Accounting For Inventories
Accounting For Inventories
Accounting For Inventories
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
1. 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.
2. Work in process inventory-
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.
3. Finished goods inventory- is the cost identified with the completed but unsold units on hand
at the end of each period.
In this chapter only the determination of the inventory of merchandise purchased for resale
commonly called merchandise inventory will be discussed.
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:
1.The sale of merchandise is the principal source of revenue for them.
2.The cost of merchandise sold is the largest deductions from sales.
3.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 of overstated), the financial
statements will be distorted.
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INVENTORY SYSTEMS: PERIODIC VS PERPETUAL
There are two principal systems of inventory accounting periodic and perpetual.
Periodic inventory system
Under this system there is no continuous record of merchandise inventory account. The
inventory balance remains the same through out 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.
Perpetual inventory system
Under this system the accounting record continuously disclose the amount of inventory.
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.
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.
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 systems 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.
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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.
inventory. The merchandise owned
by the business may not necessarily be in the warehouse. They may be 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
(1) FOB shipping point
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.
(2) 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
consignor’s inventories and excluded
from the consignee’s inventories.
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.
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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
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.
There are four methods commonly used in assigning costs to inventory and cost of merchandise
sold. These are:
Specific identification
First-in first-out (FIFO)
Last-in first-out (LIFO)
Weighted average
Let us see these costing methods under periodic inventory system based on the following
illustration
Illustration:
Beza 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,
Br.59, 520
The ending inventory consists of 300 units, 100 from each of the last three purchases.
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
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
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300units Br. 13,600
For example, easily spoiled goods such as fruits, vegetables etc., must be sold near the time of
their acquisition. So, the inventory on hand will be from the recent purchases. As an example,
consider the previous illustration on page 4.
This method of assigning cost assumes that the most recent purchases are sold first. Their costs
are charged to cost of goods sold, and the costs of the earliest purchases are assigned to
inventory. The cost flow is in the reverse order in which expenditures were made.
In calculating the cost of goods sold, we will start from the earliest purchases.
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.
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To calculate the cost of ending inventory, we will calculate first the cost per unit of goods
available for sale
If the cost of units and prices at which they are sold remains stable, all the four methods yield the
same results. But if prices change, the three methods usually yield different amounts for:
- Ending inventory
- Cost of merchandise sold
- Gross profit or net income
In periods of rising (increasing) prices: (or if there is inflationary trend):
LIFO yields_
yields_ higher ending inventory
_ Lower cost of merchandise sold
_ Higher gross profit or net income
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Weighted average- between the two
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 Nesru Company for the month of January are as
follows:
Units Cost
Jan. 1 Inventory 15
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
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
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.10.00 Br. 50.00 10 10.00 100.00
10 10.00 100.00
10 10 Br. 12.00 Br.120.00 10 12.00 120.00
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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.
Last in, First-Out method
Unlike FIFO method, different results may occur under periodic and perpetual inventory system.
The most recent purchases change when new purchase occurs.
Let us calculate first the cost of goods sold and ending inventory for the above illustration under
perpetual inventory system. Then, we will see the results under periodic inventory system.
Perpetual - LIFO
Date Purchase Cost of merch. Sold Inventory
Qty Unit cost Total cost Qty Unit cost Total cost Qty Unit cost Total cost
Jan. 1 15 Br. 10.00 Br. 150.00
6 5 Br. 10.00 Br. 50.00 10 10.00 100.00
10 10 Br. 12.00 Br. 120.00 10 10.00 100.00
10 12.00 120.00
20 8 Br. 12.00 Br. 96.00 10 10.00 100.00
2 12.00 24.00
25 8 12.50 100.00 10 10.00 100.00
2 12.00 24.00
8 12.50 100.00
27 8 12.50 100.00 10 10.00 100.00
2 12.00 24.00
30 15 14.00 210.00 10 10.00 100.00
15 24.00 210.00
23 Br. 270.00 25 Br. 310.00
So, the cost of merchandise sold and ending inventory under perpetual inventory system are Br.
270 and Br. 310 respectively.
The results under periodic inventory system are:
Cost of ending inventory = Br. 10 x 15 = Br. 150
Br. 12 x 10 = 120
25
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Br. 270
Under this method, the average unit cost is calculated each time purchased is made to be applied
on the sales made after the purchases. 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.
So, the cost of goods sold and ending inventory under perpetual inventory system are Br. 254.00
and Br. 326.00, respectively.
Exercises
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I. The following information is related with merchandise inventories of ABC Company .
