CHAPTER -4

INVENTORIES
Definition: - Inventories is an accounting of items, component parts, raw materials finished
goods that a company either uses in production or sale.
Importance of inventories
- It is the principal source of revenue for wholesale and retail businesses.
- Cost of merchandise sold is the largest deduction from sells to determine net income.
- A substantial part of merchandising firm’s resources is invested in inventory
- It is the largest of the current assets on merchandisers businesses.
Effect of Inventory Errors on Financial Statements
Any error in the inventory count will affect both the balance sheet and the income statement. For
example, an error in the physical inventory will misstate the ending inventory, current assets, and
total assets on the balance sheet. This is because the physical inventory is the basis for recording
the adjusting entry. Also an error in taking the physical inventory misstates the cost of goods
sold, gross profit, and net income on the income statement. In addition, because net income is
closed to the owner’s equity at the end of the period owner’s equity will also be misstated on the
balance sheet. This misstatement of owner’s equity will equal the misstatement of the ending
inventory, current asset and total assets.

The effect of understatements and overstatements of merchandise inventory at the end of the
period are demonstrated in the following three sets of condensed income statements and balance
sheets.
The first set of statements is based on a correct ending inventory of $60,000;
The second set, on an incorrect ending inventory of 50,000;
The third set, on an incorrect ending inventory of 70,000.
In all three cases, net sales are 980,000, merchandise available for sale is $705,000, and
operating expenses are $100,000.

Income statement for the year Balance Sheet at the end of the year
1. Inventory at the end of the year correctly Stated $60,000
Net sales……………………..980,000 Merchandise inventory………. .$60,000
Cost of goods sold…………..645,000 Other asset……………………..340,000
Gross profit…………......$335,000 Total asset………………….400, 000
Expenses…………………….100,000 Liabilities………………………120,000
Net income………………235,000 Owners equity…………………280,000
Total ………………………400,0

2. Inventory at the end of period incorrectly stated at $50,000: (understated by 10,000).

Net sales……………………..980,000 Merchandise inventory………. .$50,000

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Cost of goods sold…………..655,000
Gross profit…………......$325,000
Expenses…………………….100,000
Net income………………225,000
Other asset…………………….340, 000
Total asset……………...…. 390,000
Liabilities………………………120,000
Owners equity…………………270,000
Total ………………………390,000

3. Inventory at the end of period incorrectly stated at $70,000 (overstated by $10,000).

Net sales……………………..980,000
Cost of goods sold…………..635,000
Gross profit…………......$345,000
Expenses…………………….100,000
Net income………………245,000
Merchandise inventory………. .$70,000
Other asset…………………….340, 000
Total asset……………...… 410,000
Liabilities………………………120,000
Owners equity…………………290,000
Total ………………………410,000

The effect of inventory on the following period’s statements

The inventory at the end of one period becomes the inventory for the beginning of the following
period, thus, if the inventory is incorrectly stated at the end of the period, the net income of that
period will be misstated and so will the net income for the following period. The amount of the
two misstatements will be equal and in opposite directions.

Therefore, the effect on net income of an incorrectly stated inventory, if not corrected, is limited
to the period of the error and the following period.

Example: assume no additional errors, both assets and owner’s equity will be correctly stated.
Assume that the ending inventory for period one was understated by $10,000, and no other errors
are made. The gross profit (and net income) would be understated for period one and overstated
for period two by $10,000, indicates as follows:
2009 2010
Correct Incorrect Incorrect Correct
Net sale 980,000 980,000 1,100,000 1,100,000
Merchandise 55,000 55,000 50,000 60,000
inventory, jan 1
Purchase 650,000 650,000 700,000 700,000
Merchandise 705,000 705,000 750,000 760,000
available for sale
Less merchandise 60,000 50,000 70,000 70,000
inventory, dec 31
Cost of 645,000 655,000 680,000 690,000
merchandise sold
Gross profit 335,000 325,000 420,000 410,000
Expense 100,000 100,000 120,000 120,000
Net income 235,000 225,000 300,000 290,000
In the illustration, the $10,000 understatement of inventory at the end of period one resulted in an
over statement of the cost of goods sold and thus an understatement of gross profit by $10,000.

