CHAPTER ONE

INVENTORIES

MINTAYTO TEBEKA ( MSc)

 Chapter One: Inventories
Objectives of the chapter:
1.Describe nature and definition of inventories
2.Describe the importance of control over Inventory.
3. The effect of inventory errors on the financial statements.

4.Describe the inventory cost flow assumptions and how they impact the
income statement and balance sheet.
5. Determine the cost of inventory under a perpetual and periodic inventory
system using Inventory costing methods.
6. Describe the valuation of inventory at other than cost.
7. Describe the estimating inventory costs.

8. Describe the presentation of merchandise inventory on the balance sheet.

 Nature and definition of inventories

 What do we mean by the term inventory?

Inventory is used to indicate:
a. Merchandise held for sale in the normal course of
business and
b. Materials in the process of production or held for
production of goods to be sold.

Inventories of merchandising businesses

Inventories
Inventories of manufacturing businesses
 Nature and definition of inventories

Classification of inventory of Manufacturers:

i. Raw materials are the basic goods that will be used in
production but have not yet been placed into production.
……………………Wood, steel..
ii. Work in process is that portion of manufactured
inventory that has been placed into the production process
but is not yet complete.

iii. Finished goods inventory is manufactured items that are

completed and ready for sale
What costs should be included in inventory?
• The cost of merchandise is its purchase price, less any purchases discounts.
• Such charges generally include:-
1. Costs of purchase: purchase price, import duties and other taxes,
transportation costs and handling costs directly related to the
acquisition of the goods
2. Costs of conversion: direct materials, direct labor, and manufacturing
overhead costs.
3. “other costs” incurred in bringing the inventories to the point of sale and in
salable condition: the costs to design a product for specific customer needs.
Period costs are those costs that are indirectly related to the acquisition or
production of goods.
Once an item is sold, the product cost, including inventory cost, becomes the cost of
sold and is reported on the income statement as cost of goods sold under current
expenses. Period cost is an expense and is reported for the accounting period
when it occurs under current expenses on the business's income statement.
• A company should record purchases of inventory in the Inventory
account when it has control of the asset.
 Internal control of inventories
Two primary objectives of internal control over inventory are:

Safeguarding the inventory …. Physical control

Properly reporting it in the financial statements… purchase and selling

 These internal controls can be either preventive or detective in nature. A

i. Preventive control is designed to prevent errors or misstatements from

Separation of duties, Pre-approval of actions and transactions, Access controls (such as
occurring. passwords and Gatorlink authentication)
Physical control over assets (i.e. locks on doors or a safe for cash/checks) and Employee screening
and training

ii. A detective control is designed to detect an error or misstatement after it has

Monthly reconciliations of departmental transactions, Review organizational
occurred. performance (such as a budget-to-actual comparison to look for any unexpected
differences), Physical inventories (such as a cash or inventory count)
 The Effect of Inventory Errors on the Financial Statements
• Occurred due to either inclusion or exclusion of inventory items.
• Errors caused by failure to count or price the inventory correctly.
• 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.
A.Income Statement Effects
• The ending inventory of one period automatically becomes the
beginning inventory of the next period.
• Ending inventory is the cost of merchandise on hand at the end of
the accounting period.
• Cost of goods (merchandise) sold =Beginning inventory + Net
purchase – Ending inventory
•Ending inventory has an indirect
(negative) relationship to cost of
merchandise sold.
• Net income
• Beginning inventory
• Asset
• Owners equity
The Effect of Inventory Errors on the Financial Statements

 Effects of inventory errors on current year’s income

statement
 The Effect of Inventory Errors on the Financial Statements

•An error in the ending inventory of the current period will have a
reverse effect on net income of the next accounting period.
B. Balance Sheet Effect
•Companies can determine the effect of ending inventory errors on the
balance sheet by using the basic accounting equation.
The Effect of Inventory Errors on the Financial Statements
Illustration
• The following amounts were reported in Ginjo Company’s financial
statements for three consecutive fiscal year ended December 31.
2008 2007 2006
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, 2006, understated by Br. 10,000

© Inventory on December 31, 2007, overstated by Br. 15,000

Determine the correct amount of the items listed above.

