UNIT ONE

ACCOUNTING FOR INVENTORIES

Introduction
In this unit, we focus on the accounting for inventories. In doing so, let's assume, Dire Electronics
company may have purchased thousands of television (TV) over the past year at different costs.
At the end of a period, some of the TV will still be in inventory, and some will have been sold.
But which costs relate to the sold TV, and which costs relate to the TV still in inventory or TV on
hand? In this unit, we will discuss such issues as how to determine the cost of merchandise in
inventory and the cost of merchandise have been sold. However, we begin this unit by discussing
the definition and importance of inventory.
1.1. Definition of inventories

Different types companies hold different types of inventories. First of all, let’s, define the term
inventory. The term inventory is used to designate: Any type of good that is held for sale in normal
course of business which is termed as merchandise inventory. Or,
Materials in process of production or held for such use, manufacturing inventory.
Merchandising sector companies hold only one inventory, which is products in their original
purchased form, called merchandise inventory. Manufacturing sector companies typically have
three types of inventories:
I. Direct materials inventory: materials in stock and awaiting use in the manufacturing
process.
II. Work-in-process inventory: goods partially worked on but not yet completed.
III. Finished goods inventory: goods completed but not yet sold.
1.2. Importance of inventories

Inventories has the following importance for businesses:

✓ It is the largest current asset in amount. The sale of inventory is the principal source of revenue
of firms.
✓ It is the most active element in the operation of merchandising firms as many of the transactions
in merchandising firms are related to purchase and sale of inventories.
✓ It appears on financial statements of the business; on balance sheet as major current asset and
on income statement the cost of merchandise sold (CMS) is the largest item deducted from
sales in determining the net income of the period.

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✓ The accuracy of financial statement is affected by the amount reported as inventory.

1.3. Internal control of inventories

Inventories has got vital significance to the firm, as the above mentioned. So, this vital current
asset should be safe. Hence, control of inventory have two primary objectives:
1. Safeguarding the inventory from damage or theft.
2. Reporting inventory in the financial statements. Let's discuss those method one by one:
Safeguarding inventory

Safeguarding inventory from damage or theft is one of primary objective of internal control over
inventories. Therefore, controls for safeguarding inventory must be begin as soon as the inventory
is ordered. Hence, various documents are often used for inventory control. These are:
✓ Purchase order
✓ Receiving report
✓ Vendor’s invoice
The purchase order is an initial document which is authorizes the purchase of the inventory from
an approved vendor. While, as soon as the inventory is received, a receiving report is prepared
and completed. Why? To make sure the inventory received is what was ordered, the receiving
report and company’s purchase order compared. Whereby, the price, quantity, and description of
the item on the purchase order and receiving report are then compared to the vendor’s invoice.
Finally, if the receiving report, purchase order, and vendor’s invoice agree, the inventory is
recorded in the accounting books. While, if any differences exist, they should be investigated and
reconciled.
Finally, controls for safeguarding inventory should include security measures to prevent damage
and customer or employee theft. Some examples of security measures include the following:
Storing inventory in areas that are restricted to only authorized employees.
Locking high-priced inventory in cabinets.
Using two-way mirrors, cameras, security tags, and guards.
Reporting inventory

Reporting inventory in the financial statements is another means of control over inventory. The
quantity of inventory reported in the financial statements must be accurate. Hence, a physical

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 inventory or count of inventory should be taken near year-end. While the quantity of inventory on
hand is determined, the cost of the inventory is assigned for reporting in the financial statements.
Most companies assign costs to inventory using inventory cost flow assumptions. We will see later
the different inventory cost flow assumptions.

1.4. Effect of inventory errors on financial statements

Any error in inventory count will affect both the statements of financial position and the income
statement. If
 CMS (Cost of Merchandise Sold) = BI (Beginning Inventory) + Net Purchase – EI (Ending
Inventory), then
 CMS = CMAS (Cost of Merchandise Available for Sale) – EI or CMS + EI = CMAS.
This implies that at the end of the period the CMAS is divided in to EI and CMS. Therefore, an
error in determining EI will cause misstatement on CMS. This in turn will affect Gross Profit (GP)
and Net Income (NI) on the income statement of the period; and asset and capital reported on the
balance sheet at the end of the period. EI of the current period becomes BI of the next period. Thus,
if EI is incorrectly stated at the end of the current period, the CMS, GP & NI of the current period
will be misstated and so will the CMS, GP & NI for the next period. The amount of the two
misstatements will be equal and in opposite directions. Therefore, the effect on CMS, GP & NI of
an incorrectly stated inventory, if not corrected, is limited to the period of the error (current period)
and the next period. At the end of the next period, assuming no additional errors, both assets and
owners’ equity (capital) will be correctly stated.
The relationship of Inventory with Net Income:
1. If EI is Understated, CMS is Overstated, Net Income is Understated
2. If EI is Overstated, CMS is Understated, Net Income is Overstated
3. If BI is Understated, CMS is Understated, Net Income is Overstated
4. If BI is Overstated, CMS is Overstated, Net Income is Understated
 BI is part of CMS whereas EI is not part of CMS; Remember the Formula (CMS = BI + Net Purchase – EI)

