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CHAPTER ONE
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.
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.
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).
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.
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.
►Perpetual inventory system updates inventory accounts after each purchase or sale.
►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
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).
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.
There are four methods of assigning costs to inventory and cost of goods sold:
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.
►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:
Disadvantages: a) Violates the matching principle (FIFO matches some of the previous
year’s inventory cost against current revenue.
c) Does not adjust Cost of Goods Sold for the effect of inflation.
►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.
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
2. LIFO
►Will get different results under periodic/perpetual systems
►Can use for tax purposes only if also used for financial reporting
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
To illustrate inventory costing under the periodic inventory system, consider the following example.
Required: Determine the cost of ending inventory and the cost of goods sold for the month, may using
periodic inventory system under:
Solution
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.
=$6715/2150units =$3.1232558
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.
3. Sale--------------------------------------------300units
7. Purchase------------------------------------- 700units@$4.25
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
b) LIFO ? ?
c) AC ? ?
A) FIFO method
700 $4.25
400 $4.25
800 $4.3
100 $4.30
600 $4.3
560 $4.30
500 $4.4
B) LIFO method
700 $4.25
200 $4.25
800 $4.30
200 $4.25
400 $4.3
200 $4.25
400 $4.3
600 $4.30
200 $4.25
60 $4
500 $4.4
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:
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
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)
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).
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
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
Sales (2,016,000)
Estimated ending balance, inventory @ retail value $84,000
Estimated ending balance, inventory @ cost
($84,000 X 68%) $57,120