CHAZPTER ONE

ACCOUNTING FOR INVENTORIES

What is Inventories?
Inventories: are “assets
a. held for sale in the ordinary (normal) course of business,
 for merchandising company
→has one inventory account on the balance sheet called Merchandise Inventory;
→ the cost of the inventory sold is transferred to Cost of Goods Sold (COGS) on the income
statement
 for manufacturing company
→ Finished goods inventory
b. in the process of production for such sales, or
 for manufacturing company
→ work-in-process (goods in process) inventory
c. In the form of materials or supplies to be consumed in the production process or in the
rendering of services”.
 for manufacturing company
→ Raw materials inventory
Its use rather than size is important in defining inventory.
Importance of Inventory Control
An accurate inventory accounting system is important for:
1. Ensuring availability of inventory items
2. Preventing excessive accumulation of inventory items
The perpetual system maintains a continuous record of inventory changes
The periodic system updates inventory records only periodically
Classification of Inventories
Based on the operation of the business, inventories are classified as:
1. Merchandising inventories
Merchandise inventory represents goods on hand purchased for resale by a retailer or a trading
company such as an importer or exporter for resale. Generally, goods acquired are not physically
altered by the purchaser company; the goods are in finished form when they leave the

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manufacturer’s plant. Only one inventory classification, merchandise inventory, is needed to
describe the many different items that make up the total inventory.
2. Manufacturing Inventory
A. Raw materials inventories: consisting of goods to be used in the manufacture of
products.
B. Work-in-process (goods-in-process) inventories: consisting of goods being
manufactured but not yet completed.
C. Finished goods inventory: consisting goods completed and awaiting sale.
D. Factory (Manufacturing) supplies
e.g., → lubrication oil for the machinery
→cleaning materials
→ Other materials that make up an insignificant part of the finished products.
3. Miscellaneous inventories:
It includes items such as office, janitorial and shipping supplies.
Regardless of the classification, all inventories are reported under current assets on the balance
sheet.
INVENTORY SYSTEMS
In merchandising inventory there are two inventory accounting systems used to collect
information about cost of goods sold of inventory on hand. The two systems are called periodic
and perpetual systems.
Periodic Inventory system
 The merchandise inventory account is updated only once at the end of the accounting period.
 When merchandise is sold, revenue is recorded
 Cost of goods sold is not recorded as each sale occurs.
 It does not require continual updating of the inventory account.
 The company records the cost of new merchandise in a temporary purchase account. When
financial statements are prepared, the company takes a physical count of inventory by
counting quantities of merchandise on hand.
Perpetual Inventory system
 A perpetual inventory system keeps a continual record of the amount of inventory on hand.
 The merchandise inventory account is updated after each purchase and each sale.

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 Cost of goods sold account also is updated after each sale
 When an item is sold, its cost is recorded in a cost of goods sold inventory.
Comparisons of Periodic and Perpetual Inventory Systems
Inventory, purchases, and sales data
January1. Merchandise inventory (beginning).........................Br.52,500
1-31 Purchases (on account) -------------------------------------------26,200
1-31 Sales (on account)-selling price...................................... 49,750
Sales -cost price ---------------------------------------------------------28,000
31 Merchandise inventory (ending) -----------------------------------50,700
Periodic Perpetual
Jan 1 Merchandise inventory
 Merchandise inventory account  Merchandise inventory account
reflect inventory on hand, Br. 52,500 reflects inventory, on hand, Br.
52,500

Entries to record purchases, Jan 1-31

Periodic Perpetual
Purchase ................26,200 Merchandise inventory ............26,200
Accounts payable ......... 26,200 Accounts payable .................. 26,200

Entries to records sales Jan 1-31

Periodic
Account Receivable ............ 49,750
Sales........................ 49,7500
Perpetual
Account Receivable........ 49,750
Sales ............................... 49,750
Cost of merchandise ..........28,000
Merchandise inventory.... 28,000

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Adjusting Entries for Jan. 31 merchandise inventory
Periodic Perpetual
Income summary ........52,500 No Entries necessary
Merchandise inventory ..........52,500

Merchandise inventory..50,700
Income summary................. 50,700

Reporting cost of merchandise sold in Jan. on Income statement

Cost of merchandise sold: Periodic Perpetual
Jan. 1. Inventory........ Br….. 52,500 Cost of merchandise sold Br. 28,000
January purchases.............. 26,200
Merchandise available
for sale............................. Br. 78,700
Less: Jan.31. Inventory..... 50,700
Cost of merchandise sold ...Br.28,000
Reporting merchandise Inventory Jan. 31, on Balance sheet
Periodic Perpetual
Merchandise Inventory......... Br. 50, 700 Merchandise Inventory......... Br. 50, 700
Inventory Costing Methods under Periodic and Perpetual Systems
1. First-in, first out method (FIFO)
 Item (goods) purchased first are assumed to have been sold first.
 Ending inventory comprises the most recent costs.
2. Last-in, first out method (LIFO)
 Goods purchased last are assumed to have been sold first.
 The ending inventory comprises purchases made earlier in a year.
3. Average Cost Method
 The average cost method, sometimes called the weighted average method. Assumes
that the goods available for sale are homogeneous.
 Average unit cost has to be determined and applied both to ending inventory and
beginning inventory.

