Chapter Two

Accounting for Inventories

2.1. Introduction

Inventories are asset items held for sale in the ordinary course of business or goods that will be
used or consumed in the production of goods to be sold. They are mainly divided into two major:
 Inventories of merchandising businesses
 Inventories of manufacturing businesses
i. Inventories of merchandising businesses are merchandise purchased for resale in the
normal course of business. These types of inventories are called merchandise
inventories.
ii. Inventories of manufacturing businesses manufacturing businesses are businesses that
produce physical output. They normally have three types of inventories. These are:
 Raw material inventory
 Work in process inventory
 Finished goods inventory
a) 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.
b) 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.
c) Finished goods inventory- is the cost identified with the completed but unsold units on hand at
the end of each period.

2.2 Importance of Inventories

Merchandise purchased and sold is the most active elements in merchandising business, i.e. in
wholesale and retail type of businesses. This is due to the following reasons:

a) The sale of merchandise is the principal source of revenue for them.

b) The cost of merchandise sold is the largest deductions from sales.
c) Inventories (ending inventories) are the largest of the current assets or those firms.

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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2.3. Inventory Systems: periodic Vs perpetual

There are two principal systems of inventory accounting periodic and perpetual.
2.3.1 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 revenue from sales is recorded each time a sale is made. No entry is made for the cost of
goods sold. So, physical inventory must be taken periodically to determine the cost of inventory
on hand and goods sold.

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. This system is
often used by retail enterprises that sell many kinds of low unit cost merchandise such as
groceries, drugstores, hardware etc.

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
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

2.3.2 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.

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Companies that sell items of high unit value, such as appliances or automobiles, tended to use the
perpetual inventory system. Given the number and diversity of items contained in the
merchandise inventory of most businesses, the perpetual inventory system is usually more
effective for keeping track of quantities and ensuring optimal customer service. Management
must choose the system or combination of systems that is best for achieving the company's goal.

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

2.4. Determining actual quantities in the inventory

The physical count of inventory is needed under both inventory systems. Under periodic
inventory system, it is needed to determine the cost of inventory and goods sold. The inventory
account under a perpetual inventory system is always up to date. Yet events can occur where the
inventory account balance is different from inventory on hand. such events include theft,, loss,
damage, and errors. The physical count (some times called “taking an inventory”) is used to
adjust the inventory account balance to the actual inventory on hand.

We determine a birr (dollar) amount for physical count of inventory on hand at the end of a
period by:
(1) Counting the units of each product on hand
(2) Multiplying the count for each product by its cost per unit
(3) Adding the cost for all products

At the time of taking an inventory, all the merchandise owned by the business on the inventory
date, and only such merchandise, should be included in the inventory. The merchandise owned
by the business may not necessarily be in the warehouse. They may be in transit.

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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
a) FOB shipping point- the ownership title passes too 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.
b) FOB destination – the title passes to the buyer when the goods arrive at their destination,
i.e. at the buyer’s point.

So, 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. And goods in transit
purchased on FOB destination terms are included in the inventories of the seller and excluded
from the inventories of the buyer.

There are also a problem with goods on consignment at the time of taking and inventory. Goods
on consignment to another party (agent) called the consignee. A Consignee is to sell the goods
for the owner usually on commission are included in the consignor’s inventories and excluded
from the consignee’s inventories.

2.5. DETERMINING THE COST OF INVENTORY

Costs included in merchandise inventory are those expenditures necessary, directly or indirectly,
to bring an item to a salable condition and location. In other words, cost of an inventory item
includes its invoice price minus any discount, plus any added or incidental costs necessary to put
it in a place and condition for sale. Added or incidental costs can include import duties,
transportation-in, storage, insurance against losses while the goods are in transit, and costs
incurred in an aging process(for example, aging of wine and cheese).

Minor costs that are difficult to allocate to specific inventory items may be excluded from
inventory cost and treated as operating expenses of the period. This is based on materiality
principle or the cost-to –benefit constraint.

