These types of inventories are called merchandise inventories.
Inventories of manufacturing businesses: are businesses that produce physical output. Thus,
a manufacturing firm has three types of inventories: Raw material, Work-in-Process, and
Finished goods.
 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.
 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.
 Finished goods inventory- is the cost identified with the completed but unsold units on
hand at the end of each period.
Merchandising entity (generally a retailer or wholesaler) has a single inventory account which is
usually titled merchandise inventory.
- Inventories are typically classified as current assets on the balance sheet. The accounting
problems associated with inventory are complex; this chapter discusses the basic issues
involved in recording, valuing, and reporting merchandise inventory.
- But why do we need to have proper accounting for inventories? The description and
measurement of inventories demand careful attention because
a) they take substantial investment of money
b) the frequency of transactions involving inventory are high
c) they are principal source of revenue for trading firms
d) Cost of inventories sold is the largest deduction from revenue in the form of COGS.
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

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1.2 The Effect of inventories on current and following period’s financial statements

1.2.1 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.

I. Income statement
A. Cost of goods (merchandise) sold =Beginning inventory + Net purchase – Ending inventory
As you see, ending inventory is a deduction in calculating 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).

II. 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

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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).

1.2.2 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:

I. 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.

II. Balance sheet

1. Current assets – The inventory included in current ass ets 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.

1.2.3 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 current period. Let us summarize it
I. Income statement of the following period
Cost of merchandise sold direct relationship
Gross profit indirect relationship
Net income indirect relationship

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II. 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.
Illustration - 1
The following amounts were reported in Belay Company’s financial statements for three
consecutive fiscal year ended December 31.
2000 2001 2002
a) Cost of merchandise sold Br. 130,000 Br. 154,000 Br. 140,000
b) Net income 40,000 50,000 42,000
c) Total Current assets 210,000 230,000 200,000
d) Owner’s equity 234,000 260,000 224,000
In making the physical counts of inventory, the following errors were made:
 Inventory on December 31, 2000, under stated by Br. 12,000
 Inventory on December 31, 2001, overstated by Br. 6000
Required:
Determine the correct amount of the items listed above.
Solution
2000 2001 2002
a) Cost of merchandise sold:
Reported Br. 130,000 Br. 154,000 Br. 140,000
Adjustment of
2000 error (12,000) 12,000 _
2001 error _ 6,000 (6,000)
Corrected Br. 118,000 Br. 172,000 Br. 134,000
b) Net income:
Reported Br. 40,000 Br. 50,000 Br. 42,000
Adjustment of
2000 error 12,000 (12,000) _
2001 error _ (6,000) 6,000
Corrected Br. 52,000 Br. 32,000 Br. 48,000

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c) Total current assets:
Reported Br. 210,000 Br. 230,000 Br. 200,000
Adjustment of
2000 error 12,000 _ _
2001 error _ (6,000) _
Corrected Br. 222,000 Br. 224,000 Br. 200,000
d) Owner’s equity:
Reported Br. 234,000 Br. 260,000 Br. 224,000
Adjustment of
2000 error 12,000 _ _
2001 error _ (6,000) _
Corrected Br. 246,000 Br. 254,000 Br. 224,000
1.3 Inventory Systems
Inventory records may be maintained on a perpetual or periodic inventory system. The essential
difference between these two systems from an accounting point of view is the frequency with
which the physical flows are assigned a value. Here are the major differences between the two:

1.3.1 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 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

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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

1.3.2 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.
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 purchased
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

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4. No adjusting entry or closing entry for merchandise inventory is needed at the end of
each accounting period.

