CHAPTER -1-

Merchandise
Inventories
Outlines
Nature and definition of inventories
Internal control of inventories
The effect of inventory errors on the financial statements
Inventory cost flow assumptions
Inventory costing methods under a perpetual and periodic inventory
system
Valuation of inventory at other than cost (LCNRV)
Estimating inventory costs
Presentation of merchandise inventory in the financial statements
 Nature and Meaning of Inventories
Inventories are merchandise held for sale
in the normal course of business which is
termed as merchandise inventory or materials
in the process of production or held for
production
Raw materials inventory
Work in progress inventory
Finished goods- Merchandise inventory
3
 Control of Inventory
• Internal controls over inventory are intended to
help a company verify that it has sufficient
resources to:
– Produce and sell goods to meet demand
– Avoid maintaining excess products, and
– Eliminate costs associated with purchasing, producing,
and holding excess products
• The objectives of control over inventory include:
– Safeguarding the inventory from damage or theft
– Manage quantities at hand inline with customer needs
– Reporting inventory in the financial statements 4
 Safeguarding Inventory
The following documents are often used for inventory control:
1. The purchase order authorizes the purchase of the
inventory from an approved vendor. As soon as the
inventory is received, a receiving report is completed
2. The receiving report to make sure the inventory
received is what was ordered, the receiving report is
compared with the purchase order
3. Vendor’s invoice the price, quantity, and description of
the item on the purchase order and receiving report are
then compared to the vendor’s invoice
Reporting Inventory: A physical inventory or count of inventory
should be taken near year-end to make sure that the quantity of
inventory reported in the financial statements is accurate 5
 Importance of inventories
It is the principal source of revenue for
wholesale and retail businesses
Cost of merchandise sold is the largest
deduction from sells to determine net
income= NI=S-CGS
A substantial part of merchandising firm’s
resources is invested in inventory
It is the largest of the current assets on
merchandisers businesses
6
Effect of Inventory Errors on Financial Statements
Inventory errors will affect both the balance sheet and
income statement of the given (current) period and
subsequent (next) periods too
Example:
• The first set of statements is based on a correct
ending inventory of $60,000
• The second set, on an incorrect ending inventory of
50,000
• The third set, on an incorrect ending inventory of
70,000
In all three cases, net sales are 980,000, merchandise
7
Correct Ending Inventory (60,000)
Income statement for the year Balance Sheet at the end
of the year
Net sales……………………..980,000 Merchandise inventory………. .
$60,000
Cost of goods sold…………..645,000 Other
asset……………………..340,000
Gross profit…………......$335,000 Total asset…………..
……….400, 000
Incorrect Ending Inventory
Expenses…………………….100,000
(50,000)
Liabilities………………….………
120,000
Income statement for the year Balance Sheet at
Net income………………235,000 Owners equity………….………
the end of the year
280,000
Net sales……………………..980,000 Merchandise inventory……..…. .
Total ……………………
$50,000
400,000
Cost of goods sold…………..655,000 Other asset…………….….
…….340, 000
Gross profit…………......$325,000 Total asset……………..…...….
390,000 8
Expenses…………………….100,000 Liabilities……………………………
Incorrect Ending Inventory (70,000)
Income statement for the year Balance Sheet at the
end of the year
Net sales……………………..980,000 Merchandise inventory………. .
$70,000
Cost of goods sold…………..635,000 Other asset……………..……….340,
000
Gross profit…………......$345,000 Total asset……………..…...…
410,000
Expenses…………………….100,000 Liabilities…………………………
120,000
Net income………………245,000 Owners equity……………………
290,000
Total ………………………
410,000

9
 The effect of inventory on the following period’s
statements
2009 2010
Correct Incorrect Incorrect Correct
Net sale 980,00 980,00 1,100,0 1,100,0
0 0 00 00
Merchandise 55,000 55,000 50,0 60,0
inventory, Jan 1
00 00
Purchase 650,00 650,00 700,0 700,0
0 0 00 00
Merchandise 705,00 705,00 750,0 760,0
available for 0 0 00 00
sale
Less 60,0 50,0 70,0 70,0
merchandise 00 00
inventory, dec 00 00
31
Cost of 645,00 655,0 680,00 690,00
10
 Exercise
Saron Hardware reported cost of goods sold as follows.
2008 2009
Beginning inventory Br. 27,000 Br. 40,000
Cost of goods purchased 200,000 235,000
Cost of goods available for sale 227,000 275,000
Ending inventory 40,000 45,000
Cost of goods sold Br. 187,000 Br. 230,000

Saron has made two errors: (1) 2008 ending inventory was overstated by Br.6,000,
and (2) 2009 ending inventory was understated by Br.11,000.