Item X
Date Unit’s Unit cost
Jan. 1 Inventory 400 Br. 14
March 10 Purchase 200 15
May 9 Purchase 300 16
Sep. 22 Purchase 250 20
Nov. 28 Purchase 100 21
Required:
a. Calculate the cost of merchandise available for sale
b. Apply the four different methods of inventory costing to calculate ending
inventory & Cost of merchandise sold under:
II. Eyassu Furniture Company sold 2200 doors during 19 x 5 at Br. 320 per door. Its
beginning inventory on January 1 was 130 doors at Br. 112. Purchases made during
the year were as follows:
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Required:
1. Prepare a schedule to compute the cost of goods available for sale.
2. Prepare an income statement under each of the following assumptions:
(a) costs are assigned to inventory using the average cost method
(b) costs are assigned to inventory using the FIFO method
(c) costs are assigned to inventory using LIFO method
In applying LCM, cost is the acquisition price of inventory computed using one of the historical
cost methods - specific identification, FIFO, LIFO, and Weighted average; market is defined as
the current market value (cost) of replacing inventory. It is the current cost of purchasing the
same inventory items in the usual manner. It is important to know that market is not defined as
the sales prices. A decline in market cost reflects a loss of value in inventory. This is because the
recorded cost of inventory is higher than the current market cost. When this occurs, a loss is
recognized. This is done by recognizing the decline in merchandise inventory from recorded cost
to market cost at the end of the period.
The less similar the items are that make up inventory, the more likely it is that companies apply
LCM to individual items. Advances in technology further encourage the individual item
application.
Illustration
The following are the inventory of ABC motor sports, retailer.
Inventory units per unit
Items on hand cost market
Cycles:
Roadster 50 Br. 15,000 Br. 14,000
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Sprint 20 9,000 9,500
Off Road:
Trax-4 10 10,000 11,200
Blaz’m 6 16,000 14,500
When LCM is applied to the whole of inventory, the market cost is Br. 1,089,000. Since this
market cost is Br. 37,000 lower than Br. 1,126,000 recorded cost, it is the amount reported for
inventory on the balance sheet. When LCM is applied to individual items of inventory, the
marked cost is Br. 1,067,000. Since market is again less than Br. 1,126,000 cost, it is the amount
reported for inventory. When LCM is applied to the major categories of inventories, the market
is Br. 1,086,000 which is also lower than cost.
In practice, an inventory amount is estimated for some purposes. When it is impossible to take a
physical inventory or to maintain perpetual inventory records.
Example
1) Monthly income statements are needed. It may b e too costly, to take
physical inventory. This is especially the case when periodic inventory system is used.
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2) When a catastrophe such as a five has destroyed the inventory. In
such case, to ask claims from insurance companies, the is a need of estimated inventory.
To estimate the cost of inventory, two methods are used. These are retail method and gross profit
method.
This method is mostly used by retail business. The estimate is made based on the relation ship
between the cost and the retail price of merchandise available for sale.
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
(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
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.
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(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
EXERCISES
A. Short answer questions
1. From three ways of applying lower of cost or market, which one results in minimum
value of inventory?
2. When do we use the inventory estimation methods to determine the cost of inventory?
Replacement cost is determined to be the best measure of market. Calculate lower of cost or
market for the inventory
a. As a whole b. Applied separately to each products
2. The records of the unlimited provided the following information for the year ended December
31:
At cost At retail
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Jan. 1 beginning inventory Br. 160,450 Br. 264,900
Purchases 1,100,140 1,828,200
Purchases returns 17,600 34,100
Sales _ 1,570,200
Sales returns _ 15,600
Transportation in 13,000 _
2. Rahel Company's Dress shop had net retail sales of Br. 1,000,000 during the current year.
The following additional information was obtained from the accounting records:
At Cost At Retail
Beginning Inventory Br. 160,000 Br. 240,000
Net Purchase 560,000 880,000
Transportation – In 41,600
Required:
a) Estimate the company's ending inventory at cost using the retail method.
b) Assume that a physical inventory taken at year-end revealed an inventory on hand of Br.
72,000 at retail value. What is the estimated amount of inventory shrinkage (loss due to
theft, damage, and so forth) at cost?
3. Fantu and his family is a large retail furniture company that operates in two adjacent
warehouses. One warehouse is a showroom, and the other is used to store merchandise. On
the night of March 13, a fire broke out in the storage warehouse and destroyed the
merchandise stored there.
Fortunately, the fire did not reach the showroom, so all the merchandise on display was
saved.
Although, the company maintained a perpetual inventory system, its records were rather had
hazard, and the last reliable physical inventory was taken on December 31. In addition, there
was not control of the flow of the goods between the show room and the warehouse.
Thus, it was impossible to tell what goods should be in either place. As a result, the insurance
company required an independent estimate of the amount of loss. The insurance company
examiners were satisfied when they were provided with the following information.
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7. Merchandise Inventory in Showroom March 13 402,906
8. Average gross Margin 44%
Required:
Prepare a schedule that estimates, the amount of the inventory lost in the fire.
4. Sanete Trading Company switched recently to the retail inventory method to estimate
the cost-ending inventory. To test this method, the company took a physical inventory one
month after its implementation. Cost, retail, and the physical inventory data are as follows:
At Cost At Retail
Beginning Inventory, January 1 Br. 472,132 Br. 622,800
Purchase 750,000 1,008,400
Freight – In 8,350
Purchases Returns and Allowances (25,200) (34,800)
Sales 1,060,000
Sales Returns and Allowances (28,000)
January 31, Physical Inventory 508,200
Required:
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