 Periodic  Perpetual
 The inventory value and COGS are determined only at  Continuous record of both the physical flow and the
important point in time .e.g. end of reporting period cost of inventories and COGS. Every point in time
 Only revenue is recorded at time of sale you determine the level of inventory
 Purchase & purchase related accounts are used  Both revenue and COGS are recorded
 More appropriate for low unit cost items  No purchase and purchase related accounts
 Physical inventory is undertaken to determine EI cost.  For high unit cost items (not economical for low unit
Units sold are determined indirectly by subtracting the cost items)
units on hand from the sum of the units available for  Physical inventory should be undertaken to test
sale during the period. accuracy, to discover any shortage or overage b/c of
 This makes preparation of interim f/sts more costly waste, breakage , theft, improper entry, failure to
unless inventory estimation technique is used. record acquisitions etc
 Weaker for internal control  Facilitates the preparation of interim f/sts
 Stronger for internal control
Sep.1 Goods were purchased for $10,000 terms 2/10,n/30
Periodic Perpetual
Sep.1 Purchases -------------- 10,000 Sep.1 Merchandise inventory ------ 10,000
Accounts Payable ---- 10,000 Accounts Payable --------- 10,000
Sep.2 Paid freight charge of $250 on merchandise purchased
Sep.2 Freight in ----------- 250 Sep.2 Merchandise Inventory------- 250
Cash --------------------- 250 Cash ------------------------------ 250
Sept.5 Returned $1000 of merchandise previously bought.
Sep.5 Accounts Payable -------1000 Sep.5 Accounts Payable ----------- 1000
Purch. ret & allow. ----- 1000 Merchandise Inventory ---- 1000
Sept. 6 Goods costing $6000 were sold for $10,000 terms 2/10,n/30
Sep.6 Accounts receivable -- 10,000 Sep.6 Accounts receivable ------ 10,000
Sales ----------------- 10,000 Sales ----------------- 10,000
COGS ----------------- 6,000
Merchandise inventory ---- 6,000
Sept. 11 Paid for the September 1 purchases

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Sep.11 Accounts payable ---- 9,000 Sep.11 Accounts payable ------ 9,000
Cash --------------------- 8,820 Cash ------------------------ 8,820
PD(2%*$9000)---------- 180 Merchandise inventory ------ 180
Sept. 13 Issued a credit memo. for merchandise returned $2,000 with a cost of $1,200.
Sep.13 Sales ret.& allow ----- 2,000 Sep.13 Sales ret.& allow --------- 2,000
Accounts Receivable --- 2,000 Accounts Receivable ----- 2,000
Merchandise inventory --- 1,200
COGS --------------------- 1,200

1.4 Inventory costing methods under periodic inventory system

One of the most important decisions in accounting for inventory is determining 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. There are three methods commonly used in assigning costs to
inventory and cost of merchandise sold. These are:
Specific identification
First-in first-out (FIFO)
Weighted average
Let us see these costing methods under periodic inventory system based on the following
illustration
Illustration:
Beza Company began the year and purchased 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

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The ending inventory consists of 300 units, 100 from each of the last three purchases.
A. 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
B. 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, easily spoiled goods such as fruits, vegetables etc., must be sold near the time of their
acquisition. So, the inventory on hand will be from the recent purchases. As an example, consider
the previous illustration;
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

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 Cost of merchandise sold = Br.59, 520 – Br. 12,360
C. 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
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
A. 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)
Weighted average yields the results between the two.

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B. In periods of declining (decreasing) prices:
FIFO yields;
Lower ending inventory
Higher cost of merchandise sold
Lower gross profit or net income
Weighted average- between the two
1.5 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 Nesru Company for the month of January is 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
A. 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.

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Fundamentals of Accounting II Chapter One August, 2022
Perpetual - FIFO
Date Purchase Cost of merchandise Inventory
sold
Qty UC TC Qty UC TC Qty UC TC
Jan. 1 15 Br. 10.00 Br. 150.00
6 5 Br.10.00
Br. 50.00 10 10.00 100.00
10 10 10.00 100.00
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
25 2 10.00 20.00
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
15 2 12.00 24.00
30 14.00 210.00 8 12.50 100.00
15 14.00 210.00
23 Br. 25 Br. 334.00
246.00
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. 150 +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.

