UNIT ONE:

ACCOUNTING FOR

MERCHANDISING INVENTORIES

Introduction

In our economy, inventories are an important barometer of business activity. Any

company classifies its inventory depending on whether the firm is a merchandiser or
a manufacturer. The accounting principles and concepts discussed in this unit apply
to inventory of merchandising business. Merchandising business is engaged in buying
products and reselling them to customer.

In this chapter you will learn about the two-inventory accounting systems, i.e.
periodic and perpetual. You will also discuss the procedures for determining
inventory quantities and the methods used in determining the cost of inventory on
hand at the balance sheet date. In addition, you will learn how inventory valuation
differs in periodic and perpetual inventory system, the use of estimates in determining
inventory costs, and the effect of errors on a company’s financial statements.

Objectives:
After completing the study of this chapter, you will be able to:

▪ Understand the importance of control over inventory

▪ Comprehend the inventory accounting and recording issues
▪ Differentiate between periodic and perpetual inventory system
▪ Explain and apply inventory valuations methods
▪ Show how inventories are reported in balance sheet

1.1 Introduction: basic concepts of inventories

In a merchandising enterprise, inventory consists of many different items. For
example, in a grocery store, canned goods, dairy products and meats, are just a few of
the inventory items on hand.

Merchandise inventory is items or commodities held for sale to customers in the

ordinary course of the business.

These items have two common characteristics:

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 1.they are owned by the company, and
2.they are in a form ready for sale to customers in the ordinary course of business

In a manufacturing enterprise, inventories are also owned by the company, but some
goods may not yet be ready for sale. as a result, inventory is usually classified in to
three categories: finished goods, work in process, raw materials.

Finished Goods inventory: consists of completed products ready for sale. This
inventory is similar to merchandise inventory.

Work in process (Goods in process): consists of products in the process of being

manufactured but not yet completed.

Raw materials inventory: refers to the goods a company acquires to use in making
products.

In this chapter we will focus on the accounting principles and concepts of

merchandise inventory. The accounting issues relating to merchandising inventories:
➢ Internal control of inventories
➢ Determination of inventory Quantity as of reporting date/inventory taking
➢ Selection of inventory recording system
➢ Determination of inventory values and cost of goods sold

1.2 : Internal control of inventories

Inventories are the most valuable and significant assets of any merchandising entity.
The company should carefully account for their inventories, say on purchase,
shipment/logistics, sales, in taking physical count, storage, etc… Hence designing
appropriate internal control and management is crucial. The primary control issues
for inventories are: 1) safeguarding inventory from theft or damage 2) reporting
inventories in financial statement

Safeguarding inventories

Controls for safeguarding inventories begin as soon as the inventory is ordered. The
following documents are often used for inventory control.
- Purchase order
- Receiving report
- Vendor’s invoice/Purchase invoice
The purchase order authorizes the purchase of inventory from approved
vendor/suppliers. As soon as the inventories purchased are received, a receiving
report is completed. The receiving report establishes an initial record of the receipt
of an inventory. To make sure the inventory received is what was ordered, the

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receiving report is compared against the company’s purchase order. The price,
quantity, and the description of the items on the purchase order and receiving report
are then compared against the vendor’s/purchase invoice. If the three, purchase order,
receiving report and vendor’s invoice agree, the inventory purchase is recorded in the
accounting system. If any difference exists they should be investigated and
reconciled.
To ensure effective internal control, segregation of these duties among different
personnel is required so that check and balance system would be established. That
means personnel who places purchase order, who authorizes or approves the
purchase, who perform the purchasing procedure, who receive and keep custody of
stock, who maintains the accounting records and who checks the accuracy and
reconciles must be different.
Recording inventory using perpetual inventory system is also an effective means of
control. The amount of inventory is always available in the subsidiary inventory
ledger. This helps keep inventory quantities at proper levels. For example, comparing
inventory quantities with maximum and minimum level allows for the timely
reordering of inventories and prevents excess inventory holdings.
Finally control for safeguarding inventory should include security measures to
prevent damages and customer or employee theft. Some example of security measures
includes the following:
➢ Storing inventories in areas that are restricted to only authorized employees
➢ Locking high-priced more valuable inventories in cabinets or safe places
➢ Using technologies such as: two-way mirrors, cameras, security tags, etc…

1.3. Determining Inventory Quantities and presentation in financial

reports

In order to prepare financial statement, it is necessary to determine the number of

units of inventory owned by the company at the statement date. For many companies,
determining inventory quantities consists of two steps;
(a) Taking a physical inventory of goods on hand, and
(b) Determining the ownership of goods.

Taking a Physical Inventory

Taking a physical inventory involves actually counting, weighing, or measuring each

kind of inventory on hand. In many company inventory is a formidable task. An
inventory count is generally more accurate when goods are not being sold or received
during the counting. Consequently companies often “take inventory” when the
business is closed or when business is slow. Many retailers, for example, close early
on a chosen day in January – after the holiday sales and returns – to count their
inventory.

