Addis Ababa University, School of

Commerce
Department of Accounting & Finance
Principles of Accounting II

Chapter 1

INVENTORY
Chapter April, 2020
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 Preview of CHAPTER 1

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 Classifying Inventory

Merchandising Manufacturing
Company Company

One Classification: Three Classifications:

 Inventory  Raw Materials
 Work in Process
 Finished Goods

Regardless of the classification, companies report all inventories under

Current Assets on the balance sheet.

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 Determining Inventory Quantities

Physical Inventory taken for two reasons:

Perpetual System
1. Check accuracy of inventory records.
2. Determine amount of inventory lost (wasted raw
materials, shoplifting, or employee theft).

Periodic System
1. Determine the inventory on hand.
2. Determine the cost of goods sold for the period.

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 Determining Inventory Quantities

Taking a Physical Inventory

Involves counting, weighing, or measuring each kind of
inventory on hand.
Taken,
 when the business is closed or business is slow.
 at end of the accounting period.

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 Determining Inventory Quantities

Determining Ownership of Goods

Goods in Transit
 Purchased goods not yet received.
 Sold goods not yet delivered.

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 sale.

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 Determining Inventory Quantities

Goods in Transit

Ownership of the goods

passes to the buyer when the
public carrier accepts the
goods from the seller.

Ownership of the goods

remains with the seller until
the goods reach the buyer.

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 Determining Inventory Quantities

Question
Goods in transit should be included in the inventory of the
buyer when the:

a. public carrier accepts the goods from the seller.

b. goods reach the buyer.

c. terms of sale are FOB destination.

d. terms of sale are FOB shipping point.

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 Determining Inventory Quantities

Determining Ownership of Goods

Consigned Goods
 Goods held for sale by one party.
 Ownership of the goods is retained by another
party.

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 Inventory Costing

Unit costs can be applied to quantities on hand using

the following costing methods:
 Specific Identification
 First-in, first-out (FIFO)
Cost Flow
 Last-in, first-out (LIFO) Assumptions
 Average-cost

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 Inventory Costing

Illustration: Assume that Crivitz TV Company purchases

three identical 50-inch TVs on different dates at costs of $700,
$750, and $800. During the year Crivitz sold two sets at $1,200
each. These facts are summarized below.

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 Inventory Costing

Specific Identification
If Crivitz sold the TVs it purchased on February 3 and May 22,
then its cost of goods sold is $1,500 ($700 + $800), and its
ending inventory is $750.

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 Inventory Costing

Specific Identification
Actual physical flow costing method in which items still in
inventory are specifically costed to arrive at the total cost of
the ending inventory.
 Practice is relatively rare.
 Most companies make assumptions (Cost Flow
Assumptions) about which units were sold.

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 Inventory Costing

Cost Flow
Assumptions
do not need to match the

physical movement of
goods

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 Inventory Costing

Illustration: Data for Houston Electronics’ Astro condensers.

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

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 Inventory Costing

First-In-First-Out (FIFO)
 Earliest goods purchased are first to be sold.

 Often parallels actual physical flow of merchandise.

 Generally good business practice to sell oldest units

first.

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 Inventory Costing

First-In-First-Out (FIFO)

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 Inventory Costing

First-In-First-Out (FIFO)

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 Inventory Costing

Last-In-First-Out (FIFO)
 Latest goods purchased are first to be sold.

 Seldom coincides with actual physical flow of

merchandise.

 Includes goods stored in piles, such as coal or hay.

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 Inventory Costing

Last-In-First-Out (FIFO)

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 Inventory Costing

Last-In-First-Out (FIFO)

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 Inventory Costing

Average Cost
 Allocates cost of goods available for sale on the basis
of weighted-average unit cost incurred.

 Assumes goods are similar in nature.

 Applies weighted-average unit cost to the units on

hand to determine cost of the ending inventory.

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 Inventory Costing

Average Cost

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 Inventory Costing

Average Cost

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 Inventory Costing

Financial Statement and Tax Effects

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 Inventory Costing

Question
The cost flow method that often parallels the actual
physical flow of merchandise is the:

a. FIFO method.

b. LIFO method.

c. average cost method.

d. gross profit method.

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 Inventory Costing

Question
In a period of inflation, the cost flow method that results
in the lowest income taxes is the:

a. FIFO method.

b. LIFO method.

c. average cost method.

d. gross profit method.

