Principles of accounting II

CHAPTER ONE

1. ACCOUNTING FOR INVENTORIES

1.1 Importance of inventories

Apposite inventory costing system, particularly for merchandising and manufacturing organizations, is
extremely important. Why? It is so important because the Cost of Goods Sold is typically the largest
expense on the income statements of merchandising and manufacturing businesses, and Inventory is often
the largest current asset on the balance sheets of these businesses. 

The fact that the unit cost of inventory doesn’t remain the same throughout the accounting system makes
inventory costing so knotty and important. Moreover, an error in inventory costing messes up both the
balance sheet and the income statement. An error made during the current period doesn’t affect only that
period, the error as well affects the following year too. To illustrate this point let’s consider the following
example.

Example

Suppose that a company’s ending inventory for the year 2000 was overstated by Birr2500. Now look how
this inventory error affects the financial statement of the company for the year 2000 if it is not discovered
and corrected in the same year.

1. Cost of goods sold is understated by Birr 2500

2. Gross profit is overstated by Birr 2500

3. Operating income is overstated by Birr 2500

4. Current asset is overstated by Birr 2500

If this error is not yet discovered and corrected in the following year, it will affect the financial statements
of the company. Assuming the company has no inventory error other than the one mentioned above the
financial statements of the company for the year 2001 will be misstated as indicated below.

1. Beginning inventory will be overstated by Birr2500

2. Cost of goods sold will be overstated by Birr2500

3. Gross profit will be understated by Birr2500

4. Operating income will be understated by Birr2500

You might have noted from the example shown above that an error of overstating (or understanding)
inventory in year one generates the opposite error in year two.  Thus, over a two year period total net
income for the two year period is correct.  Of course, inventory errors are important and hence, correct net
income should be reported every year.

What items should be included in the inventory?

Compiled by Habtamu T. MU, CBE, DCS 1

Principles of accounting II
Items in merchandise inventory-includes all goods owned by a company and held for sale. More over, the
following items need to be considered while reporting:

 Goods in transit: Reported as merchandise on the book of the buyer if the shipping term is FOB
shipping point. If the shipping term is FOB destination, such items should be included in the books
of the seller.

 Goods on consignment: as these goods are owned by consignor, they should be reported as
merchandise on the book of the consignor

 Goods damaged or obsolete: such goods are not included if they are un-salable. If they are salable,
they are included at their net realizable value (sales price minus cost of making the sale).

1.2 Cost of Merchandise Inventory

Cost of inventory includes all expenditures necessary, directly or indirectly, in bringing an item to a salable
condition and location. Invoice price minus any discount, plus transportation-in, storage, and insurance are
additions to the cost of inventory.

1.3 Inventory systems

As discussed in cooperative accounting I of chapter 4, there are two basic systems of accounting for
inventories, such as periodic and perpetual inventory systems.

1 Perpetual inventory system

►Perpetual inventory system updates inventory accounts after each purchase or sale.     

►Inventory subsidiary ledger is updated after each transaction.

►Inventory quantities are updated continuously

►Each purchase of merchandise is recorded in a merchandise inventory account.

2 Periodic Inventory system

►Periodic inventory system records inventory purchase in "Purchases" account.

►"Purchases" account is updated continuously; however, "Inventory" account is updated on a periodic

basis- at the end of each accounting period (e.g., monthly, quarterly)

►Inventory subsidiary ledger is not updated after each purchase or sale of inventory.
►Inventory quantities are not updated continuously.
►Inventory quantities are updated on a periodic basis.
In the periodic system the cost of inventory may be regarded as a pool of costs consisting two elements:
    ►Beginning inventory and

  ►Merchandise inventory purchased during the year

The sum of these two figures equals Goods available for sale.  At the end of the year when the ending
inventory is taken, ending inventory is subtracted from goods available to determine cost of goods sold.  In
other words in the periodic system, cost of goods sold is a calculation not a formal account (as it is in the
perpetual inventory method).

Compiled by Habtamu T. MU, CBE, DCS 2

Principles of accounting II
1.4 Determining the actual quantities of inventory

Generally physical inventory is taken at the end of a fiscal year or when inventory amounts are low (at least
once per year). This physical inventory is undertaken to adjust the Inventory account balance to the actual
inventory on hand (to determine the actual quantities of inventory on hand) and thus account for theft, loss,
damage and errors.

1.5 Inventory costing methods

There are four methods of assigning costs to inventory and cost of goods sold:

1 specific identification method

2 First-in, first-out (FIFO)method

3 Last-in, first-out (LIFO)method

4 Average costing method

Any of these costing methods is permission under GAAP regardless of the actual physical flow of
inventory. 