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To minimize errors in taking the inventory, a company should adhere to the following
internal control principles by adopting certain procedures:
1. The counting should be done by employees who do not have custodial
responsibility for the inventory. (Segregation of duties)

2. Each counter should establish the authenticity of each inventory item, e.g., each
box does contain a 25-inch television set and each storage tank does contain
gasoline. (Establishment of responsibility)
3. There should be a second count by another employee. (Independent internal
verification)
4. Pre numbered inventory tags should be used, and all inventory tags should be
accounted for. (Documentation procedures)
5. A designated supervisor should ascertain at the conclusion of the count that all
inventory items are tagged and that no items have more than one tag. (Independent
internal verification)

After the physical inventory is taken, the quantity of each kind of inventory is listed
on inventory summary sheets. To assure the accuracy of the summary sheet, the listing
should be verified by a second employee or supervisor. Subsequently, unit cost will
be applied to the quantities in order to determine a total cost of the inventory – which
is the topic of later sections.

Determining Ownership of Goods

Before we can begin to calculate the cost of inventory, we need to consider the
ownership of goods: specifically, we need to be sure that we have not included in the
inventory any goods that do not belong to the company.

Goods in Transit

Goods are considered to be in transit when they are in the hands of a public carrier,
such as a railroad, trucking, or airline company at the statement date. Goods in transit
should be included in the inventory of the party that has legal title to the goods. Legal
title is determined by the terms of sale, as shown below:

1. When the terms are FOB (free on board) shipping point, ownership of the goods
passes to the buyer when the public carrier accepts the goods from the seller.
2. When the terms are FOB destination, legal title to the goods remains with the
seller until the goods reach the buyer.

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Significant errors may occur in determining inventory quantities if goods in transit at
the statement date are ignored. Assume, for example, that Hargrove Company has
20,000 units of inventory on hand on December 31 and the following goods in transit :

(1) Sales of 1,500 units shipped December 31 FOB destination, and

(2) Purchases of 2,500 units shipped FOB shipping point by the seller on
December 31. Hargrove has legal title to both the units sold and the units
purchased. Consequently, inventory quantities would be understated by 4,000
units (1,500) if units in transit are ignored.

Consigned Goods

In some lines of business, it is customary to acquire merchandise on consignment.

Under a consignment arrangement, the holder of the goods (called the consignee) does
not own the goods. Ownership remains with the shipper of the goods (called the
consignor) until the goods are actually sold to a customer. Because consigned goods
are not owned by the consignee, they should not be included in the consignee’s
physical inventory count. Conversely, the consignor should include merchandise held
by the consignee as part of its inventory.

Presentations of related information in financial statements

Merchandise inventory is usually presented on the balance sheet immediately

following receivables. In addition, both the method of determining the cost of the
inventory (FIFO, or average) and the method of valuing the inventory (cost, or lower
of cost or NRV) should be shown.

Effects of inventory error

Unfortunately, errors occasionally occur in taking or costing inventory. In some cases,
errors are caused by failure to count or price the inventory correctly. In other cases,
errors occur because proper recognition is not given to the transfer of legal title to
goods that are in transit. When errors occur, they affect both the income statement
(because CGS = Beginning inventory + Purchases - Ending inventory) and the balance
sheet.
The effects of inventory errors on the current year’s income statement are shown in
bellow:

Cost of
Inventory Error Goods sold Net Income
Understate beginning inventory Understated Overstated
Overstated beginning inventory Overstated Understated

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 Understate ending inventory Overstated Understated
Overstated ending inventory Understated Overstated

The effect of ending inventory errors on the balance sheet can be determined by using
the basic accounting equation: assets equal liabilities plus owner’s equity. Errors in
the ending inventory have the following effects on these components:

Ending Inventory
Error Assets Liabilities Owner’s Equity
Overstated Overstated None Overstated
Understated Understated None Understated
Exercises
1. Selam company report cost of goods sold as follows:
2014 2015
Beginning inventory Br20, 000 Br30, 000
Cost of goods purchased 150,000 175,000
Cost of goods available for sales 170,000 205,000
Ending inventory 30,000 35,000
Cost of goods sold 140,000 170,000

The company made two errors:

2014 ending inventory was overstated Br 4000 and
2015 ending inventory was understated Br3000
Required
Compute the correct cost of goods sold for each year.
2. A company takes a physical count of inventory at the end of 2015 and finds
ending inventory is overstated by 20,000. Does this error cause an overstating
or an understated cost of goods sold in 2015? What about on year 2016? By how
much?

1.4. Accounting/recording system for inventories

Merchandise Inventory is items or commodities held for sale to customers in the
ordinary course of the business

There are two inventory accounting systems used to collect information about cost of
goods sold and cost of inventory on hand. The two systems are called periodic and
perpetual.
1.4.1. Periodic Inventory System

A periodic inventory system requires updating the inventory account only at the end
of a period to reflect the quantity and cost of both goods on hand and goods sold. It
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does not require continual updating of the inventory account. The company records
the cost of new merchandise in a temporary purchases account. When merchandise is
sold, revenue is recorded but the cost of the cost of the merchandise sold is not yet
recorded as a cost. When financial statements are prepared, the company takes a
physical count of inventory by counting the quantities of merchandise on hand. Cost
of merchandise on hand is determined by relating the quantities on hand to records
showing each item’s original cost. The cost of merchandise on hand is then used to
compute cost of goods sold. The inventory account is adjusted to reflect the amount
computed from the physical count of inventory.

