CHAPTER ONE

INVENTORIES (IAS2)
By :AberuY. SAMARA UNIVERSITY
(2024)
 Learning outcomes;

 Describe importance of control over inventory

 Describe three inventory cost flow assumptions
 INTRODUCTION
 The term ‘inventories’ includes raw materials, work-in-progress,
finished goods and goods for resale in the ordinary course of
business.
 Agricultural produce that has been harvested by the entity from its
biological assets is in scope; it is initially recognized at its fair value
less costs to sell.
 Examples of agricultural produce would be milk from a dairy herd or
crops from a cornfield. Such produce is sold by a farmer in the
ordinary course of business and is inventory.
• Inventories are assets:
• Held for sale in the ordinary course of business;
• In the process of production for such sale; or
• In the form of materials or supplies to be consumed in the
production process or in the rendering of services.
o Depending on the facts and circumstances:
 Inventories measured at the lower of cost and net realizable
value; or
• Commodities, measured at fair value less costs to sell.
 Goods 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
• 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.
• FOB destination – the title passes to the buyer when the goods
arrive at their destination, i.e., at the buyer’s point.
• 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 seller
  Types of inventory

1. Inventories of merchandising businesses:- are merchandise

purchased for resale in the normal course of business.
2. Inventories of manufacturing businesses:-are businesses that
produce physical output. They normally have three types of
inventories.
• These are: raw material inventory, work in process inventory and
finished goods inventory
 THE EFFECTS OF INVENTORIES ON F/S

• A merchandising company can prepare accurate financial

statement only if its inventory is correctly valued.
• Net income for accounting period depends directly on the
valuation of ending inventory.
• Net sales – Cost of merchandise sold- Operating
Expenses=Operating Income/Loss
• Cost of Goods Sold = Beginning Inventory + Purchases – Ending
Inventory
 Income Statement effects:

• Ending inventory is understated ,COGS is overstated, net income

is understated.
• Beginning inventory is understated, COGS is understated, net
income is overstated.
• Ending inventory is overstated, COGS is understated, net income
is overstated.
• Beginning inventory is overstated, COGS is overstated, net
income is understated.
 Balance Sheet effects:

• Ending inventory is understated, assets and equity are

understated.
• Ending inventory is overstated, assets and equity are overstated.

Errors in beginning inventory do not yield misstatements on the

end-of-period balance sheet, but they do affect the current period’s
income statement
 Inventory costing method

• There are two principal system of inventory accounting.

1. Periodic inventory system

• In this , only the revenue from sales is recorded each time a sale is

made.

• No entry will be made to record the cost of merchandise sold at

the time of sale.

• Physical inventory will be taken to determine the cost of the

ending inventory at the end of an accounting period.

• less costly to maintain, but it gives management less information

about the current status of merchandise.

Perpetual inventory system
• Uses according records that continuously disclose the amount of
the inventory.
• The cost of merchandise sold will be recorded each time a sale is
made.
• 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
• Physical inventory is taken to compare the records with the
actual quantities on hand
 IFRS recognize three acceptable cost methods: used in assigning
costs to inventory and cost of merchandise sold.
 These are;

1. Specific identification
2. First-in, first-out (FIFO)
3. Weighted average cost
1. Specific identification
• 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.
 2. First-in, First-out (FIFO)
• Assigning cost to inventory and the goods sold assumes
inventory items are sold in the order acquired. means the cost
flow is in the order in which the expenditures were made.

• 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.
 3. 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.

• 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
COGS.
• Illustration 1: Periodic inventory system
Ab 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
The ending inventory consists of 300 units, 100 from each of the last three purchases.
Solution:
a) Specific identification method
Cost of ending inventories;
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
 a) FIFO method
The cost of ending inventory;
= 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
b) Weighted average method
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
• Illustration 2: perpetual inventory system

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
Solution:
a) 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+ Br. 120 + Br. 100 + Br. 210 = Br. 580
Cost of goods sold = Br. 580 – Br. 334 = Br 246
b. Weighted average
• We calculate the cost of goods (merchandise) sold and
inventory on hand at the time of each sale.
• So, the cost of goods sold and ending inventory under perpetual
inventory system are Br. 254.00 and Br. 326.00, respectively.
• 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
• Example: - the following units of item X are available for
sale.
• Item –X units cost
• Jan 1 inventory 20 $ 20
• 4 sale 14
• 10 purchase 18 21
• 22 sale 8
• 28 sale 6
• 30 purchase 20 22
• The firm used a perpetual inventor system, and there are 30
units of one item on hand at end of the year. What is the
total cost of goods sold and ending inventory according to:
• A. FIFO B. Average Cost Method
 Purchases Cost of merchandise sold Inventory

Quantity Unit cost Total cost Quantity Unit cost Total cost Quantity Unit cost Total cost
Date
1 20 20 400

4 14 20 280 6 20 120

10 18 21 378 6 20 120
18 21 378

22 6 20 120
2 21 42
16 21 336
28 6 21 126 10 21 210

30 10 21 210

440 20 22 440
20 22
Balance $568 $650
 Average cost method:-
Purchases Cost of merchandise sold Inventory

Quantity Unit cost Total cost Quantity Unit cost Total cost Quantity Unit cost Total cost
Date
Jan 1 20 20 400