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Illustration: Assume the following data for a particular commodity.
Jan. 1. Inventory 200 units at Br. 9 ..................Br. 1,800
Mar.10 Purchase 300 units at Br. 10 ......... ......3,000
Sep. 21 purchase 400 units at Br. 11 .......... ...... 4,400
Nov. 18 purchase 100 units at Br. 12 ......... ....... 1,200
Available for sale during year 1,000 units Br. 10,400
Total Sales for the fiscal period---------------Br 15,000. The physical count on December 31
shows that 300 units of the particular commodity are on hand.
1) First-in, first out method (LIFO)
 Goods purchased first are assumed to have been sold first.
 Ending inventory comprises the most recent costs.
Determine - Ending inventory and Cost of goods sold
Solution:
- Most recent costs, Nov.18..........................100 units x12 = Br.1,200
- Next most recent costs, Sept.21..................200 units x 11 = 2,200
Inventory Dec.31................................................300 Br. 3,400
Costs of goods sold = merchandise available for sale - Ending inventory
CGS= Br. 10,400 - 3,400
= Br. 7,000
2) Last-in, first out method (LIFO)
- Goods purchased last are assumed to have been sold first.
- The ending inventory comprises purchases made earlier in a year.
Based on the illustrative data presented above the cost of the 300 units of inventory is determined
in the following manner.
Earliest costs, Jan. 1 ...............200 units at Br. 9 ..........Br. 1,800
Next earliest costs, Mar. 10 ....100 units at 10..........Br. 1,000
Inventory Dec. 31 ...................300 Br.2,800
Cost of Merchandise sold = Merchandise available for sale - Ending inventory
= Br. 10,400 - Br. 2,800
= Br. 7,600

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3) Average Cost Method
- The average cost method, sometimes called the weighted average method.
- Assumes that the goods available for sale are homogeneous.
- Average unit cost has to be determined and applied both to ending inventory and
beginning inventory.
 Assuming the same cost data of the above illustrations the average cost of the 1,000 units
and the cost of the 300 units in inventory are determined as follows:-
Average unit cost......... Br. 10,400  1,000 = Br.10.40
Inventory Dec. 31 .......... 300 x Br.10.40..... Br.3, 120
Cost of goods sold = Merchandize available for sale - Ending inventory
= Br. 10,400 - Br. 3,120
= Br. 7,280
COMPARISIONS OF INVENTORY COSTING METHODS
FIFO LIFO WA
Sales Br15, 000 Br 15,000 Br15, 000
Cost of goods sold:
Beginning inventory 1,800 1,800 1,800
Purchases (10,400-1,800) 8,600 8,600 8,600
Available for sale 10,400 10, 400 10,400
Ending inventory 3,400 2,800 3,120
Cost of goods sold 7,000 7,600 7,280
Gross profit 8,000 7,400 7,720
Illustration: Consider the following data for YERON COMPANY for the month ended
March 31, 2009
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

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 Required: Determine:
I. Cost of ending inventory and Cost of goods sold assuming:
1) Periodic FIFO and perpetual FIFO
2) Periodic LIFO and perpetual LIFO
3) Periodic Weighted average and perpetual weighted average
Cost of goods available for sale:
March 1 Inventory 200 units at Br 40.00 Br 800
March 10 purchase 500 units at Br 4.50 Br 2250
March 20 purchase 400 units at Br 4.75 Br 1900
March 30 purchase 300 units at Br 5.00 Br 1500
Available for sale 1400 units Br 6450
1. (a) Periodic FIFO
Cost of ending inventory:
Most recent costs, March 30 300units at Br 5.00 Br 1,500
Next most recent costs, March 20 200unit at Br 4.75 950
Inventory for sales 500 units Br 2450
Cost of goods sold:
Cost of goods available for sales Br 6,450
Less- cost of ending inventory 2,450
Cost of goods sold 4,000
(b) Perpetual FIFO
Date Purchase Cost of goods sold Inventory
Qty Unit cost Total cost Qty Unit cost Total cost Qty Unit cost Total cost
Mar 1 - - - - - 200 4.00 800
10 500 4.50 2,250 - - - 200 4.00 800
500 4.50 2,250
15 - - - 200 4.00 800 200 4.50 900
300 4.50 1350
20 400 4.75 1,900 - - - 200 4.50 900
400 4.75 1900
25 - - - 200 4.50 900 200 4.75 950
200 4.75 950
30 300 5.00 1,500 - - - 200 4.75 950*
300 5.00 1500*
4,000