Periodic systems were historically used by companies such as hardware, drug, and
department stores that sold large quantities of low-value items. Without today’s
computers and scanners, it was not feasible for accounting systems to track such small
items as pencils, toothpaste, paper clips, socks, and Toothpicks through inventory and
into customers’ hands.

1.4.2. Perpetual Inventory System

A perpetual inventory system keeps a continual record of the amount of inventory on

hand. A perpetual system accumulates the net cost of merchandise purchases in the
inventory account and subtracts the cost of each sale from the same inventory account.
When an item is sold, its cost is recorded in a Cost of Goods sold account. With a
perpetual system we can find out the cost of merchandise on hand at any time by
looking at the balance of the inventory account. We can also find out the current
balance of cost of goods sold anytime during a period by looking in the Cost of Goods
Sold account.

Under a perpetual system, the cost of each item is debited to the Merchandise
inventory account when purchased. At the time of sale, the cost of each item is
transferred from the Merchandise inventory account to the Cost of Goods sold
account. Thus, the Cost of Goods Sold account at all times equals the cost of
merchandise sold during the period, and the Merchandise inventory account at all
times equals the cost of merchandise on hand.

Before advancements in computing technology, a perpetual system was often limited

to businesses making a limited number of daily sales such as automobile dealers and
major appliance stores.Because there were relatively few transactions, a perpetual
system was feasible. In to day’s information age, with widespread use of
computing technology, the use of a perpetual system has dramatically grown. Also,
the number of companies using a perpetual system continues to increase.

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 Illustration
To illustrate the recording of merchandise transactions under a periodic and
perpetual inventory system, we will use selected transactions of Country Clothiers
Co. The beginning inventory on July 1 is Br. 68,000 and the ending inventory on
July 31 is Br. 93,940.
➢ Purchase of Merchandise on Credit- On July 5, Country Clothiers
purchased Br. 40, 000 of merchandise on account from Wear Apparel Co,
terms 2/10, n/30.
➢ Purchase Returns and allowances- On July 6, Country Clothiers returned
merchandise received from Wear apparel Co. on July 5 for a credit of Br2,
000.
➢ Freight Costs on Purchases- Country Clothiers received a bill on July 8
from Overhand Trucking Co. for freight charges on the July 5 purchase,
terms n/30, Br200.
➢ Payment on Account with a Discount- On July 14, Country Clothiers paid
Wear apparel Co. in full for the July 5 purchase, less Br2, 000 that was
returned on July 6 and less the discount of Br760 [(Br40, 000 - Br2, 000) x
2%].
➢ Sale of Merchandise on Credit- On July 16, Country Clothiers sold
merchandise on credit to Squire Men’s Wear, terms 1/10, n/30 FOB
destination, Br24, 000. The merchandise cost Br12, 000.
➢ Return of Merchandise Sold-Country Clothiers on July 18 accepted for full
credit the return of Br1, 000 of merchandise sold to Squire Men’s Wear on
July 16, the cost of which was Br500.
➢ Cash Received on Account with a Discount- On July 25, Country Clothiers
received payment in full of the account from Squire Men’s Wear, less the
return of July 18 and less the discount of Br230 [(Br24, 000 - Br1, 000) x
1%].

Journal entry to record the above transactions are summarized as follows:

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 Transaction Perpetual inventory Periodic Inventory
System System
July 5 Purchase Merchandise Inventory 40,000 Purchases 40,000
on Credit Accounts Payable 40,000 Accounts Payable 40,000

July 6 Purchase Accounts Payable 2,000 Accounts Payable 2,000

returns Merchandise 2,000 Purchase Returns And 2,000
and Inventory Allowances
allowances

July 8 Freight costs Merchandise Inventory 200 Freight-in 200

on Purchases. Accounts Payable 200 Accounts Payable 200

July 14 Payment with Accounts Payable 38,000 Accounts Payable 38,000

a discount Cash Accounts
37,240Paya 37,240
Cash
Merchandise 760 Purchase Discounts 760
Inventory

July 16 Sales of Accounts Receivable 24,000 Accounts Receivable 24,000

merchandise Sales Revenue 24,000 Sales Revenue 24,000
on credit

Costs of Goods Sold 12,000

Merchandise 12,000 No entry
Inventory

July 18 Return of Sales Returns and 1,000 Sales Returns and allowance 1,000
merchandise Allowances
sold Accounts Receivable 1,000 Accounts Receivable 1,000

Merchandise Inventory 500

cost of Goods Sold 500 No entry

July 25 Cash received Cash 22,770 Cash 22,770

on account Sales Discount 230 Sales Discounts 230
with a discount Accounts receivable 23,000 Accounts Receivable 23,000

July 31 End of period No entries are necessary Adjusting entries are

entries for necessary
Inventory
account's

The account, merchandise Income Summary 68,000

inventory s,
Show the ending Inventory Merchandise Inventory 68,000
(Beginning)
Mer.Inventory(Ending) 93,940
Income Summery 93,940