Costs Excluded from Inventories

a) Abnormal amounts of wasted materials, labour or other production costs!
b) Administrative OHs that do not contribute to bringing inventories to their present
Location & Condition!
c) Selling costs!

2.6. INVENTORY COSTING METHODS UNDER PERIODIC INVENTORY SYSTEM

One of the most important decisions in accounting for inventory is determining the 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

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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.

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.
Three common cost flow assumptions (cost formula) are shown below:
Specific identification
First-in first-out(FIFO)
Weighted average

 Use Specific Identification Method of Inventory Costing, for;

 Items that are not ordinarily unique
 Goods or services produced & segregated for specific order.
 When there are large numbers of items of inventory that are ordinarily
interchangeable/replaceable use either;
 The First-In, First-Out (FIFO) or
 Weighted Average Cost Formula.

Illustration:
Beza Company began the year and purchased identical units of 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.

2.6.1 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

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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
w Cost of Ending inventory cost = Br. 13,600
w The cost of merchandise sold = Cost of goods available for sale - Ending inventory
= Br. 59,520 – Br. 13,600
= Br. 45,920

2.6.2 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, grocery stores shelve milk and other perishable products by expiration dates.
Products with early expiration dates are stocked in front. In this way, the oldest products (earliest
purchases) are sold first.

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

‡ Cost of merchandise sold = Br. 59,520 – Br. 12,360
= Br. 47,160

2.6.3 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. 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

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 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

2.7. 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 Nile Company for the month of January are 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

2.7.1 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.

Perpetual - FIFO
Date Purchase Cost of merchandise sold Inventory

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 Qty. Unit cost Total cost Qty Unit Total cost Qty Unit cost Total cost
cost
Jan. 1 15 Br. 10.00 Br. 150.00
6 5 Br. Br. 50.00 10 10.00 100.00
10.00
10 10.00 100.00
10 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
2 10.00 20.00
25 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
2 12.00 24.00
30 15 14.00 210.00 8 12.50 100.00
5 14.00 210.00
23 Br. 246.00 25 Br. 334.00
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. 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.
2.7.2 Weighted average cost method.
When the average cost method is used in a perpetual inventory system, an average unit cost for
each 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. 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.

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 Average Cost Method (Moving Average)
Purchase Cost of merchandise sold Inventory
Date Qty Unit cost Total cost Qty Unit cost Total cost Qty Unit cost Total cost

Jan. 15 Br. 10.00 Br. 150.00

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6 5 Br. 10.00 Br. 50.00 10 10.00 100.00
20 11.00 220.00
10 10 12.00 Br. 120.00 =
100+120
10+10
20 8 11.00 88.00 12 11.00 132.00
20 11.60 + 232.00
25 8 12.00 100.00 132+100
12+8

27 10 11.60 116.00 10 11.60 116.00

30 15 14.00 210.00 15 13.04 326.00
116+210
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

2.8. Valuation of Inventory at other than cost

2.8.1 VALUATION AT Lower-of-Cost-or-Net Realizable Value

(LCNRV)
Inventories are recorded at their cost. However, if inventory declines in value below its original
cost, a major departure from the historical cost principle occurs. Whatever the reason for a
decline—obsolescence, price-level changes, or damaged goods—a company should write down
the inventory to net realizable value to report this loss. A company abandons the historical cost
principle when the future utility (revenue producing ability) of the asset drops below its original
cost.

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Net Realizable Value
Recall that cost is the acquisition price of inventory computed using one of the historical cost-
based methods—specific identification, average-cost, or FIFO. The term net realizable value
(NRV) refers to the net amount that a company expects to realize 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 estimated costs to make a sale.