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On the balance sheet, merchandise inventory and owner’s equity would be understated by
$10,000. Because the ending inventory of period one becomes the beginning inventory for period
two, the cost of goods sold was understated and gross profit was overstated by $10,000 for
period two. Both merchandise inventory and owner’s equity will be correct at the end of period
two.
Inventory Systems
There are two principal system of inventory accounting.
1. Periodic
2. Perpetual.
Periodic inventory system
- In this system, only the revenue from sales is recorded each time a sale is made.
- No entry will be made to record the cost of merchandise sold at the time of sale.
- Physical inventory will be taken to determine the cost of the ending inventory at the end
of an accounting period.
Perpetual inventory system
- Uses according records that continuously disclose the amount of the inventory.
- The cost of merchandise sold will be recorded each time a sale is made.
- Physical inventory is taken to compare the records with the actual quantities on hand.
Determining actual quantities in the inventory
The first stage in the process of “taking “an inventory is to determine the quantity of each kind
of merchandise owned by the enterprise.
All of the merchandise owned by the business on the inventory date and only such merchandise
should be included in the inventory.
Determine who has legal title to merchandise in transit on the inventory date by examining
purchase and sales invoices.
Shipping terms:
- FOB shipping point – title usually passes to the buyer when goods are shipped.
- FOB destination – title doesn’t pass to the buyer until the good are sold.
Consignments terms:
- Consignee – acts as an agent of the consignor to sell the goods.
- Consignor – retains title until the goods are sold.

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Determining the cost of inventory:
The cost of merchandise inventory is made up of the purchase price and all expenditures incurred
in acquiring such merchandise, including transportation, customs duties, and insurance against
losses in transit.
Those cost that are difficult to associate with specific inventory items may be prorated on some
equitable basis. On the other hand, if it is minor cost it can be treated as operating expense of the
period.
One of the most significant problems in determining inventory cost comes about when identical
units of a certain commodity have been acquired at different unit cost prices during the period.
In such a case it is necessary to determine the unit price of the items till on hand. At this time
there are four methods commonly used in assigning costs to inventory and of goods sold.
They are
i. Use of specific identification method
ii. First-in-first-out;
iii. Weighted average.
The three most common assumptions of determining the cost of merchandise sold are as
follows:
1. Cost flow is in the order in which the expenditures were made – first- in, first –out.
2. Cost flow is in the reverse order in which the expenditures were made – last –in, first –
out.
3. Cost flow is an average of the expenditures.
Inventory costing methods under a periodic system
When the periodic inventory system is used, only revenue is recorded each time a sale is made.
No entry is made at the time of the sale to record the cost of the merchandise sold. At the end of
the accounting period, a physical inventory is taken to determine the cost of the inventory and
the cost of merchandise sold.
First- in – first- out method (FIFO)
This method of costing inventory is based on the assumption that costs should be changed
against revenue in the order in which they were incurred. Hence, the inventory remain is
assumed to be made up of the most recent costs and the cost of inventory sold is made up of the
earliest costs.

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Example: - The units of an item available for sale during the year were as follows (Assume
selling price of $ 50)
Jan.1 inventor 35 units at $ 23 $805
Mar.4 purchase 10 units at $ 25 $250
Aug.20 purchase 30 units at $28 840
Nov.30 purchase 25 units at $ 30 750
100 2,645
The physical count on December 31 shows that 45 units of the particular commodity are on
hand. In accordance with the assumption that the inventory is composed of the most recent costs,
the cost of the 45 units is determined as follows:
FIFO method: (45 units were on hand).
Most recent cost, Nov. 30………..25 units at $30………. $750
Next most recent costs, Aug. 20…20 units at $28………. $560
Inventory, Dec. 31…………………………………… 1,310
Deduction of the inventory of 1,310 from the 2,645 of merchandise available for sale yields
1,335 as the cost of merchandise sold, which represents the earliest costs incurred for this
commodity. Or
Earliest cost jan1. 35 units at $ 23 $ 805
Next earliest cost Mar 4, 10 units at $ 25 250
Next earliest cost Aug 20 10 units at $ 28 280
Cost of merchandise sold 55 1335
The cost of inventory at Dec 31= $ 2,645-1,335 = $ 1,310
In most businesses, there is a tendency to dispose of goods in the order of their acquisition. This
would be particularly true of perishable merchandise and goods in which style or model changes
are frequent. Thus, the FIFO, methods is generally in harmony with the physical movement of
merchandise is an enterprise.
Last –In, First–Out method
In this method of costing is based on the assumption that the most recent cost incurred should be
charged against revenue. Hence the inventory remaining is assumed to be composed of the
earthiest costs. Based on the above example the 45 units of inventory is determined in the
following manner:

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Earliest costs, Jan. 1 …….........35 units at $ 23…………..$ 805
Next earliest costs, Mar.4 ……10 units at $ 25 ………… $ 250
Inventory, Dec. 31 …………45………………………..1,055
Deduction of the inventory of $1,055 from the $2,645 of merchandise available for sale yields
$1,590 as the cost of merchandise sold, which represents the most recent costs incurred for this
particular commodity.
Or
Most recent cost Nov.30 25 units at $ 30 $750
Next most recent costs, Aug 20 30 units at 28 840
Cost of merchandise sold 55 1590
The cost of inventory at Dec 31 = $ 2,645- $ 1,590 = $1055
Average cost method
The average cost method is sometimes called the weighted average method. When this meted is
used, cost is matched against revenue according to the weighted average unit costs of the goods
sold. The same weighted average unit cost are used in determine the cost of the merchandise
remaining in the inventory.
The weighted average unit cost is determined by dividing the total cost of the identical units of
each commodity available for sale during the period by the related number of units of that
commodity.
Average unit cost = total cost of the available units
Number of units
= $ 2,645 = $26.45
100 units
The cost of ending inventory at Dec 31= 45* $26.45 = 1190.25
Cost of merchandise sold =55 units at 26.45 = $ 1,454.75
Or 2,645-1,190.25=1,454.75

Accounting for and reporting Inventory under a perpetual system

In a perpetual inventory system, all merchandise increases and decreases are recorded in a
manner similar to the recording of increases and decreases in cash. The merchandise inventory
account at the beginning of an accounting period indicated the merchandise in stock on that date.

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Purchases are recorded by debiting merchandise inventory and crediting cash or accounts
payable, on the data of each sale the cost of merchandise sold is recorded by debiting cost of
merchandise sold and crediting merchandise Inventory.
Example: - the following units of item X are available for sale.
Item –X units cost
Jan 1 inventory 20 $ 20
4 sale 14
10 purchase 18 21
22 sale 8
28 sale 6
30 purchase 20 22
The firm used a perpetual inventor system, and there are 30 units of one item on hand at end of
the year. What is the total cost of goods sold and ending inventory according to:
A. FIFO B. LIFO C. Average Cost Method
First- in, first – out (FIFO) method
Using cost, costs are included in the merchandise sold in the order in which they were incurred.
Purchases Cost of merchandise sold Inventory

Date Quantity Unit cost Total cost Quantity Unit cost Total cost Quantity Unit cost Total cost

1 20 20 400

4 14 20 280 6 20 120

10 18 21 378 6 20 120
18 21 378
22 6 20 120
2 21 42 16 21 336
28 6 21 126 10 21 210

30 10 21 210
20 22 440 20 22 440
Balanc $568 $650
e

Thus cost of merchandise sold = $ 568, cost of ending inventory = $ 650.

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Last-in, first- out method (LIFO)
When the LIFO method is used in a perpetual inventory system, the cost of the units sold is the
cost of the most recent purchases.
Purchases Cost of merchandise sold Inventory
Date Unit
Quantity Unit cost Total cost Quantity Unit cost Total cost Quantity Total cost
cost
1 20 20 400

4 14 20 280 6 20 120
6 20 120
10 18 21 378 18 21 378
6 20 120
22 8 21 168 10 21 210
6 20 120
28 6 21 126 4 21 84
6 20 120
4 21 84

30 20 22 440 20 22 440

Balance $574 $644

Thus, cost of merchandise sold: $ 574, cost of ending inventory $ 644

Average cost method
When the average cost method is used in a perpetual inventory system an average unit cost for
each type of item is computed each time a purchase is made. This unit cost is then used to
determine the cost of each sale until another purchase is made and a new average is computed.
This averaging technique is called a moving average.
Average cost method:-
Purchases Cost of merchandise sold Inventory

Date Quantity Unit cost Total cost Quantity Unit cost Total cost Quantity Unit cost Total cost