To summarize, the differences between the periodic and the perpetual systems
are:

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 1. The perpetual inventory system records all purchases in the Merchandise
inventory account; it uses no Purchases account. The periodic inventory system
uses a purchases account.
2. The perpetual inventory system records returns of purchased merchandise by
directly reducing the Merchandise Inventory account. The periodic inventory
system uses a Purchase Returns and Allowances account.
3. The perpetual inventory system increases the Merchandise Inventory account
for additional cost of purchases like freight-in and decreases Merchandise
Inventory directly for reductions in purchases like purchase discounts. The
periodic inventory system uses Freight- in and Purchase discounts.
4. The perpetual inventory system increases Cost of Goods Sold and decreases
Merchandise Inventory when merchandise is sold. The periodic inventory
system computes cost of goods sold based on the inventory count at the end of
the period.
5. The perpetual inventory system records customer returns and allowances by
decreasing Cost of Goods sold and increasing the Merchandise Inventory
account. The periodic inventory system makes no entry for the cost of a sales
return

Under the perpetual inventory system, the cost of goods sold and the amount of
inventory are continuously updated, and the balances are readily available at any time.
Under the periodic inventory system, cost of goods sold and inventory amounts are
not available until they are computed and are accompanied by a physical inventory
count

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Exercise
1.Differentiate between the periodic system and the perpetual system of inventory
determination.
2. XYZ company has the following data for the year ended December 31,1996.
Merchandise inventory account balance on January 1, 1996, show br. 60,000 During the
year goods purchased was Br 380,000, Assuming that there were no purchased returns
and discounts. Ending merchandise (on hand) at the end of the fiscal period is Br 50,000.
Compute the cost of good sold of the period.
3. Record the following business transactions in the space provided, under

(a) Periodic inventory system

(b) Perpetual inventory system

September 6- purchased merchandise on account at cost of Br 6,,000 terms 2/10,n/30.

September 10- Returned Br 5000 of the merchandise purchased on September 6.

September 15- paid the liability that incurred on September 6.

September 20- Sold merchandise on account for Br 9,000 to customer, the cost of this
goods was Br 6,800, Terms 2/10,n/30

The customer returned Merchandise sold on sep.20. The sales value of the returned
good is Br 1000 and the cost was Br 700

Received the balance due from the customer for its sales made on September 20.

1.5. Inventory valuation: Assignment of costs to ending inventory

and costs of goods sold
With a reliable physical count of the inventory (considering both goods in transit and
consigned goods), we are now ready to assign costs to the inventory.

All expenditures necessary to acquire the goods and to make them ready for sale are
included as inventoriable costs. Inventoriable costs may be regarded as a pool of costs
that consists of two elements:

(1) The cost of the beginning inventory and

(2) The cost of goods purchased during the year.

Inventorable costs include:

➢ Invoice purchase price,
➢ non refundable taxes and custom duties paid on goods purchased,
➢ insurance cost and Freight charges paid by purchaser
➢ Less Purchase discounts taken by purchaser and
➢ Less Purchase returns and allowances granted by the seller

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What about the costs of the purchasing, receiving, and warehousing departments whose efforts
make the goods available for sale? Conceptually those costs should also be included
in inventoriable costs. However, because of the practical difficulties in allocating
these costs to inventory, they are generally accounted for as operating expenses in the period in
which they are incurred.

Inventor able costs are allocated to ending inventory and to cost of goods sold. Under a periodic
inventory system, the allocation is made at the end of the accounting period. Under perpetual
inventory system, the allocation is continuously recognized as purchases are made.
Under both inventory systems there are four generally accepted methods of cost assignment called
methods of inventory valuation. These are:
1. Specific identification
2. Firs-in-first-out (FIFO) method
3. Weighted average method

1.5.1. Inventory Costing Methods under a Periodic inventory System

Costing of the inventory is complicated because the units on hand for a specific item
of inventory may have been purchased at different prices. For example, in a period of rising prices,
a company may experience several increases in the cost of identical goods within a given year.
Alternatively, unit costs may decline. Under such circumstances, how should the different unit
costs in the cost of goods available for sale is allocated between the ending inventory and cost of
goods sold?

Using Actual Physical Flow Costing – Specific Identification

One answer is to use specific identification of the units purchased. This method tracks the actual
physical flow of the goods. Each item of inventory is marked, tagged, or coded with its “specific’
unit cost. Items still in inventory at the end of the year are specifically costed to arrive at the total
cost of the ending inventory. Assume, for example, that Southland Music Company purchases
three 46-inch television sets at costs of Br700, Br750, and Br800, respectively. During the year,
two sets are sold at Br1, 200 each. At December 31, the company determines that the Br750 set is
still on hand. Accordingly, the ending inventory is Br750 and the cost of goods sold is Br1, 500
(Br700 + Br800).

Specific identification is possible when a company sells a limited variety of high-unit cost items
that can be clearly identified from the time of purchase through the time of sale. Examples of such
companies are automobile dealerships (cars, trucks, and vans), music stores (pianos and organs),
and antique shops (tables and cabinets).