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Illustration 1.1:

Suppose Beginning inventory, January 1, 2020: Birr 10,000, Net purchase for the year 2020: Birr
130,000; Then, CMAS = 10,000 + 130,000 = Birr 140,000
Assumption 1: EI as of December 31, 2020 is Birr 20,000; correctly stated
Assumption 2: EI as of December 31, 2020 is Birr 12,000; Understated by Birr 8,000
Assumption 3: EI as of December 31, 2020 is Birr 27,000; Overstated by Birr 7,000
Assumption 1 Assumption 2 Assumption 3
EI as of Dec. 31,2020 EI as of Dec. 31,2020 EI as of Dec.31,2020
Correctly stated Understated by Birr 8,000 Overstated by Birr 7,000
CMAS……. Birr 140,000 Birr 140,000 Birr 140,000
Less: EI…... (20,000) (12,000) (27,000)
CMS……… Birr 120,000 Birr 128,000* Birr 113,000*

Effect of inventory error on current and next periods financial statements

1. If EI of the current period (2020) is understated by Birr 8,000 and no additional error in the
next period (2021).
On Current Period’s Income On Next Period’s Income Net effect of the error
Statement Statement over a two years period
- CMS will be understated - Overstatement of
- CMS will be overstated by by Birr 8,000 CMS is offset by the
Birr 8,000 - GP & NI will be Understatement.
- GP & NI will be overstated by Birr 8,000 - Understatement of GP
understated by Birr 8,000 & NI is offset by the
Overstatement
On Current Period’s On Next Period’s
Statement of financial Statement of financial
position position
- Asset & Capital will be - Asset & Capital will be
understated by Birr 8,000 stated correctly since the
due to the understatement error offsets each other.
of EI and NI.

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 2. If EI of the current period (2020) is overstated by Birr 7,000 and no additional error in the
next period (2021).
On Current Period’s Income On Next Period’s Income Net effect of the error
Statement Statement over a two years period
- CMS will be understated by - CMS will be overstated - Understatement of
Birr 7,000 by Birr 7,000 CMS is offset by the
- GP & NI will be Overstatement.
- GP & NI will be overstated understated by Birr - Overstatement of GP
by Birr 7,000 7,000 & NI is offset by the
Understatement.
On Current Period’s On Next Period’s
Statement of financial position Statement of financial
- Asset & Capital will be position
overstated by Birr 7,000 due - Asset & Capital will be
to the overstatement of EI stated correctly since
and NI. the error offsets each
other.

1.5. Inventory systems

There are two principal systems of inventory, periodic and perpetual.

1.5.1. Periodic inventory system

Under periodic inventory system, increases in merchandise inventory (purchase of merchandise)
are accumulated in an account titled “Purchase”.
Date
Debit Credit
Purchase XX
Account Payable/Cash XX
To record purchase on account/cash

Decrease in merchandise inventory is not recorded after each sale; thus there is no determination
of the CMS and the EI after each sale. The only entry recorded at time of sale is:

Date
Debit Credit
Account Receivable/Cash XX
Sale XX
To record sale on account/cash
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Periodically, usually at the end of the accounting period, for the purpose of preparing statements
of financial position and income statement, the merchandise inventory on hand is determined by
physical count. Then, the CMS is determined by deducting the EI from CMAS. i.e.
CMS = CMAS - EI
And, CMAS = BI + Net Purchase
 This system is often used by firms having variety of merchandise with low unit price.
Examples: Retail Stores, Drug Stores, Groceries etc.