Required:
1. Compute the correct cost of goods sold for each year.
2. Identify the effect of error on NI of each year.
11
 Inventory Systems
There are two principal system of inventory
accounting
1. Periodic inventory system
2. Perpetual inventory system
I. Periodic inventory system
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
12
 II. 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
Physical inventory is taken to compare the records with the
actual quantities on hand
Shipping terms:
FOB shipping point – title usually passes to the buyer
when goods are shipped and transportation cost will
be paid by the buyer
FOB destination – title doesn’t pass to the buyer until the
good are sold. and transportation cost will be paid by the
13
seller
 Determining the cost of inventory
The two most common assumptions of
determining the cost of ending inventory and
cost of merchandise sold are as follows:
1. First in First Out (FIFO): Cost flow is in
the order in which the expenditures were
made
2. Weighted Average: Cost flow is an
average of the expenditures

14
 Inventory costing methods under a
periodic system
• 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
merchandise sold.
15
 Inventory systems
1) Periodic inventory system
2) Perpetual inventory system
Inventory costing methods/cost flow
assumptions
1. FIFO
2. Average
3. LIFO
4. Specific identification
16
 (1) Inventory costing methods under a periodic
system
I. First In First Out (FIFO) Method
Example: - The units of an item available for sale during
the year were as follows (Assume selling price of $ 50)
Jan.1 Inventory 35 units at $ 23 $805
Mar.4 Purchase 10 units at $
25 $250
Aug.20 Purchase 30 units at $28 $840
Nov.30 Purchase 25 units at $ 30
$750
100 $
17
 Solution:
Most recent cost, Nov. 30………..25 units at $30……….
$750
Next most recent costs, Aug. 20…20 units at $28……….
$560
Inventory, Dec. 31…………………………… $
1,310
And Cost of Goods Sold=…………………………………$
1,335
Cost of goods sold
35*23=$805
10*25=$250 18
 2) Average cost method
• It is sometimes called the weighted average
method.
• When this meted is used, cost is matched against
revenue according to the weighted average unit costs
of the goods sold.
Average unit cost =
Average unit cost ==26.45

• The cost of ending inventory at Dec 31= 45* $26.45 =

1,190.25
• Cost of merchandise sold = 55 units at 26.45 = $
19
 3) Last In First Out (LIFO) Method

Ending inventory
Jan.1 Inventory 35 units at $ 23 $805
Mar.4 Purchase 10 units at $ 25 $250
45 units $1,055
Cost of goods sold
Aug.20 Purchase 30 units at $28 $840
Nov.30 Purchase 25 units at $ 30 $750
55 units $1,590

20
 4) specific identification

The company sold 55 units. 11 units came from

January 1 at $25 each. 7 units came from march 4
at $27 each. 20 units came from August 20 at $30
and 17 units came from November 30 at $35.
Required
Calculate the cost of ending inventory and the cost of
goods sold under specific identification method
21
Accounting for and reporting Inventory under a perpetual
system
• In a perpetual inventory system, all merchandise
increases and decreases are recorded in a manner
similar to the recording of increases and
decreases in cash
• The merchandise inventory account at the beginning
of an accounting period indicated the merchandise in
stock on that date 22
 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
23
1. First- in, first – out (FIFO) method: Costs are
included in the merchandise sold in the order in
which Purchases Cost of
they were incurred.
merchandise sold
Inventory

Quan Unit Total Quan Unit Total Quan Unit Total

Date tity Cost Cost tity Cost Cost tity Cost Cost
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
20 22 440 20 22 440
Balance $568 $65
0
24
• Average cost method: Here, the average unit cost
for each type of item is computed each time a
purchase is made. This unit cost is then used to
determine the cost of each sale until another
purchase is made and a new average is computed.
This averaging technique is called a moving average.

25
 Average cost method
Purchases Cost of merchandise Inventory
sold
Quan Unit Total Qua Unit Total Quan Unit Total
Date tity Cost Cost ntity Cost Cost tity Cost Cost
Jan 1 20 20 400
4 14 20 280 6 20 120
10 18 21 37 24 20.7 498
8 5
22 8 20.75 166 16 20.7 332
5
28 6 20.75 124.5 10 20.7 207.5
5
26
1. Last- in, first – out (LIFO) method: Costs are
included in the merchandise sold in the order in
which Purchases Cost of
they were incurred.
merchandise sold
Inventory

Quan Unit Total Quan Unit Total Quan Unit Total

Date tity Cost Cost tity Cost Cost tity Cost Cost
1 20 20 400
4 14 20 280 6 20 120
10 18 21 378 6 20 120
18 21 378
22 8 21 168 6 20 120
10 21 210
28 6 21 126 6 20 120
4 21 84
30 6 20 120
4 21 84
20 22 440 20 22 440
27
Balance $574 $64
 Comparing inventory costing methods (Optional)
Partial income statements
FI FO AVERAGE COST
LIFO
Net sales (50*55 unit) $2,750 $2,750
$2,750
Cost of March sold.
Beginning inv $805 $ 805
$ 805
Purchases 1,840 1,840
1,840
MAFS $2,645 $2,645
$2,645
Less ending inventor 1,310 1,190.25
1,055
28
Cost of merch sold $1,335 $1454.75
29
Jan 1. 400 units@$6=$2,400
Jan 4. 600 units@$7=$4,200
Jan 18. 600 units@$8=$4,800
Jan 28. 400 units@$9=$3,600
2000 units $15,000
Sales = 1,700 units