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Cost Flow Assumptions and the Perpetual
Inventory Systems

Assuming the Perpetual Inventory System, compute Cost of Goods

Sold and Ending Inventory under FIFO, LIFO, and Average cost.

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 Perpetual Inventory System

First-In-First-Out (FIFO)

Cost of Goods
Ending Inventory
Sold
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 Perpetual Inventory System

Last-In-First-Out (LIFO)

Cost of Goods
Ending Inventory
Sold
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 Perpetual Inventory System

Average-Cost

Cost of Goods Ending Inventory

Sold

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 Inventory Costing

Using Cost Flow Methods Consistently

 Method should be used consistently, enhances
comparability.
 Although consistency is preferred, a company may
change its inventory costing method.

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 Inventory Costing

Lower-of-Cost-or-Market
When the value of inventory is lower than its cost

 Companies can “write down” the inventory to its market

value in the period in which the price decline occurs.

 Market value = Replacement Cost

 Example of conservatism.

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 Inventory Costing

Lower-of-Cost-or-Market
Illustration: Assume that Ken Tuckie TV has the following
lines of merchandise with costs and market values as
indicated.
Illustration 6-15

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 Inventory Errors

Common Cause:
 Failure to count or price inventory correctly.
 Not properly recognizing the transfer of legal title to
goods in transit.
 Errors affect both the income statement and balance
sheet.

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 Inventory Costing

Income Statement Effects

Inventory errors affect the computation of cost of goods
sold and net income.

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 Inventory Costing

Income Statement Effects

Inventory errors affect the computation of cost of goods
sold and net income in two periods.
 An error in ending inventory of the current period will have a
reverse effect on net income of the next accounting
period.
 Over the two years, the total net income is correct because
the errors offset each other.
 Ending inventory depends entirely on the accuracy of taking
and costing the inventory.

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 Inventory Costing
2011 2012
Incorrect Correct Incorrect Correct
Sales $ 80,000 $ 80,000 $ 90,000 $ 90,000
Beginning inventory 20,000 20,000 12,000 15,000
Cost of goods purchased 40,000 40,000 68,000 68,000
Cost of goods available 60,000 60,000 80,000 83,000
Ending inventory 12,000 15,000 23,000 23,000
Cost of good sold 48,000 45,000 57,000 60,000
Gross profit 32,000 35,000 33,000 30,000
Operating expenses 10,000 10,000 20,000 20,000
Net income $ 22,000 $ 25,000 $ 13,000 $ 10,000

Combined income for ($3,000) $3,000

2-year period is correct. Net Income Net Income
understated overstated

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 Inventory Costing

Question
Understating ending inventory will overstate:

a. assets.

b. cost of goods sold.

c. net income.

d. owner's equity.

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 Inventory Costing

Balance Sheet Effects

Effect of inventory errors on the balance sheet is determined
by using the basic accounting equation:.

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 Statement Presentation and Analysis

Presentation
Balance Sheet - Inventory classified as current asset.

Income Statement - Cost of goods sold subtracted from

sales.

There also should be disclosure of

1) major inventory classifications,

2) basis of accounting (cost or LCM), and

3) costing method (FIFO, LIFO, or average).

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 Statement Presentation and Analysis

Analysis
Inventory management is a double-edged sword
1. High Inventory Levels - may incur high carrying costs
(e.g., investment, storage, insurance, obsolescence, and
damage).

2. Low Inventory Levels – may lead to stockouts and lost

sales.

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 Statement Presentation and Analysis

Inventory turnover measures the number of times on

average the inventory is sold during the period.

Cost of Goods Sold

Inventory
=
Turnover
Average Inventory

Days in inventory measures the average number of days

inventory is held.
Days in Year (365)
Days in
=
Inventory
Inventory Turnover

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 Statement Presentation and Analysis

Illustration: Wal-Mart reported in its 2010 annual report a beginning

inventory of $34,511 million, an ending inventory of $33,160 million, and
cost of goods sold for the year ended January 31, 2010, of $304,657
million. The inventory turnover formula and computation for Wal-Mart are
shown below.

Days in Inventory: Inventory turnover of 9 times divided into 365 is

approximately 40.6 days. This is the approximate time that it takes a
company to sell the inventory.
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Estimating Inventories

Gross Profit Method

Estimates the cost of ending inventory by applying a gross profit
rate to net sales.