1.5.2. Perpetual inventory system

Under this system, increases in merchandise inventory are accumulated in a control account titled
“Merchandise Inventory” and subsidiary ledgers are maintained for each item.
Date
Debit Credit
Merchandise Inventory XX
Account Payable/Cash XX
To record purchase on account/cash

The cost of merchandise sold is recorded after each sale and the inventory account is updated for
the decrease in inventory balance as a result of the sales. Two entries are recorded at time of sale:

Date
Debit Credit
Account Receivable/Cash XX
Sale XX
Cost of Merchandise sold XX
Merchandise Inventory XX

To record sale on account/cash

Thus, accounting records perpetually (continuously) show the EI and the CMS. Under this method,
physical inventory is conducted for controlling purpose; just to compare book inventory
(merchandise inventory balance per record) with the actual count.

 This system is frequently used by companies that sell items of high unit price.

Examples: Office equipment, automobiles etc.

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1.6. Inventory costing methods under a periodic system

The prices of many kinds of merchandises are subject to frequent change. At various date during
a period, an identical item can be acquired at different price. The question is which unit price is
used to determine the cost of merchandise inventory on hand (EI) and the cost of merchandise sold
(CMS); the earliest, or average? What should be the cost of EI and the CMS that will appear on
year-end statements of financial position and income statement respectively? To determine these
figures there are two most widely accepted inventory costing methods. Those are:
 First in First out(FIFO) Method; and
 The Average Cost Method.

1.6.1. First in First out (FIFO) method

FIFO method is based on the assumption that items acquired first are to be sold first; or each
sale is made out of the oldest goods in stock and ending inventory consists the most recently
acquired goods. The cost of merchandise sold is computed by the oldest unit costs, this implies
the cost flow is in the order expenditures were made. Ending inventory cost is computed by
recent unit costs.

1.6.2. The Average cost method or weighted average (WA) method

Average cost method is based on the assumption that the cost flow is an average of expenditure
on goods. Both the cost of merchandise sold and ending inventory are computed by using the
weighted average unit cost.
There are two steps to apply this method:
Step 1: Compute the Weighted Average Unit Cost (WAUC) as follows:
WAUC = Total cost of merchandise available for sale (CMAS)
Total units available for sale
Step 2: Applying the weighted average unit cost on both units on hand and units sold.
Illustration 1.2:
Eleni Company began the year and purchased merchandise are as follows:
January 1 Beginning inventory 80 units @ Birr 60 = Birr 4,800
February 16 Purchase 400 units @ 56 = 22,400
September 2 Purchase 160 units @ 50 = 8,000
November 26 Purchase 320 units @ 46 = 14,720
December 4 Purchase 240 units @ 40 = 9,600
Units available for sale 1200 units CMAS = Birr 59,520
Assume units on hand at the end of the year were 400 units. And assume that Eleni Company
uses Periodic inventory system.
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 Instruction
Determine the cost of Ending Inventory (EI) and the Cost of Merchandise Sold (CMS), under
the following inventory costing methods
1. First in First out (FIFO) method
2. The Average cost method
Solutions:
Units sold = 800 units (1200 units available for sale – 400 units on hand).

1. Under the periodic FIFO method, the EI and CMS are computed as follows:
Cost of Ending Inventory, 400 units Cost of 800 units sold (CMS)
th
From 4 Purchase: 240 X 40 = Birr 9600 Sold-From Beg. Inventory: 80 X 60 = Birr 4800
From 3rdPurchase: 160 X 46 = 7360 Sold-From 1st Purchase: 400 X 56 = 22,400
Total Cost of EI, 400 units = Birr 16,960 Sold-From 2nd Purchase: 160 X 50 = 8000
rd
Sold-From 3 Purchase: 160 X 46 = 7360
Total Cost of 800 units sold(CMS)=Birr 42,560

2. Under the average cost method, the EI and CMS are computed as follows:

Step 1: Computing the Weighted Average Unit Cost (WAUC)

WAUC = Total cost of merchandise available for sale (CMAS)
Total units available for sale
WAUC = Birr 59,520
1,200 units
WAUC = 49.60 per unit
Step 2: Applying the WAUC on both units on hand and units sold.