The Effect of Inventory Errors on the Financial Statements

• Assume that in taking the physical inventory on December 31, 2015,

XYZ Company incorrectly recorded its physical inventory as
$115,000 instead of the correct amount of $125,000.
• The effects on XYZ Company’s financial statements are summarized
as follows:
The Effect of Inventory Errors on the Financial Statements
• Now assume that in the preceding example the physical inventory had
been overstated on December 31, 2015, by $10,000. That is, XYZ
Company erroneously recorded its inventory as $135,000.
• In this case, the effects on the balance sheet and income
statement would be just the opposite of those indicated
above.
 Inventory Systems
• Proper report and inventory error
• Inventory management,
• There are two principal systems of inventory accounting:
• Periodic
• Perpetual
• Companies use one of two types of systems for maintaining accurate
inventory records.
 I. Perpetual Inventory System
• It continuously tracks changes in the Inventory account.
• Continuously disclose the amount of inventory.
• A company records all purchases and sales (issues) of goods directly in
the Inventory account as they occur.
• A separate account for each type of merchandise is maintained in a
subsidiary ledger.
• 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.
• Companies that sell items of high unit value, such as appliances, fur
garments or automobiles
 At the time of purchase of merchandise
Merchandise inventory XX at cost
Accounts payable/cash XX
At the time of sale of merchandise
Accounts receivable or cash XX   at retail price
Sales XX Cost of goods sold XX
Merchandise inventory XX at cost
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.
 II. Periodic Inventory System
• There is no continuous record of merchandise inventory account.
• The revenue from sales is recorded each time a sale is made and
merchandise purchased record in the ‘Purchases’ account.

• At the time of sale no entry is made to record the cost of goods sold.

• A physical inventory ……the cost of inventory on hand and goods

sold.
• Used by retail enterprises that sell many kinds of low unit cost
merchandises such as groceries, drugstores, hardware ….
At the time of purchase of merchandise:
Purchases XX at cost
Accounts payable or cash XX
At the time of sale of merchandise:
Accounts receivable or cash XX at retail price 
Sales XX
To record purchase returns and allowances:
Accounts payable or cashXX
Purchase returns and allowances XX
•  
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)
 Perpetual Vs Periodic Inventory System

Perpetual Inventory System Periodic Inventory System

• Continuous Inventory record • No continuous Inventory update
• When inventory purchased inventory on hand known only
record in inventory account it through physical count.
self. • When inventory purchased
• Additionally, record CGS at time record in purchase account.
of sale • Used in low unit value
• Used in high unit value merchandise
merchandise
 Perpetual Vs Periodic Inventory System
• 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.
• The perpetual inventory system is usually more
effective for keeping track of quantities and
ensuring optimal customer service.
Which inventory system is more effective?
Or
Should companies use them accordingly?
Illustration
In its beginning inventory on Jan 1, 2008, Ziquala Trading Company had 280 units of
merchandise that cost Br. 10 per unit. The following transactions were completed during
2008.
• Janu17 Purchased 200 units of merchandise on account at Br. 12 per unit.

24 Returned 50 defective units from the January 17 purchases to the     supplier

(payment for the entire invoice was not made).
• April 19 Purchased 300 units of merchandise for cash at Br 15 per unit.
• August 26 Sold 480 units of merchandise for cash at a price of Br. 17 per unit.    These
goods are: 230 units from the beginning inventory and 100 units from January 17
purchase and the rest from the April 19 purchases.
• December 31  248 units are left on hand, 50 units from January 1 inventory, another 50
units from the January 17 purchase, and the rest from the last  purchase.
• Required: Prepare general journal entries for Ziquala Trading
Company to record the above transactions and adjusting or closing
entry for merchandise inventory on December 31, 2008 (the end of
the current fiscal period) under
(a) Periodic inventory system
(b) Perpetual inventory system

Inventory Shortage ………..xx Merchandise Inventory

……………………………………xxx
 Determining Actual Quantities in the Inventory
• The physical count of inventory is needed under both inventory
systems.
• Taking inventory is to determine the quantity of each kind of
merchandise owned by an enterprise.
• Under periodic inventory system:
• to determine the cost of inventory and goods sold.