Ordinarily, however, the identity of goods purchased at a specific cost is lost between the date of
purchase and the date of sale. For example, drug, grocery, and hardware stores sell thousands of

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relatively low unit-cost items of inventory. These items are often indistinguishable from one
another, making it impossible or impractical to track each item’s cost.

When feasible, specific identification seems to be the ideal method of allocating cost of good
available for sale. Under this method, the ending inventory is reported at actual cost and the actual
cost of goods sold is matched against sales revenue. This method, however, may enable
management to manipulate net income. For example, assume that a music store has three identical
pianos that were purchased at different costs, when selling one piano management could maximize
its net income by selecting the piano with the lowest cost to match with revenues. Alternatively, it
could minimize net income by selecting the highest-cost piano.

Using Assumed Cost Flow Methods – FIFO

and Average Cost
Because specific identification is often impractical, other cost flow methods are
allowed. These differ from specific identification in that they assume flows of costs
that may be unrelated to the physical flow of goods. For this reason we call them
assumed cost flow methods or cost flow assumptions. They are:

1. First-in, first-out (FIFO).

2. 3. Average cost.

There is no accounting requirement that the cost flow assumption be consistent with
the physical movement of the goods. The selection of the appropriate cost flow
assumption (method) is made by management. The management of companies in the
same industry may reach different conclusions as to the most appropriate method.
To illustrate these three inventory cost flow methods, we will assume that RIFT
Valley Electronics uses a periodic inventory system and has the information shown
below for its Z202 Astor condenser.
RIFT VALLEY ELECTRONICS
Z202 Astro Condensers

Date Explanation Units Unit Cost Total Cost

1/1 Beginning inventory 100 Br100 Br 10,000
4/15 Purchase 200 110 22000
8/24 Purchase 300 120 36000
11/27 Purchase 400 130 52000
Total 1,000 Br120, 000
During the year, 550 units were sold and 450 units are on hand at December 31.
First-in. First-out (FIFO)
The FIFO Method assumes that the earliest goods purchased are the first to be sold.
FIFO often parallels the actual physical flow of merchandise because it generally is
good business practice to sell the oldest units first. Under the FIFO method, therefore,

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the costs of the earliest good purchased are the first to be recognized cost of goods
sold. The allocation of the cost of goods available for sale at RIFT Valley Electronics
under FIFO is shown below:

Pool of costs
Cost of Goods
Available for Sale
Unit Total
Date Explanation Units Cost Cost
Beginning
1/1 Inventory 100 Br 100 Br 10,000
4/15 Purchase 200 110 22,000
8/24 Purchase 300 120 36,000
11/27 Purchase 400 130 52,000
Total 1,000 Br 120,000

Step 1 Step 2
Ending Inventory Cost of Goods sold
Unit Total
Date Units Cost Cost
11/27 400 Br 130 Br 52000 Cost of Goods available for sale Br 120000
8/24 50 120 6000 Less: Ending Inventory 58000
Total 450 Br 58000 Cost of Goods sold Br 62000

Note that the ending inventory is based on the latest units purchased. That is, the cost
of the ending inventory is obtained by taking the unit cost of the most recent purchase
and working backward until all units of inventory have been costed.

We can verify the accuracy of the cost of goods sold by recognizing that the first units
acquired are the first units sold. The computations for the 550 units sold are shown
below:
Date Units Unit Cost Total Cost
1/1 100 x Br100 = Br10000
4/15 200 x 110 = 22000
8/24 250 x 120 = 30000
Total 550 = Br 62000

Helpful hint Note that ending inventory of Br58000 and the cost of goods sold of
Br62000 equals cost of goods available for sale Br.120, 000
Average Cost

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The average cost method assumes that the goods available for sale are homogeneous.
Under this method, the allocation of the cost of goods available for sale is made on
the basis of the weighted average unit cost incurred. The formula and sample
computation of the weighted average unit cost is:
Average Unit cost = MAFS at cost ÷ Quantity of MAFS

The weighted average unit cost is then applied to the units on hand to determine the
cost of the ending inventory. The allocation of the cost of goods available for sale at
RIFT Valley Electronics using average cost is shown below.

Pool of costs
Cost of Goods Available
for Sale
Unit Total
Date Explanation Units Cost Cost
1/1 Beginning Inventory 100 Br 100 Br 10000
4/15 Purchase 200 110 22000
8/24 Purchase 300 120 36000
11/27 Purchase 400 130 52000
Total 1,000 Br 120000

Step 1 Step 2
Ending Inventory Cost of Goods sold
Br120,000 ÷ 1,000 = Br120.00 Cost of Goods available for sale Br120,000
Unit Total Less: Ending Inventory 54000
Units Cost Cost Cost of Goods sold Br 66000
450 X Br120.00 = Br54000

We can verify the cost of goods sold under this method by multiplying the units sold
by the weighted average unit cost (550 x Br120 = Br66000). Note that this method
does not use the average of the unit costs. That average is Br115.00 (Br100 + Br110
+ 120+ Br130 = Br460; Br460 ÷ 4). The average cost method instead uses the average
weighted by the quantities purchased at each unit cost.