Cost of Ending Inventory of 400 units Cost of 800 units sold

Total Cost of EI = 400 * 49.60 = Birr 19,840 Total CMS = 800 * 49.60 = Birr 39,680

 Or, CMS = CMAS – EI; 59,520 – 19,840 = Birr 39,680

1.6.3. Comparison of Inventory Costing Methods

Refer to the data that pertains to Eleni company in the above illustration, each of the two
assumptions to cost flow provides different ending inventory and CMS figures. The method that
provides highest ending inventory provides lowest CMS and vice versa.
The following table shows you the summary as well as the comparison of the two inventory costing
method under periodic inventory system.
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 FIFO Method Average Cost Method
CMAS Birr 59,520 Birr 59,520
EI 16,960 19,840
CMS Birr 42,560 Birr 39,680

FIFO Method
During the period of rising price, inflation, FIFO method reports highest ending inventory and
lowest cost of merchandise sold, as a result it reports higher net income. This is because the cost
of merchandise sold is computed by earlier costs, which is lower. So, in this period the use of FIFO
method results in higher income tax because of higher net income. On the other hand, when the
trend in price is declining, FIFO method reports lowest ending inventory and higher cost of
merchandise sold; as a result it reports lower net income. Refer to the above illustration the price
of the item is declining, FIFO reports lowest EI Birr 16,960 and highest CMS, Birr 42,560.
Weighted Average Method
Under this method, the effect of price trend is averaged. However, the time required to collect and
organize purchase data of each item is more than other methods.

1.7. Inventory costing methods under a perpetual inventory system

As we mentioned in the preceding section, under perpetual inventory system, we will apply the
inventory costing methods each time sale of merchandise is made. We will calculate the cost of
merchandise inventory on hand (EI) and the cost of merchandise sold (CMS) at the time of each
sale. This means the merchandise inventory account is continually updated to reflect purchase and
sales. Perpetual records may be maintained based on the First in, First out (FIFO), and Moving
Average Methods.

Illustration 1.3:

The Beginning Inventory, Purchases and Sales of ABC Company for its “Item B” during the
month of January were as follows:
Units Cost
Jan. 1 Inventory 15 Birr 10
6 Sale 5
10 Purchase 10 12
20 Sale 8
25 Purchase 8 12.5
27 Sale 10
30 Purchase 15 14

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Instructions:
Determine the cost of ending inventory (EI) as of January 31 and the cost of merchandise sold
(CMS) for the month, under the following inventory costing methods:
1. Perpetual FIFO method
2. Perpetual moving average method

1.7.1. First-in first-out (FIFO) 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's calculate the cost of goods sold and ending inventory under perpetual inventory
system from the above illustration.

Perpetual FIFO method

Purchases Cost of Merchandise Inventory
Date Sold
Qty. U.Cost T. Cost Qty. U.Cost T. Cost Qty. U.Cost T. Cost
Jan. 1 15 10 Birr 150
6 5 10 50 10 10 100
10 10 100
10 10 12 120 10 12 120
2 10 20
20 8 10 80 10 12 120
2 10 20
10 12 120
25 8 12.5 100 8 12.5 100
2 10 20 2 12 24
27 8 12 96 8 12.5 100
2 12 24
8 12.5 100
30 15 14 210 15 14 210
Total 33 Birr 430 23 Birr 246 25 Birr 334

So, the cost of EI & CMS under perpetual FIFO method are Birr 334 and Birr 246 respectively.

1.7.2. Moving Average Method

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
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inventory system. Let’s calculate the cost of merchandise sold and ending inventory comes out
from the previous illustration under perpetual inventory system.

Perpetual moving average method

Purchases Cost of Merchandise Inventory

Date Sold
Qty. U.Cost T. Cost Qty. U.Cost T. Cost Qty. U.Cost T. Cost
Jan. 1 15 10 Birr 150
6 5 10 50 10 10 100
10 10 12 120 20 220/20= 11 220

20 8 11 88 12 11 132

25 8 12.5 100 20 232/20=11.6 232

27 10 11.6 116 10 11.6 116

30 15 14 210 25 326/25=13.04 326

Total 33 Birr 430 23 Birr 254 25 Birr 326

So, the Cost of EI and CMS under Perpetual Moving Average Method are Birr 326 & Birr 254
respectively.

1.8. Valuation of inventory at other than Cost

We have seen methods used to determine inventory costs (more specifically, the cost of goods sold
and ending inventory). Mostly cost is the primary base for recording and reporting inventories. In
some cases however, inventory is recorded and reported at other than cost. This is when; the
replacement cost of inventory is below the recorded cost, and the inventory is not salable at normal
selling price which may be due to imperfections, shop wear, style changes, and other causes.