• at the end of the accounting period

• the inventory crew may work during the night or business operations may be
stopped until the count is finished
• Perpetual inventory system is always up to date
• events include theft, loss, damage, and errors
• We determine a Birr (dollar) amount for physical count of inventory
on hand at the end of a period by:
EI = unit * cost per unit

• At the time of taking an inventory, all the merchandise owned by the

business on the inventory date should be count.
• Not necessarily be in the warehouse…………… in-transit
• The legal title to the merchandise in transit depends on
• FOB shipping point and FOB destination
Activity

• Aba Jifar Company, found in Jimma, purchased goods from Zumra

Trading, found in Gondar, on FOB Destination terms.
Who will cover transportation charges? Why?
Who is the owner of the inventory?
 Inventory Cost Flow Assumptions
• WHICH COST FLOW ASSUMPTION TO ADOPT?
• During any given fiscal period, companies typically purchase merchandise
at several different prices ( Br. 40, 41, 42,…..)
• If a company prices inventories at cost and it made numerous purchases at
different unit costs, which cost price should it use?
• Which cost should be allocated to the CGS and EI?
• Which cost should be assigned to which inventory?
• Conceptually, a specific identification of the given items sold and unsold
seems optimal.
• Therefore, the IASB requires use of the specific identification method in
cases where inventories are not ordinarily interchangeable or for goods
and services produced or segregated for specific projects.
• For example, an inventory of single family homes. …

• In the retail trade………..jewelry, fur coats, automobiles, and some

furniture
• In manufacturing,… it includes special orders and many products
manufactured under a job cost system.

• Only in situations where inventory easily distinguishable, turnover is

low, unit price is high, or inventory quantities are small are the
specific identification criteria met.
• A major accounting issue arises when identical units of merchandise
are acquired at different unit costs during a period.
• To illustrate, assume that three identical units of Item X are purchased
during May, as shown below.
• Assume that one unit is sold on May 30 for $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 $13 and the gross profit is $7 ($20-$13).

• If, however, the unit sold was purchased on May 10, the cost assigned
to the unit is $9 and the gross profit is $11 ($20-$9).
• To illustrate, assume that Call-Mart Inc.’s 6,000 units of inventory
consists of 1,000 units from the March 2 purchase, 3,000 from the
March 15 purchase, and 2,000 from the March 30 purchase..

• Matches actual costs against actual revenue.

• Allows a company to manipulate net income.
 Cost Assign Inventory

• So, Which cost flow assumption should be used?

• In other cases, the cost of inventory should be measured using one of
two cost flow assumptions:
• first-in, first-out (FIFO)
• average-cost
 Inventory Cost Flow Assumptions
• There are two assumed cost flow methods:
1. First-in, first-out (FIFO) assumes that the earliest goods purchased
are the first to be sold, ending inventory is based on the prices of
the most recent units purchased.
• Costs are flow in order they incurred.
2. Average-cost allocates the cost of goods available for sale on the
basis of the weighted-average unit cost incurred.
 Inventory Costing Methods Under 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.
Inventory Costing Methods Under a Perpetual Inventory System
• 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, or average cost method is used.
Item B Units Cost
 Entries and Perpetual Inventory Account (FIFO)
• Item B
 Perpetual Inventory Account (Average-Cost)
Data Purchase Cost of goods sold Balance (Inventory)
Unit Unit cost Total cost Unit Unit cost Total cost Unit Unit cost Total cost

Jan. 1 10 20 200(10@20)
4 7 20 140 3 20 60(3@20)
10 8 21 168 3 20 60(3@20)
11 20.73 228(20.73@
11)

22 4 20.73 82.92 7 20.73 145.11{7@2

0.73)
24 2 20.73 41.46 5 20.73 103.65(5@2
0.73)
30 10 22 220 5 20.73 103.65(5@2
0.73)
15 21.58 323.65(21.4
9@15)
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.
Inventory Costing Methods Under a Periodic Inventory System