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 Estimating Inventories

Illustration: Kishwaukee Company’s records for January show net

sales of $200,000, beginning inventory $40,000, and cost of goods
purchased $120,000. The company expects to earn a 30% gross
profit rate. Compute the estimated cost of the ending inventory at
January 31 under the gross profit method.

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 Estimating Inventories

Retail Inventory Method

Company applies the cost-to-retail percentage to ending
inventory at retail prices to determine inventory at cost.

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 Estimating Inventories

Illustration:

Note that it is not necessary to take a physical inventory to

determine the estimated cost of goods on hand at any given time.

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 Key Points
 The requirements for accounting for and reporting
inventories are more principles-based under IFRS. That is,
GAAP provides more detailed guidelines in inventory
accounting.
 The definitions for inventory are essentially similar under
IFRS and GAAP. Both define inventory as assets held-for-
sale in the ordinary course of business, in the process of
production for sale (work in process), or to be consumed in
the production of goods or services (e.g., raw materials).

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 Key Points
 Who owns the goods—goods in transit or consigned goods
—as well as the costs to include in inventory, are accounted
for the same under IFRS and GAAP.
 Both GAAP and IFRS permit specific identification where
appropriate. IFRS actually requires that the specific
identification method be used where the inventory items are
not interchangeable (i.e., can be specifically identified). If the
inventory items are not specifically identifiable, a cost flow
assumption is used. GAAP does not specify situations in
which specific identification must be used.

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 Key Points
 A major difference between IFRS and GAAP relates to the
LIFO cost flow assumption. GAAP permits the use of LIFO
for inventory valuation. IFRS prohibits its use. FIFO and
average-cost are the only two acceptable cost flow
assumptions permitted under IFRS.
 IFRS requires companies to use the same cost flow
assumption for all goods of a similar nature. GAAP has no
specific requirement in this area.

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 Key Points
 In the lower-of-cost-or-market test for inventory valuation,
IFRS defines market as net realizable value. Net realizable
value is the estimated selling price in the ordinary course of
business, less the estimated costs of completion and
estimated selling expenses. In other words, net realizable
value is the best estimate of the net amounts that
inventories are expected to realize. GAAP, on the other
hand, defines market as essentially replacement cost.

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 Key Points
 Under GAAP, if inventory is written down under the lower-of-
cost-or-market valuation, the new value becomes its cost
basis. As a result, the inventory may not be written back up
to its original cost in a subsequent period. Under IFRS, the
write-down may be reversed in a subsequent period up to
the amount of the previous write-down. Both the write-down
and any subsequent reversal should be reported on the
income statement as an expense. An item-by-item approach
is generally followed under IFRS.

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 Key Points
 Unlike property, plant, and equipment, IFRS does not permit
the option of valuing inventories at fair value. As indicated
above, IFRS requires inventory to be written down, but
inventory cannot be written up above its original cost.
 Similar to GAAP, certain agricultural products and mineral
products can be reported at net realizable value using IFRS.

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 Looking to the Future

One convergence issue relates to the use of the LIFO cost flow
assumption. IFRS specifically prohibits its use. Conversely, the
LIFO cost flow assumption is widely used in the United States
because of its favorable tax advantages. With a new conceptual
framework being developed, it is highly probable that the use of
the concept of conservatism will be eliminated. Similarly, the
concept of “prudence” in the IASB literature will also be
eliminated. This may ultimately have implications for the
application of the lower-of-cost-or-net realizable value.

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 IFRS Self-Test Questions

Which of the following should not be included in the

inventory of a company using IFRS?

a) Goods held on consignment from another company.

b) Goods shipped on consignment to another company.

c) Goods in transit from another company shipped FOB

shipping point.

d) None of the above.

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 IFRS Self-Test Questions

Which method of inventory costing is prohibited under

IFRS?

a) Specific identification.

b) FIFO.

c) LIFO.

d) Average-cost.

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 IFRS Self-Test Questions

Specific identification:

a) must be used under IFRS if the inventory items are not

interchangeable.

b) cannot be used under IFRS.

c) cannot be used under GAAP.

d) must be used under IFRS if it would result in the most

conservative net income.

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 END
Chapter 1

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