1.5.2 Inventory Costing Methods Under Perpetual Inventory System

Each of the inventory cost flow methods described in this section for a periodic
inventory system may be used in a perpetual inventory system. To illustrate the
application of the three assumed cost flow method (FIFO), average cost), we will use
the date shown below for module X 268l4 Econo radios in the Glorious company

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Date Purchases Sale Balance in units

April 3 4,000@$80.00 4,000

April 10 12,000@$88.00 16000
April 26 8,000 units 8,000
April 29 4,000@$83.00 12,000

Specification Identification Method:

The amount of costs assigned to inventory and cost of good sold is the same under
perpetual and periodic system when using specific identification. This is because
specification identification precisely defines which units are in inventory and which
are sold.
Using Cost Flow Assumption:
First-In, First-Out (FIFO)

Under FIFO, the cost of earliest goods on hand prior to each sale is changed to cost
of goods sold. Therefore, the cost of goods sold on April 26 consists of the items
purchased on April 3 and April 10. The inventory on a FIFO method perpetual system
is shown below

Date Purchases Sales (cost of goods sold) Balance

April 3 (4,000 @ $80.00) $320,000 (4,000 @80.00) $ 320,000
April 10 (12,000@ $88.00) $1,056,000 (12,000@$88.00) $1,056,000
$1,376,000
April 26 (4,000 @ $80.00)=$320,000
(4,000 @ $88.00) = 352,000 (8,000 @ $ 88.00) $704,000
$672,000

April 29 (4,000 @ $83.0) $ 332,000 (8,000 @ $ 88.00) $704,000

(4,000 @ $83.000) $332,000
The ending inventory in this situation is $ 1,036,000 and the cost of good sold is
$672,000

The results under FIFO in a perpetual system are the same as in a periodic system.
Regardless of the system, the first cost in are the first assigned to cost of goods sold.
Average Cost
The average cost method in perpetual inventory system is called the moving average
method. Under this method a new average is computed after each purchase.
The average cost is completed by dividing cost of goods available for sale by the
units on hand. The average cost is then applied to: (1) The units sold, to determine the
cost of goods sold, and (2) the remaining units on hand, to determine the ending
inventory amount. The application of the average cost method for Glorious Company
is shown below

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 Date Purchases Sales (cost of goods sold) Balance
April 3 (4,000 @ $80.00) $320,000 (4,000 @80.00) $ 320,000
April 10 (12,000@ $88.00) $1,056,000 (12,000@$88.00) $1,056,000
$1,376,000
Average cost per unit= $1,376,000/16,000= $86 per
unit

April 26 8,000@ $86.00= $688,000 (8,000 @ $86.00) $ 688,000

April 29 (4,000 @ $83.00) $332,000 (8,000 @ $86.00) $688,000

(4,000 @ $83.00) $332,000
$1,020,000
Average cost per unit = $9,020,000/12000 =751,667 per
unit
The ending inventory in this situation is $ 1,020,000 and the cost of good sold is
$688,000

As indicated above, a new average is computed each time a purchase is made. On

April 10, after 12,000 units are purchased for $105,600, a total of 16,00 is $ 137,600
divided ($32,000+$105,600) is on hand. The average unit cost is $137,600 divided by
16,000, or $8.60. This unit’s cost is completed. Accordingly, the unit cost of the 8,000
units sold on April 26 is shown at $ 8.60,and the total cost of goods sold is $68,800.
On April 29, following the purchase of 4,000 units for $33,200, there are 12,000 unites
in hand costing $102,000 ($68,800+$33,200). The new average cost is $8.50
($102,000 ÷12,000)

17
Exercises
1. Consider the following data for ANDINET COMPANY for the month ended
March 31, 1996.
Inventory, March 1 200 units at Br. 4
Purchases:
March 10 500 units at Br.4.50
March 20 400 units at Br 4.75
March 30 300units at Br5.00
Sales:
March 15 500 units
March 25 400 units
Required
(a) Determine the cost of inventory on hand and cost of goods sold using FIFO
periodic Inventory system.
(b) Determine the cost of inventory on hand and cost of goods sold using FIFO
perpetual inventory system.
2. Based on the above data for ANDINET COMPANY for the month of March;
Determine
3. Based on the above data for ANDENET CAMPANY compute the cost of
inventory on hand and cost of goods sold, using
(a) Average cost - periodic (b) Weighted average –perpetual
5. Anbesa Shoes Factory had a beginning inventory of 400 units of Boots shoes at a
cost of Br.8.00 per unit. During the year, purchases were:
Feb. 20 700 units at Br. 9.00
May 5 500 units at Br. 10.00
Aug. 12 300 units at Br. 11.00
Dec. 8 100 units at Br. 12.00
At December 31, 450 units are on hand. The company uses periodic inventory
system.
Instruction:
(a) Determine the cost of goods available for sale.
(b) Determine (1) The ending inventory, and (2) The cost of goods sold under each
of the assumed cost flow methods (FIFO and Average Cost)

6. Tariku Company uses a perpetual inventory system and the following beginning
inventory, purchases and sales during 1999.