1. First-In, First-Out Method

To illustrate the use of the FIFO method in a periodic inventory
system, we assume the following data
Inventory Costing Methods Under a Periodic Inventory System
• The physical count on December 31 shows that 300 units have not
been sold.
Using the FIFO method, the cost of the 700 units sold is determined as
follows:

• Earliest costs, Jan. 1: 200 units at $ 9 $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 $7,000

Zewude T. (MSc. In Accounting and Finance)

Inventory Costing Methods Under a Periodic Inventory System

• Deducting the cost of merchandise sold of $7,000 from the $10,400 of

merchandise available for sale yields $3,400 as the cost of the
inventory at December 31.
• The $3,400 inventory is made up of the most recent costs incurred for
this item.

Zewude T. (MSc. In Accounting and Finance)

Inventory Costing Methods Under a Periodic Inventory System
• 

Inventory in units 1,000 units

Ending inventory 300@10.4 = $3,120

Cost of goods available for sale $10,400

Deduct: Ending inventory 3,120
Cost of goods sold $ 7,280
Inventory Costing Methods Under a Periodic Inventory System

Comparing Inventory Costing Methods

Assume that net sales were $15,000, the following partial income
statements indicate the effects of each method when prices are rising.
Valuation of Inventory at Other than Cost

• 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
(Replacement cost Vs historical cost) and
2. The inventory is not salable at normal sales prices.
• Inventory valuation
1. at lower of cost or market (LCM),
2. Net realizable value (NRV)
 Valuation at Lower of Cost or Market
• If the cost of replacing an item in inventory is lower than
the original purchase cost, the (LCM) method is used to
value the inventory.

• 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.
• Example: If Commodity
A & B are the main
category and Commodity
C &D are the main
category.
• Find ending inventory
of each item/commodity,
categories of commodity
and the inventory as
whole
 Valuation at Net Realizable Value
• As you would expect, 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 $1,000 can be
sold for only $800, and direct selling expenses are estimated to be
$150. This inventory should be valued at $650 ($800-$150), which is
its net realizable value.
 Presenting Merchandise Inventory on the Balance Sheet
• Merchandise inventory is usually presented in the Current Assets
section of the balance sheet, following receivables.

• Both the method of determining the cost of the inventory (FIFO, or

average) and the method of valuing the inventory (cost or LCM)
should be shown.
 Estimating Inventory Cost

•It may be necessary for a business to know the amount of inventory

when perpetual inventory records are not maintained and
•it is impractical to take a physical inventory.

•When a disaster such as a fire has destroyed the inventory, the

amount of the loss must be determined (estimated).

•Taking a physical inventory is impossible, and even if perpetual

inventory records have been kept, the accounting records may also
have been destroyed.
•In such cases, the inventory cost can be estimated by using
i. the retail method
ii. the gross profit method.

Retail Method of Inventory Costing

•The retail inventory method of estimating inventory cost is based on the
relationship of the cost of merchandise available for sale to the retail
price of the same merchandise.
• To use this method,
• The retail prices of all merchandise are maintained and totaled.
• The inventory at retail is determined by deducting sales for the
period from the retail price of the goods that were available for sale
during the period.

• The estimated inventory cost is then computed by multiplying the

inventory at retail by the ratio of cost to selling (retail) price for the
merchandise available for sale.
• For example, the inventory on January 1 is assumed to be $19,400 at
cost and 36,000 at retail, the net purchases during the month are
$42,600 at cost and 64,000 at retail, and the net sales during the
month are $70,000.
• Gross Profit Method of Estimating Inventories
• The gross profit method uses the estimated gross profit for the
period to estimate the inventory at the end of the period.

• The gross profit is usually estimated from the actual rate for the
preceding year, adjusted for any changes made in the cost and
sales prices during the current period.
•By using the gross profit rate, the dollar amount of sales for a
period can be divided into its two components:
1.Gross profit and
2.Cost of merchandise sold
• For example, the inventory on January 1 is assumed to be
$57,000, the net purchases during the month are $180,000, and
the net sales during the month are $250,000. In addition, the
historical gross profit was 30% of net sales.
Estimate a company’s inventory on January 31, using the gross
profit method.