To illustrate, assume that AJ CO. has unfinished inventory with a cost of €950, a sales value of
€1,000, estimated cost of completion of €50, and estimated selling costs of €200. AJ's net
realizable value is computed as shown below:
LUSTRATION 9.1 Computation of Net Realizable Value
Inventory value—unfinished €1,000
Less: Estimated cost of completion € 50
Estimated cost to sell 200 250
Net realizable value € 750

AJ reports inventory on its statement of financial position at €750. In its income statement, AJ
reports a Loss on Inventory Write-Down of €200 (€950 − €750). A departure from cost is
justified because inventories should not be reported at amounts higher than their expected
realization from sale or use. In addition, a company like AJ should charge the loss of utility
against revenues in the period in which the loss occurs, not in the period of sale.

Companies therefore report their inventories at the lower-of-cost-or-net realizable value

(LCNRV) at each reporting date.

Recording Net Realizable Value Instead of Cost

One of two methods may be used to record the income effect of valuing inventory at net
realizable value. One method, referred to as the cost-of-goods-sold method, debits cost of goods
sold for the write-down of the inventory to net realizable value. As a result, the company does
not report a loss in the income statement because the cost of goods sold already includes the
amount of the loss. The second method, referred to as the loss method, debits a loss account for
the write down of the inventory to net realizable value. We use the following inventory data for
AJ to illustrate entries under both methods.
Cost of goods sold (before adjustment to net realizable value) €1,500
Ending inventory (cost) 950
Ending inventory (at net realizable value) 750

Cost-of-Goods-Sold Method Loss Method

To reduce inventory from cost to net realizable value
Cost of Goods Sold 200 Loss Due to Decline of Inventory to NRV 200
Inventory (€950 −€750) 200 Inventory (€950 −€750) 200

The cost-of-goods-sold method buries the loss in the Cost of Goods Sold account. The loss
method, by identifying the loss due to the write-down, shows the loss separate from Cost of
Goods Sold in the income statement.

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IFRS does not specify a particular account to debit for the write-down. We believe the loss
method presentation is preferable because it clearly discloses the loss resulting from a decline in
inventory net realizable values.

Underlying Concepts
The income statement under the cost-of-goods-sold method presentation lacks representational
faithfulness. This is the cost-of-goods-sold method does not represent what it purports to
represent. However, allowing this presentation illustrates the concept of materiality.

Use of an Allowance
Instead of crediting the Inventory account for net realizable value adjustments, companies
generally use an allowance account, often referred to as Allowance to Reduce Inventory to Net
Realizable Value. For example, using an allowance account under the loss method, AJ makes the
following entry to record the inventory write-down to net realizable value.

Loss Due to Decline of Inventory to Net Realizable Value 200

Allowance to Reduce Inventory to Net Realizable Value 200
Use of the allowance account results in reporting both the cost and the net realizable value of the
inventory. AJ reports inventory in the statement of financial position as shown in

Illustration
Presentation of Inventory Using an Allowance Account
Inventory (at cost) €950
Allowance to reduce inventory to net realizable value (200)
Inventory at net realizable value €750
The use of the allowance under the cost-of-goods-sold or loss method permits both the income
statement and the statement of financial position to reflect inventory measured at €950, although
the statement of financial position shows a net amount of €750. It also keeps subsidiary
inventory ledgers and records in correspondence with the control account without changing
prices. For homework purposes, use an allowance account to record net realizable value
adjustments, unless instructed otherwise.

2.9. Estimating Inventory cost

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.
To estimate the cost of inventory, two methods are used. These are retail method and gross profit
method.

2.9.1 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:

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(1) Calculate the cost to retail ratio = Cost of merchandise available for sale
Retail Price of merchandise available for sale
(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

2.9.2 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 cost of merchandise sold.
Example
Oct. 1, beginning inventory (cost) – Br. 36,000
Net purchases during October (cost) 204,000
Net sales during October 220,000
Estimated gross profit rate is 40%

The ending inventory is estimated as follows:

(1) Estimated gross profit = 0.4 X 220,000
= Br. 88,000

(2) Estimated cost of merchandise sold

= Br. 220,000 – Br. 88,000
= Br. 132,000

(3) Estimated cost of ending inventory

= (Br. 36,000 + 204,000) – Br. 132,000
= Br. 240,000 – Br. 132,000
= Br. 108,000

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