4 14 20 280 6 20 120

10 18 21 378 24 20.75 498

22 8 20.75 166 16 20.75 332

28 6 20.75 124.5 10 20.75 207.5

30 20 22 440 30 21.57 647.5

Balance $570.5 $647.5

Cost of merchandise sold = 570.5, Cost of ending inventory =647

valuation of inventory at other than cost (LCNRV)
 The standard’s basic rule is that inventories are measured at the
lower of cost and net realizable value.
 Net realizable value is the estimated selling price in the
ordinary course of business less the estimated costs of
completion and the estimated costs necessary to make the sale.
 The amount that the entity actually expects to realize from
selling that particular inventory in the ordinary course of
business, while fair value is not
 1.Valuation at lower of cost or Market (LCM)

• If the cost of replacing inventory is lower than its recorded

purchase cost, the lower of- cost-or-market (LCM) method is

used to value the inventory.

• The lower-of-cost-or-market method can be applied in one of

three ways. The cost, market price, and any declines could be

determined for the following:

1. Each item in the inventory.

2. Each major class or category of inventory.

3. Total inventory as a whole.

 Cont…
Example: - On the basis of the following data, determine the value of inventory at the lower of
cost or market.
Commodity Inventory Quantity Unit Cost Price Unit Market Price
A 10 $ 325 $320
B 17 110 115
C 12 275 260
D 15 51 45
E 30 95 100
 Cont.…
Answer
______Total_____
Commodity Inventory Unit cost Unit market Cost Market LCM
Quantity Price Price
A 10 $ 325 $320 3,250 3,200 3,200
B 17 110 115 1,870 1,955 1,870
C 12 275 260 3,300 3,120 3,120
D 15 51 45 765 675 675
E 30 95 100 2,850 3,000 2,850
Total ………………………………………………. $12035 $11,950 $11,715
 2. Valuation at net realizable value

• Merchandise that is out of date, spoiled, or damaged can often

be sold only at a price below its original cost. Such
merchandise should be valued by Net realizable value and it
is determined as follows:
• Net Realizable Value = Estimated Selling Price - Direct Costs
of Disposal
• Direct costs of disposal include selling expenses such as special

advertising or sales commissions on sale.

 Example

To illustrate, assume the following data about an item of damaged

merchandise:
 Original cost $1,000
 Estimated selling price 800
 Selling expenses 150
 The merchandise should be valued at its net realizable value of
$650 as shown below.
 Net Realizable Value = $800 - $150 = $650
 1.7 Estimating Inventory Cost

• The two commonly used methods of estimating inventory cost are

1. The retail method

2. The gross profit method.

 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 is taken only once a year.

 1.Retail Method of Inventory Costing

• The retail inventory method of estimating inventory cost

requires costs and retail prices to be maintained for the
merchandise available for sale. A ratio of cost to retail price
is then used to convert ending inventory at retail to estimate
the ending inventory cost.
The retail inventory method is applied as follows:
Step 1. Determine the total merchandise available for sale at
cost and retail.
Step 2. Determine the ratio of the cost to retail of the
merchandise available for sale.
Step 3. Determine the ending inventory at retail by deducting
the net sales from the merchandise available for sale at retail.
Step 4 : Estimate the ending inventory cost by multiplying
the ending inventory at retail by the cost to retail ratio.
Example: on the basis of the following data, estimate the cost of the merchandise
inventory at June 30 by the retail method
Cost Retail
June 1. Merchandise inventory $ 428,300 $ 670,500
1-30 purchasers (net) 608,500 949,500
1-30 sales (net) 1,140.000
Solution:
Cost Retail
Merchandise inventory June 1 $ 428,300 $ 670,500
Purchases in June (net) 608,500 949,500
Merchandise available for sale $1,036,800 1,620,000
Ratio of cost to retail price: 1,036,800 = 64%
1,620,000
Sales for June (net) 1,140,000
 Cont.…
Merchandise inventory, June 30, at retail 480,000
Merchandise inventory, June 30, at estimated cost
(480.000*64%)…………………................................................................................307,200
 2. 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 estimated from the preceding year,
adjusted for any current-period changes in the cost and
sales prices.
• The gross profit method is applied as follows:
Step 1. Determine the merchandise available for sale at
cost.
Step 2. Determine the estimated gross profit by
multiplying the net sales by the gross profit percentage.
 Cont.…

Step 3. Determine the estimated cost of merchandise sold by

deducting the estimated gross profit from the net sales.

Step 4. Estimate the ending inventory cost by deducting the

estimated cost of merchandise sold from the merchandise available
for sale.
Example: The merchandise inventory was destroyed by fire on October 20. The following data
were obtained from the accounting records.
Jan 1. Merchandise inventory $ 160,000
Jan 1. Oct purchases (net) 850,000
Sales (net) 1,080,000
Estimated gross profit rate 36%
Required: Estimate the cost of merchandise destroyed:
 Cont.…
Solution:
Merchandise inventory, January $160.000
Purchase (net) 850,000
Merchandise available for sales $1,010,000
Sales (net) $1,080,000
Less estimated gross profit
(1,080,000*36%) (388,800)
Estimated cost of merchandise sold ($691,200)
Estimated merchandise inventory, Oct 20 $318,800
The gross profit method is useful for estimating inventories for monthly or quarterly financial
statements. It is also useful in estimating the cost of merchandise destroyed by fire or other
disasters.