1. Specific Identification Method

►As sales occur the cost of goods sold is charged with the actual or invoice cost, leaving actual costs of
inventory on hand in the inventory account.

2. First-in, First-out (FIFO) Method

►As sales occur, charges costs of the earliest units acquired to cost of goods sold, leaving costs of most
recently purchases in inventory.

Note that under FIFO the first units acquired are assumed to be the first units sold. When there is a price
rise, this method has the following merits and demerits:

 Advantages: a) reports the current cost to the cost of ending inventory.

b) reports the highest net income.  

 Disadvantages: a) Violates the matching principle (FIFO matches some of the previous
year’s inventory cost against current revenue.

b) Results in higher taxes and lower cash flows.

   c) Does not adjust Cost of Goods Sold for the effect of inflation.

3. Last-in, First-out (LIFO) Method

►As sales occur, charges costs of the most recent purchase to cost of goods sold, leaving costs of earliest
purchases in inventory.

Under the LIFO method the last units acquired are assumed to be the first units sold. 

 Advantages: i) always match with expense and revenue.

        ii) Results in lower taxes and higher cash flows.
 Disadvantages: a) Reports lower net income.
b) Reports understated ending inventory.
Compiled by Habtamu T. MU, CBE, DCS 3
Principles of accounting II
c) Can be used to manipulate income.

4. Weighted-Average Method

►As sales occur, computes the average cost per unit of inventory at time of sale and charges this cost per
units sold to cost of goods sold leaving average cost per unit on hand in inventory.
Comparison of Inventory Costing Methods
1. FIFO
►Will get same results under both periodic/perpetual systems
Advantages ►Easy to apply
►Cost assumption usually well matched to physical flow
►No manipulation of income
►Balance sheet, inventory account reflects current value
Disadvantages ►Recognition of paper profits
►Heavy tax burden if under inflation

►Will result in following results

Inflation
►Highest profits
► (Charging off inventory
with the lowest costs)
►Lowest COGS
►Highest Gross Margin
Deflation
►Lowest profits
► (Charging off inventory
with the highest costs)
►Highest COGS
►Lowest Gross Margin

2. LIFO
►Will get different results under periodic/perpetual systems
►Can use for tax purposes only if also used for financial reporting

Advantages ►Eliminates "illusionary" profits due to inflation

►Better matching of current revenues and expenses
►Periods of inflation, results in lower profits, lower taxes.
Disadvantage ►Ending inventory, balance sheet does not reflect replacement cost
►Permits income manipulation
►Timing of buying inventory at year end can increase, decrease reported
profits.

3. Ac methods
►Used for identical items
►Under perpetual system must compute new weighted average cost per unit after each
new purchase. (Moving weighted average)
Advantages ►Easy to use
Disadvantages ►Time consuming

1.6 Inventory costing methods under the periodic inventory system

To illustrate inventory costing under the periodic inventory system, consider the following example.

May 1, 2000, Beginning Inventory 400units@$3.00

May 5, 2000, Purchase 450units@$3.10

May10, 200, Purchase 800units@$3.15

May28, 2000, Purchase 500units@$3.20

Compiled by Habtamu T. MU, CBE, DCS 4

Principles of accounting II
May31, 2000, Ending Inventory 620units

Required: Determine the cost of ending inventory and the cost of goods sold for the month, may using
periodic inventory system under:

a) FIFO method, b) LIFO method, and c) average costing method?

Solution

Cost of ending inventory-FIFO

Latest purchase 500units@$3.20=$1600

Next latest purchase 120units@$3.15=$378

Cost of ending inventory-FIFO 620units=$1978

Cost of goods sold-FIFO:

Earliest cost 400units@$3=$1200

Next earliest cost 450units@$3.10=$1395

Next earliest cost 680units@$3.15=$2142

Cost of goods sold-FIFO 1530units =$4737

Cost of ending inventory-LIFO

Earliest cost 400units@$3=$1200

Next earliest cost 220units@$3.1=$682

Cost of ending inventory-LIFO 620units= $1882

Cost of goods sold-LIFO:

Latest cost 500units@$3.20=$1600

Next latest cost 800units@$3.15=$2520

Next latest cost 230units@$3.10=$713

Cost of goods sold-LIFO 1530units=$4833

Cost of ending inventory-Weighted average Steps

1. Find the total no. of units available for sale.

2. Find the total cost of units available for sale.

3. Divide the total cost to the total no. of units available for sale.

4. Multiply the total no. of ending inventory by the average unit cost to get the cost of ending
inventory.

5. Multiply the total no. of units sold by the average unit cost to get the cost of goods sold.

Compiled by Habtamu T. MU, CBE, DCS 5

Principles of accounting II
Goods available for sale = BI + Purchases=400 + 450 + 800 + 500=2150units