Jan. 1 Inventory 400 units at Br. 14

15 Sales 200units at Br. 30
Mar.10 Purchase 200 units at Br. 15
Apr. 1 Sales 200 units at Br. 30

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 May 9 purchase 300 units at Br. 16
Sep. 22 Purchase 250 units at Br. 20
Nov. 1 Sales 300 units at Br. 35
28 Purchase 100 units at Br. 21
Instruction:
(a) Determine the cost of goods available for sale.
(b) Determine (1) The ending inventory, and (2) The cost of goods sold under
each of the assumed cost flow methods (FIFO, and Weighted Average)

1.6. Other Methods of Valuing inventory : Valuation at the lower of cost or

NRV and Valuation by estimation(special valuation models)

Special circumstances sometimes call for inventory valuation methods other than
those presented in section. For example, consider to following situations:

Suppose you are the owner of a retail store that sells Compaq Desk Pro computers.
During a recent 12-month period, the cost of the computers dropped Br1,800 (almost
50%). At the end of your fiscal year, you have some of these computers in inventory.
Do you think your inventory should be stated at cost in accordance with the cost
principle, or at its lower replacement cost?

Or, suppose that your inventory of lumber was destroyed by fire. Without having the
inventory available for a physical count, how can you value it in order to determine
the loss?

The first situation requires a departure from the cost basis of accounting. The second
situation requires that inventory be estimated, rather than counted, to determine its
ending balance. Each of these approaches is discussed below.
1.6.1. Valuing Inventory At The Lower Of Cost Or Net realizable value (NRV)

When the value of inventory is lower than its cost, the inventory is written down to
its market value. This is accomplished by valuing the inventory at the lower of cost
or net realizable value (NRV) in the period in which the price decline occurs. NRV is
an example the accounting concept of conservatism. Conservatism means that when
choosing among accounting alternatives, the best choice is to select the method that
is least likely to overstate assets and net income.

Under the NRV basis, NRV is defined as current selling price less cost to sale. For a
merchandising company, market is the cost of purchasing the same goods at the

19
present time from the usual suppliers in the usual quantities. Current replacement cost
is used because a decline in the replacement cost of an item usually leads to a decline
in the selling price of the item.

The lower of NRV basis may be applied to (1) individual items of inventory,(2) major
categories of inventory, (3) total inventory.

For example, assume that Len’s TV has the following lines of merchandise with costs
and NRV as indicated. NRV produces the following three results:

Lowe of Cost or NRV by:

Individual Major Total

Cost NRV Items Categories Inventory
Television set
Consoles Br 60,000 Br 55,000 Br 55,000
Portables 45,000 52,000 45,000
Total 105,000 107,000 Br 105,000
Video Equipment
Recorders 48,000 45,000 45,000
Movies 15,000 14,000 14,000
Total 63,000 59,000 59,000
Total Inventory Br 168,000 Br166,000 Br 159,000 Br 164,000 Br 166,000

The amount (Br. 159,000) entered in the individual items column is the lower of the
cost or NRV amount for each item. For the major categories column, the amount (Br.
164,000) is the lower of total cost or total NRV for each category. Finally, the amount
(Br, 166,000) for the total inventory column is the lower of the cost or marker for the
entire inventory.

The common practice is to use individual items in determining the NRV valuation.
This approach gives the most conservative valuation for balance sheet purposes and
also the lowest net income. NRV should be applied consistently from period to period.

1.6.2. Estimating Inventories

We have assumed throughout the unit that a company would be able to do a physical
count of its inventory. But what if it cannot, as in the example of the lumber inventory
destroyed by fire? In that case, we would use an estimate.

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Two circumstances explain the reasons for estimating rather than counting
inventories. First, management may want monthly or quarterly financial statements
but a physical inventory is taken only annually. Second, a casualty such as fire, flood,
or earthquake may make it impossible to take a physical inventory. The need for
estimating inventories is associated primarily with a periodic inventory system
because of the absence of detailed inventory records.

There are two widely used methods of estimating inventories: (1) the gross profit
method and (2) the retail inventory method.

Gross Profit Method

The gross profit method estimates the cost of ending inventory by applying a gross
profit rate to net sales. It is used in preparing monthly financial statements when
physical inventories are not taken. This method is a relatively simple but effective
estimation technique. To use this method, a company needs to know its net sales, cost
of goods available for sale, and gross profit rate. The company then uses the gross
profit rate to estimate its gross profit for the accounting period. The following steps
can be followed.
Step 1: determine net sales
Step 2: compute estimated gross profit by multiplying gross profit by net sales
Step 3: deduct gross profit from net sales to obtain estimated cost of goods sold
Step 4: The ending inventory would then be obtained by deducting cost of goods sold
from merchandise available for sale
To illustrate,
assume that Wesen Company wishes to prepare an income statement for the month of
January, when its records show net sales Br200, 000; beginning inventory Br40,000;
and cost of goods purchased Br120,000. In the preceding year, the company realized
a 30% gross profit rate, and it expects to earn the same rate this year. Given these
facts and assumptions, the estimated cost of the ending inventory at January 31, under
the gross profit method is Br 20,000, computed as follows:
Step 1:
Net Sales Br200, 000
Less: Estimated gross profit (30% X Br 200,000) 60,000
Estimated cost of goods sold Br140, 000

Step 2:
Beginning Inventory Br 40,000
Cost of Goods Purchased 120,000
Cost of Goods Available for Sale 160,000
Less: Estimated Cost of Goods Sold 140,000

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 Estimated Cost of Ending Inventory Br 20,000

The gross profit method is based on the assumption that the rate of gross profit will
remain constant from one year to the next. It may not remain constant though, because
of the change either in merchandising policies or in market conditions. In such cases,
the rate of the prior period should be adjusted to reflect current operating conditions.
In some cases, a more accurate estimated may be obtained by applying this method
on department or product-line basis.