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B. Weighted average cost method.
Under this method, the average unit cost is calculated each time purchased is made to be applied on
the sales made after the purchases. 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 UC TC Qty UC TC Qty UC TC

Jan. 1 15 Br. 10.00 Br. 150.00

6 5 Br. 10.00 Br. 50.00 10 10.00 100.00
11.00= 100+120
20 220.00
10 10 12.00 Br. 120.00 10+10
20 8 11.00 88.00 12 11.00 132.00
11.60
20 =132+100 232.00
25 8 12.00 100.00
12+8
27 10 11.60 116.00 10 11.60 116.00
13.04
30 15 14.00 210.00 15 116+210 326.00
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.

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1.6 Valuation at lower of cost or market (LCM)
It was explained how costs are assigned to ending inventory and cost of goods sold using one of
four costing methods (FIFO, , Weighted average, or specific identification). Yet, the cost of
inventory is not necessarily the amount always reported on a balance sheet. Accounting principles
require that inventory be reported at the market value of replacing inventory when market is lower
than cost. Merchandise inventory is then said to be reported on the balance sheet at the lower of
cost or market (LCM).In applying LCM, cost is the acquisition price of inventory computed using
one of the historical cost methods - specific identification, FIFO, LIFO, and Weighted average;
market is defined as the current market value (cost) of replacing inventory. It is the current cost of
purchasing the same inventory items in the usual manner. It is important to know that market is not
defined as the sales prices. A decline in market cost reflects a loss of value in inventory. This is
because the recorded cost of inventory is higher than the current market cost. When this occurs, a
loss is recognized. This is done by recognizing the decline in merchandise inventory from recorded
cost to market cost at the end of the period.
LCM is applied in one of three ways:
(1) Separately to individual item
(2) To major categories of items
(3) To the whole of inventory
The less similar the items are that make up inventory, the more likely it is that companies apply
LCM to individual items. Advances in technology further encourage the individual item
application.
Illustration
The following are the inventory of ABC motor sports, retailer.
Inventory units per unit
Items on hand cost market
Cycles:
Roadster 50 Br. 15,000 Br. 14,000
Sprint 20 9,000 9,500
Off Road:
Trax-4 10 10,000 11,200
Blaz’m 6 16,000 14,500

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Let us see LCM computation under the three ways:
(1) Separately to each individual item
Inventory items Total cost Total market LCM
Roadster Br. 750,000 Br. 700,000 Br. 700,000
Sprint 180,000 190,000 180,000
Categories subtotal Br. 930,000 Br. 890,000
Trax-4 100,000 112,000 100,000
Blaz’m 96,000 87,000 87,000
Categories subtotal Br. 196,000 Br. 199,000
Totals Br.1, 126,000 Br. 1,089,000 Br. 1,1,067,000
(2) Major categories of items
Inventory Categories Categories LCM
Categories total cost total market
Cycles Br. 930,000 Br. 890,000 Br. 890,000
Off. Road 196,000 199,000 199,000
Totals Br. 1,126,000 Br. 1089,000 Br. 1,086,000

1.7 Estimating inventory cost

In practice, an inventory amount is estimated for some purposes, when it is impossible to take a
physical inventory or to maintain perpetual inventory records.
Example
1) Monthly income statements are needed. It may be too costly, to take physical inventory. This is
especially the case when periodic inventory system is used.
2) When a catastrophe such as a fire has destroyed the inventory. In such case, to ask claims from
insurance companies, there is a need of estimated inventory.
To estimate the cost of inventory, two methods are used; retail method and gross profit method.
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

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(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
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 CM.
E.g.; Oct. 1, beginning inventory (cost) – Br. 36,000 The ending inventory is estimated as follows:
Net purchases during October (cost) 204,000 (2) Estimated cost of merchandise sold
Net sales during October 220,000 = Br. 220,000 – Br. 88,000
Estimated gross profit rate is 40% = Br. 132,000
The ending inventory is estimated as follows: (3) Estimated cost of ending inventory
(1) Estimated gross profit = 0.4 X 220,000 = (Br. 36,000 + 204,000) – Br. 132,000
= Br. 88,000 = Br. 240,000 – Br. 132,000 = Br. 108,000

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= Br. 108,000T.)
Firomsa Page16