Total cost= (400*3) + (450*3.1) + (800*3.15) + (500*3.2)

=1200 + 1395 + 2520 + 1600 =$6715

Average unit cost = Total cost/No. of units available for sale

=$6715/2150units =$3.1232558

Cost of ending inventory-Weighted average =$3.1232558 * 620 units=$1936.42

Cost of goods sold-Weighted average =$3.1232558 * 1530 units=$4778.5

1.7 Inventory costing methods under Perpetual Inventory system

Each of the inventory costing methods discussed in the periodic system above can be used in a perpetual
inventory system.  FIFO, LIFO, and Average Cost in a perpetual inventory system are shown below.  Note
that the FIFO costing method in a perpetual inventory system is exactly the same as under a periodic
system

To illustrate how to keep individual perpetual records, consider the following example.

June 1, 2000, Beginning Inventory---------------400units@$4

3. Sale--------------------------------------------300units

7. Purchase------------------------------------- 700units@$4.25

12. Sale------------------------------------------ 500 units

16. Purchase------------------------------------- 800units@$4.30

19. Sale------------------------------------------- 400units

21. Purchase------------------------------------- 600units@$4.30

23. Sale------------------------------------------- 1260units

27. Purchase-------------------------------------- 500units@$4.40

Required: Calculate the cost of ending inventory and cost of goods sold for the month, June using both
periodic and perpetual inventory system under: a) FIFO method, b) LIFO method, c) WA method?

Solution

1) Periodic inventory system Costs

Methods Ending inventory Goods sold

a) FIFO (40*4.3) + (500*4.4)=$2372 (300*4)+(100*4….=$10,423

b) LIFO ? ?

c) AC ? ?

2) Perpetual inventory system

A) FIFO method

Compiled by Habtamu T. MU, CBE, DCS 6

Principles of accounting II
Date Purchase Cost of goods sold Balance of inventory

Units Unit Total Units Unit Total Units Unit Total

cost cost cost cost cost cost

June 1 400 $4 $1600

4 300 $4 $1200 100 $4 $400

7 700 $4.25 $3375 100 $4 $3775

700 $4.25

10 100 $4 $2100 300 $4.25 $1275

400 $4.25

15 800 $4.3 $3440 300 $4.25 $4715

800 $4.3

19 300 $4.25 $1705 700 $4.3 $3010

100 $4.30

21 600 $4.3 $2580 700 $4.3 $5590

600 $4.3

23 700 $4.30 $5418 40 $4.3 $172

560 $4.30

26 500 $4.4 40 $4.3 $2372

500 $4.4

► Cost of ending inventory = $2372

►Cost of goods sold = $1200 + $2100 + $1705 + $5418=$10, 423

B) LIFO method

Date Purchase Cost of goods sold Balance of inventory

Units Unit Total Units Unit Total Units Unit Total

cost cost cost cost cost cost

June 1 400 $4 $1600

4 300 $4 $1200 100 $4 $400

7 700 $4.25 $3375 100 $4 $3775

700 $4.25

10 500 $4.25 $2125 100 $4 $1250

Compiled by Habtamu T. MU, CBE, DCS 7
 Principles of accounting II
200 $4.25

15 800 $4.3 $3440 100 $4 $4690

200 $4.25

800 $4.30

19 400 $4.3 $1720 100 $4 $3420

200 $4.25

400 $4.3

21 600 $4.3 $2580 100 $4 $6000

200 $4.25

400 $4.3

600 $4.30

23 1000 $4.30 $5390 40 $4 $160

200 $4.25

60 $4

26 500 $4.4 $2200 40 $4 $2360

500 $4.4

►Cost of ending inventory = $2360

►Cost of goods sold = $1200 + $2125 + $1720 + $5390=$10, 435

C) WA methods?
Exercise
Example 1 (Company A)
   Inventory transactions in May 2006.
Date Transactions Units Unit Cost Inventory Units
May 1 Beginning Inventory 700 $10 700
May 3 Purchase 100 $12 800
May 8 Sale (500) ?? 300
May 15 Purchase 600 $14 900
May 19 Purchase 200 $15 1,100
May 25 Sale (400) ?? 700
May 27 Sale (100) ?? 600
May 31 Ending Inventory   ??  
  

Required:

Compiled by Habtamu T. MU, CBE, DCS 8

Principles of accounting II
A. Determine the cost of ending inventory and the cost of goods sold using both periodic and perpetual
inventory system under: a) FIFO method, b) LIFO method, and c) Ac methods?