The gross profit method should not be used in preparing a company’s financial
statements at the end of he year. These statements should be based on a physical
inventory count.
Retail Inventory Method
A retail store has thousands of different types of inventory at low unit costs. In such
cases the application of units cost to inventory quantities is difficult and time-
consuming. An alternative is to use the retail inventory method to estimate the cost of
inventory. In most retail concerns, a relationship between cost and sales price can be
established. Under the retail inventory method, the cost to retail percentage is then
applied to the ending inventory at retail prices to determine inventory at cost.
To use the retail inventory method, a company must maintain records that show both
the cost and retail value of the goods available for sale. Under the retail inventory
method, the estimated cost of the ending inventory is derived from the steps below:
Step 1: determine merchandise available for sale both at cost and retail selling price
Step 2: determine cost-to-retail ratio by from merchandise available for sale
Step 3: deduct net sales from merchandise available for sale at retail to get ending
inventory at retail selling price
Step 4: Convert ending inventory at retail to equivalent cost by using the appropriate
percentage
The logic of the retail method can be demonstrated by using unit cost data. Assume
that 10 units purchased at Br7.00 each are marked to sell for Br10 per unit. Thus, the
cost to retail ratio is 70% (Br70÷Br100). If 4 units remain unsold, their retail value is
Br40 and their cost is Br28 (Br40 x 70%), which agrees with the total cost of goods
on hand on a per unit basis (4 x Br7).
Illustration, the accounting recodes of Lucy company disclosed the following
information’s: Beginning inventory at cost Br.14, 000, at retail Br.21, 500; Cost of
goods purchased at cost Br.61,000, at retail Br.78,500; and Net sales Br.70,000.

Note that it is not necessary to take a physical inventory to determine the estimated
cost of goods on hand at any given time.

The application of the retail method based on the accounting records and
supplementary data for Lucy Co. is shown below.
Step- 3
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 At Cost At Retail
Beginning inventory Br14, 000 Br21, 500
Goods purchased 61,000 78, 500
Goods available for sale Br75, 000 100,000
Net sales 70,000
(1) Ending inventory at retail -------- Br 30,000
(2) Cost to retail ratio = (Br75, 000 ÷ Br100, 000) = 75%
(3) Estimated cost of ending inventory = (Br30, 000 x 75%) Br22, 500

The retail inventory method also facilitates taking a physical inventory at the end of
year. With this method, the goods on hand can be valued at the prices marked on the
merchandise. The cost to retail ratio is then applied to the goods actual on hand at
retail to determine the ending inventory at cost.

The major disadvantage of the retail method is that it is an averaging technique. It

may produce an incorrect inventory valuation if the mix of the ending inventory is not
representative of the mix in the goods available for sale. Assume, for example, that
the cost to retail ratio of 75% in the Lucy Co. consists of equal proportions of
inventory items that have cost to retail ratios of 70%, 75%, and 80% respectively. If
the ending inventory contains only items with a 70% ratio, an incorrect inventory cost
will result. This problem can be minimized by applying the retail method on a
departmental or product-line basis.

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Exercises
1. Zesh Camera Shop uses the lower of cost or NRV basis for its inventory. The
following data are available at December 31.

Item Units Unit cost NRV

Cameras
Minolta 5 Br 175 Br160
Canon 7 150 152
Light meters
Vivitar 12 125 110
Kodak 10 115 135

Instruction:
Determine the amount of the ending inventory by applying the lower of cost or market
basis to:
Individual items
Inventory categories and
The total inventory
2. ABC company ending inventory includes the following items

Product Units Unit cost Unit NRV value

A 20 Br 6 Br 5
B 40 9 8
C 10 12 15
Required
Compute the amount to be reported on the balance sheet applying the lower of cost or
NRV on individual items.
3. The inventory of susan company was destroyed by fire on march1. From an
examination of the accounting records, the following data for the first 2month of
the year are obtained sales Br 51,000; sales return and allowance Br 1,400.
Required:
Determine the merchandise lost by fire, using gross profit method, assuming that: (a)
a begging inventory of Br 20,000 and gross profit rate of 30% on net sales. (b) A
begging inventory of Br 25,000 and gross profit off 25% on net sale:
4. The following information is available to you:
Beginning Inventory at cost Br 32,000
Cost of goods purchased at cost 148,000
Net sales 185,000
Beginning Inventory at retail 45,000
Cost of goods purchased at retail 180,000
Required
Compute the estimated cost of ending inventory under the retail inventory system.

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