30
 Solution
1) Periodic FIFO
Most recent cost, Jan. 28………..300 units at $9………. $2,700
Inventory, Dec. 31…………………………..……………… $ 2,700
And Cost of Goods Sold=………………..…………………$ 12,300
Cost of goods sold
Jan 1. 400 units@$6=$2,400
Jan 4. 600 units@$7=$4,200
Jan 18. 600 units@$8=$4,800
Jan 28. 100 units@$9=$900
1700 units $12,300

31
 2) Periodic average (weighted average)

Weighted average unit cost= $15,000/2000 units= $7.5/units

The cost of ending inventory at Dec 31= $7.5/units *300 units= $2,250
The cost of goods sold= $7.5/units *1,700 units= $12,750
The cost of goods sold= $15,000-$2,250=$12,750

3) Periodic LIFO
Jan. 1………..300 units at $6………. $1,800
Inventory, Dec. 31…………………… $ 1,800
And Cost of Goods Sold=……………$ 13,200

32
 Purchases Cost of Inventory
merchandise sold
Quan Unit Total Quan Unit Total Quan Unit Total
Date tity Cost Cost tity Cost Cost tity Cost Cost
1 400 6 2,400
4 600 7 4,20 400 6 2,400
0 600 7 4,200
10 400 6 2,400 100 7 700
500 7 3,500
18 600 8 4,80 100 7 700
0 600 8 4,800
22 100 7 700 200 8 1,600
400 8 3,200
28 200 8 1,600
3,60 400 9 3,600
400 9 0
30 200 8 1,600 300 9 2,700
100 9 900 33
$12,30 $2,7
 Purchases Cost of merchandise sold Inventory

Quantit Unit Total Quanti Unit Total Cost Quantit Unit Cost Total Cost
y Cost Cost ty Cost y
Date
Jan 1 400 6 2,400

4 600 7 4,20 1,000 6.6 6,600

0
10 900 6.6 5,940 100 6.6 660

18 600 8 4,80 700 7.8 5,460

0
22 500 7.8 3,900 200 7.8 1,560

28 600 8.6 5,100

3,60
400 9 0
30 300 8.6 2,580 300 8.6 2,580
34
 Purchases Cost of Inventory
merchandise sold
Quan Unit Total Quan Unit Total Quan Unit Total
Date tity Cost Cost tity Cost Cost tity Cost Cost
1 400 6 2,400
4 600 7 4,20 400 6 2,400
0 600 7 4,200
10 600 7 4,200 100 6 600
300 6 1,800
18 600 8 4,80 100 6 600
0 600 8 4,800
22 500 8 4,000 100 6 600
100 8 800
28 100 6 600
3,60 100 8 800
400 9 0 400 9 3,600
30 300 9 2,700 100 6 600
100 8 800
35
100 9 900
FIFO
Net sales=1,700*$15= $25,500
Cost of goods sold= ($12,300)
Gross profit = $13,200

36
 Valuation of inventory at other than cost
• Cost is the primary basis for valuating
inventories. In some cases however,
inventor is values at other than cost. This
is when,
a) The cost of replacing items in inventory
is below the recorded cost and
b) The inventory is not salable at normal
sales prices which may be due to
imperfections, shop wear, style changes,
and other causes. 37
 1. Valuation at lower of cost or Net Realizable
Value (LCNRV)
• Under the LCNRV basis, net realizable value refers to the
net amount that a company expects to realize (receive) from
the sale of inventory. Specifically, net realizable value is the
estimated selling price in the normal course of business, less
estimated costs to complete and sell.
• Example: - On the basis of the following data, determine the
value of inventory at the LCNRV.
Commodity Cost NRV LCNRV
A 3,250 3,200 3,200
B 1,870 1,955 1,870
C 3,300 3,120 3,120

D 765 675 675

Presentation of Merchandise inventory on the
balance sheet
• Merchandise inventory is usually presented in the
current asset section of the balance sheet,
following receivables.

39
 Estimating Inventory Cost
• In practical an inventory amount may be need in
order to prepare an income statement when it is
impractical or impossible to take a physical
inventory or to maintain perpetual inventory records,
the amount of inventory on hand can be estimated.
• The two commonly used methods of estimating
inventory cost are
1. The retail method
2. The gross profit method.
40
 1. Retail method of inventory costing
• 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 is taken only once
a year.

41
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
42
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
43
 Cost
Retail
June 1. Merchandise inventory $ 428,300 $
670,500
1-30 purchasers (net) 608,500
949,500
Merch Avail for sale
$1,036,8001,620,000

1-30 sales (net)

1,140,000
Merchandise inventory, June 30, at retail 44
 ii. 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 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.
Step 3. Determine the estimated cost of merchandise
sold by deducting the estimated gross profit from the
net sales.
45
GP%= Net Sales-Cost of Goods Sold
Net sales
GP%*Net Sales= Net Sales-Cost of Goods Sold
Cost of Goods Sold= Net Sales- GP%*Net Sales
Cost of Goods Sold= Net Sales(1- GP%)

46
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%

47
 Solution:
Merchandise inventory, January
$160,000
Purchase (net) 850,000
Merch avail 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) 48
49
50