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 Cost of ending inventory
200 units at 4.75 ------950*
300 units at 5.75-------1500*
500 2,450
Cost of goods sold
 From cost of goods sold column Br 4,000
2. (a) periodic- LIFO
Cost of ending inventory
Earliest cost, March 1 200 units at BR 4.00 Br 800
Next earliest costs, March 10 300 units at Br 4.50 1350
Inventory March 31 500 units Br 2150
Cost of goods sold
Cost of goods available for sales Br 6450
Less; cost of ending inventory 2150
Cost of goods sold 4300
(b) Perpetual LIFO
Purchase Inventory
Cost of goods sold

Date Qty Unit Total Qty Unit Total Qty Unit Total cost
cost cost cost cost cost
Mar 1 - - - - - 200 4.00 800
10 500 4.50 2,250 - - - 200 4.00 800
500 4.50 2,250
15 - - - 500 4.50 2250 200 4.00 800
20 400 4.75 1,900 - - - 200 4.00 800
400 4.75 1900
25 - - - 400 4.75 1900 200 4.00 800
30 300 5.00 1,500 - - - 200 4.00 800*
300 5.00 1500*
4,150

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 Cost of ending inventories
200 units at Br 4.00 Br 800*
300 Units at Br 5.00 1500*
500 Br 2300
Cost of goods sold
From cost of goods sold column = Br 4150
(a) Weighted average- periodic
Average cost per unit = Cost of goods available for sale = 6450 =Br 4.61/unit
Total units available for sales 1400
Cost of ending inventory
500 units at Br 4.6 =Br 2,305
Cost of goods sold
Cost of goods available for sale Br 6450
Less: Cost of ending inventory 2305
Cost of goods sold 4,145
(b) Weight average- perpetual
Purchases Sales Balance
Date

March 1 200 units at Br 4 = 800

March 10 500 units at Br 4.5=2250 700 units at Br 4.36=3052
March 15 500 units at Br 4.36= 2180* 200 units at Br 4.36=872
March 20 400 units at Br 475=1900 600 units at Br 4.62=2772
March 25 400 units at Br 4.62= 1848* 200 units at Br 4.62=924
March 30 300 units at Br 500= 1500 500 units at Br 4.85=2425

Cost of ending inventory = 500 units x Br4.85/unit =Br2,425

Cost of goods sold=Br 2180* + Br 1848* =4028

Financial Statement Effects of Cost Flow Methods
Each of the three cost flow methods is acceptable. The reasons why companies
adopt different inventory cost flow methods are varied but they usually involve one
of the following factors:

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 1. Income statement effects
2. Balance sheet effects
3. Tax effects
Income Statement Effects
 FIFO reports lower cost of goods sold and higher gross profit –which results in higher net
income before taxes.
 LIFO reports higher cost of goods sold and lowers gross profit –which results in lower net
income before taxes.
 The report of Weighted Average falls in between FIFI and LIFO
Income statement Effects
Both beginning inventory and ending inventories appear on the income statement.
The ending inventory of one period automatically becomes the beginning inventory of
the next period.
Inventory errors affect the determination of cost of goods sold and net income

Cost of goods sold = BI + cost of goods purchased - EI

The effects on cost of goods sold can be determined by entering the incorrect data in the above
formula and then substituting the correct data. If beginning inventory is understated, cost of
goods sold will be understated. On the other hand, an understatement of ending inventory will
overstate cost of goods sold.
The effects of inventory errors on the current year’s income statement are as follows:
Inventory Error Cost of goods sold Net income
Understate beginning inventory -------- Understated Overstated
Overstate beginning inventory----------- Overstated Understated
Understate ending inventory-------------- Overstated Understated
Overstate ending inventory --------------- Understated Overstated
An error in ending inventory of the current period will have a reverse effect on net income of the
next accounting period.
Balance Sheet Effects
 FIFO reports higher ending inventory as compared to LIFO
 LIFO reports lower ending inventory as compared to FIFO

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  The report of Weighted Average ending inventory falls in between FIFO and LIFO
Balance sheet Effects
The effect of ending inventory errors on the balance sheet can be determined by using the basic
accounting equation:
Assets = Liabilities + 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
Tax Effects
 FIFO cost flow assumption results with higher income tax liability in the
period of raising price as the above comparison than LIFO cost flow
assumption. But in the period of falling price, the report will be reversed.
 The Weighted Average’s report of tax liability falls between FIFO and LIFO

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