In such cases, inventories are valued using:

1. The Net Realizable Value (NRV) method

1.8.2. Valuation at Net Realizable Value (NRV)

Merchandises that are spoiled, damaged, out of date, or that can be sold only at prices below cost
should be valued at net realizable value.
NRV = Estimated selling price - Any direct cost of disposition
Illustration 1.5:
Assume that damaged merchandise costing Birr 1,500 can be sold for only Birr 1250 and direct
selling expenses are estimated to be Birr 175.

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 NRV = Birr 1250 – 175
= Birr 1075
Ending inventory is reported at Birr 1075 and loss of Birr 425 (Birr 1500 – 1075) is added to CMS
or recorded separately as general expense. Under a perpetual system, the inventory account is
credited by Birr 425 to adjust the net realizable value.

1.9. Estimating cost of inventory

Dear learners, 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 physical inventory is taken only
once a year.
There are two widely used methods of estimating inventory cost.
1. The Retail Method
2. The Gross Profit Method

1.9.1. The Retail method of inventory costing

 The retail 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 estimated ending inventory cost.

Steps in applying this method:

 Step 1: Determine the total merchandise available for sale at cost and retail
 Step 2: Determine the ratio of the cost to retail of merchandise available for sale
 Step3: Determine the ending inventory at retail by deducting the net sales from the
merchandise available for sale at retail
 Step4: Estimate ending inventory cost by multiplying the ending inventory at retail by
the cost to retail ratio.
When estimating the cost to retail ratio, the mix of items in the ending inventory is assumed to be
the same as the merchandise available for sale. If ending inventory is made up of different classes
of merchandise, cost to retail ratios may be developed for each class of inventory. An advantage
of the retail method is that it provides inventory figures for preparing monthly statements. Because

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department stores and similar retailers often determine gross profit and operating income each
month, but may take physical inventory only once or twice a year. Thus, the retail method allows
management to monitor operations more closely.
Illustration 1.6:
At Cost At Retail
Merchandise inventory, January 1………………… Birr 19,400 Birr 36,000
Net purchase during January……………………… 42,600 64,000
Net sales during January…………………………... 70,000
Estimate cost of ending inventory and cost of merchandise sold (CMS) using retail method.
Solution: Let's estimate the cost of ending inventory and cost of merchandise sold (CMS) using
Retail method:

at Cost at Retail
Merchandise inventory, January 1 Birr 19,400 Birr 36,000
Purchase in January (net) 42,600 64,000
Merchandise available for sale ← Step 1 Birr 62,000 Birr 100,000
Ratio of cost to retail price: Birr 62,000
100,000
= 62% ← Step 2
Sales for January (net) (70,000)
Merchandise inventory, January 31, at retail ← Step 3 Birr 30,000
Merchandise inventory, January 31, at cost ← Step 4 Birr 18,600
(Birr 30,000 * 0.62)

Estimating EI at cost: Birr 18,600

Estimated CMS = CMAS at cost - Estimating EI at cost
= Birr 62,000 – 18,600
= Birr 43,400

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 1.9.2. The Gross Profit method of inventory costing

 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.

Steps in applying this method:

 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/rate
 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.

Illustration 1.7:
Merchandise inventory, January 1………………… Birr 57,000
Net Purchase during January……………………… 180,000
Net Sales during January…………………………... 250,000
Estimated Gross profit rate………………………... 30%
Assume the merchandise inventory of the business was lost by fire.
Estimate cost of ending inventory lost by fire using Gross profit method.

Solution: Let's estimate the cost of ending inventory lost by fire using Gross profit method:

Cost
Merchandise inventory, January 1 Birr 57,000
Purchase in January (net) 180,000
Merchandise available for sale (Step 1) Birr 237,000
Sales for January (net) Birr 250,000
Less: Estimated gross profit (Birr 250,000*0.3) (Step 2) (75,000)
Estimated cost of merchandise sold (Step 3) (175,000)
Estimated merchandise inventory, January 31 (Step 4) Birr 62,000

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1.10. Presentation of merchandise inventory on the balance sheet

Merchandise inventory is usually presented in the current asset section of the balance sheet,
following receivables. Both the method of determining the cost of inventory (FIFO, or Average
Cost) and the method of valuing the inventory (cost or the lower of cost or market (LCM)) should
be shown. The details may be disclosed in parentheses on the balance sheet or in a foot note to the
financial statements. The company may change its inventory costing methods for valid reason. In
such cases, the effect of the change and the reason for the change should be disclosed in the
financial statements for period in which the change occurred.

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