Using average cost (called moving average cost) in a perpetual system a new average is computed after
each purchase.  The average cost is computed by dividing the cost of goods available by the units on hand.  
This average cost is then applied to cost of goods sold and the remaining units in inventory.  See Page 262. 

Though the LIFO and moving average cost methods can be complex using a manual accounting system,
accounting software readily calculates the correct cost of goods and remaining inventory figures

1.8 Valuation of Inventory at other that cost

The fair market value of inventory sometimes falls below its cost.  When market value of inventory falls
below its historical cost, it must be written down to market value The Lower of cost or market (LCM)-
Accounting principle requires that inventory be reported on the balance sheet at market value when market
is lower than cost.

►Market normally means replacement cost. If a comparison of cost to market discloses market is lower,
inventory is written down to market. The loss of inventory value is recorded as an increase to the period's
cost of goods sold.

►Lower of cost or market pricing is applied either to the inventory as a whole, or to major categories of
products or separately to each product in the inventory.

(Refer the class notes for further reading and understanding about the LCM and NRV with their
examples)

1.9 Estimating Inventory costs

Why do we need to estimate the cost of inventory?
►Used for interim statements for periodic system
►Compare with physical inventory to determine if shortages exist
►Determine amounts recoverable for insurance claims for destroyed inventory

There are two estimation techniques of inventory cots: the gross profit method and the retail method
1. Gross Profit Method: used when an estimate of a firm's inventory is required. It is acceptable for
interim reporting but not general annual reporting (FASB recommends retail for interim).

We need 4 items of information to estimate EI:

1. Cost of beginning inventory
2. Cost of purchases for the period
3. Sales during the period
4. Markup (% of cost or % of sales)

Note: in this context, the terms gross margin, gross profit and markup are synonymous.

Concept of Markup:
Example
An item costs birr60 and is sold for birr75 has a gross profit or markup of birr15.
Markup as a % of sales (will always be lower):
Markup/SP = $15/75 = 20%
Markup as a % of cost (if given alone, must covert to gross profit on sales):
Markup/cost = $15/60 = 25%
Formula for converting markup on cost to markup or gross profit on sales:
% markup on cost/(100% + % markup on cost)
Example
Assume that the following data is given for Mars stationary.
Compiled by Habtamu T. MU, CBE, DCS 9
Principles of accounting II
Beginning inventory------------------------Birr 60, 000
Purchases--------------------------------------Birr 90, 000
Sales-------------------------------------------- Birr 100, 000
Markup on cost is 25%
►Determine: Solution
a) Markup on sales (or gross profit on sales)? a) 25 %/( 100% + 25%) = 20%
b) Cost of goods sold? b) Sales x (100% - gross profit on sales 20%) = 80%
$100,000 x 80% = $80,000
3. Use inventory model to determine ending inventory:
Beginning inventory Br 60,000
Purchases 90,000
Cost of goods available for sale 150,000
Sales at cost(cost of goods sold) (80,000)
Ending inventory 70,000

2. Retail Inventory Method

Retail Inventory Method: this is another estimate of ending inventory. Unlike GPM, however, this method
produces estimates that may be acceptable for financial statement purposes.
We need the following:
1. Beginning inventory at cost and at retail
2. Purchases for period at cost and at retail
3. Sales during the period
4. The cost and/or retail amounts of markups, markdowns, employee discounts, spoilage.
Ending inventory at cost:
Retail value of goods available for sale-----------------------xxx
- Sales -----------------------(xxx)
Ending inventory at retail---------------------------------------xxx
x cost to retail ratio
Ending inventory at cost--------------------xxx

There are 3 basic steps in computing all retail inventory problems:

1. Compute EI at retail. This step is the same regardless of which variation is used.
2. Compute the cost to retail ratio. This step will vary depending on which variation of the retail method is
used.
3. Apply the cost to retail ratio (from #2) to EI at retail (from #1) to obtain EI at cost or at LCM. The step
will vary depending on which variation of the retail method is used.
4. If fluctuating prices (dollar-value LIFO retail), have to deflate EI arrived at in #3, layer it to base layer
and new layer and then restate at appropriate dollar values.

Illustration:
Cost Retail
Beginning balance, inventory $105,000 $155,400
Net Purchases 1,323,000 1,944,600
Cost of merchandise available for sale 1,428,000 2,100,000

Cost to retail ratio: ($1,428,000/$2,100,000) = 68%

Sales (2,016,000)
Estimated ending balance, inventory @ retail value $84,000
Estimated ending balance, inventory @ cost
($84,000 X 68%) $57,120

Compiled by Habtamu T. MU, CBE, DCS 10