Jan 1 20 20 400

4 14 20 280 6 20 120

10 18 21 378 24 20.75 498

22 8 20.75 166 16 20.75 332

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 28 6 20.75 124.5 10 20.75 207.5

30 20 22 440 30 21.57 647.5

Balanc $570.5 $647.5

e

Cost of merchandise sold = 570.5, Cost of ending inventory =647

Comparing inventory costing methods (Optional)
Since a different cost flow is assumed for each of the three alternatives method of costing
inventories, the three methods have yielded a different amount for:-
1. the cost of the merchandise sold for the period
2. the gross profit (and net income ) for the period, and
3. the ending inventory
Example: - Using the preceding example for the periodic inventory system, the following partial
income statements indicate the effect of each method when prices are rising.
Partial income statements
FI FO AVERAGE COST LIFO
Net sales (150*55 unit) $2,750 $2,750 $2,750
Cost of March sold.
Beginning inv $805 $ 805 $805
Purchases 1,840 1,840 1,840
Mer avail For sale $2,645 $2,645 $2,450
Less ending inventor 1,310 1,190.25 1,055
Cost of merch sold $1,335 $1454.75 $1,590
Gross profit $ 1,415 $1345.25 $1,460
- The FIFO method yielded the lowest amount for the cost of merchandise sold and the
highest amount for gross profit (and net income). It also yielded the highest amount for
ending inventory.
- The LIFO method yielded the highest amount for cost of goods sold, and the lowest
amount for gross profit (and net income), and the lowest amount for ending inventory.
- The average cost method yield results that were b/n those of LIFO and FIFO.
Uses of FIFO
- Corresponds to the actual physical flow of goods.

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 - Less subject to manipulation than other recent costs
- Ending inventory is shown at the most recent costs
Disadvantages of FIFO
- Older cost is matched against revenues.
- In periods of rising prices, can result in higher income taxes.
Uses of LIFO
- Matches current cost against current sales revenue.
- During periods of rising prices, using LIFO offers an income tax saving b/c LIFO reports
the lowest net income.
Disadvantages of LIFO
- Seldom conforms to actual flow of goods.
- During periods of rising prices, the ending inventors are low (quite different from its
current replacement cost).
- Reported income is generally lower in periods of rising prices.
Uses of average cost method.
- Amounts for cost of goods sold and ending inventory fall b/n FIFO and LIFO values. B/S
values are close to FIFO values (current replacement values)
Valuation of inventory at other than cost
Cost is the primary basis for valuating inventories. In some cases however, inventor is values at
other than cost. This is when,
A. the cost of replacing items in inventory is below the recorded cost and
B. the inventory is not salable at normal sales prices which may be due to imperfections, shop
wear, style changes, and other causes.
1. Valuation at lower of cost or Market (LCM)
If the cost of replacing inventory is lower than its recorded purchase cost, the lower of- cost-or-
market (LCM) method is used to value the inventory. Market, as used in lower of cost or market,
is the cost to replace the inventory. The market value is based on normal quantities that would be
purchased from suppliers.
The lower-of-cost-or-market method can be applied in one of three ways. The cost, market price,
and any declines could be determined for the following:
1. Each item in the inventory.

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2. Each major class or category of inventory.
3. Total inventory as a whole.
The amount of any price decline is included in the cost of merchandise sold. This, in turn,
reduces gross profit and net income in the period in which the price declines occur. This
matching of price declines to the period in which they occur is the primary advantage of using
the lower-of-cost-or-market method.
Example: - On the basis of the following data, determine the value of inventory at the lower of
cost or market.
Commodity Inventory Quantity Unit Cost Price Unit Market Price
A 10 $ 325 $320
B 17 110 115
C 12 275 260
D 15 51 45
E 30 95 100
Answer
______Total_____
Commodity Inventory Unit Cost Unit Market Cost Market LCM
Quantity Price Price
A 10 $ 325 $320 3,250 3,200 3,200
B 17 110 115 1,870 1,955 1,870
C 12 275 260 3,300 3,120 3,120
D 15 51 45 765 675 675
E 30 95 100 2,850 3,000 2,850
Total ……………………………………………………. $12035 $11,950 $11,715

2. Valuation at net realizable value

Merchandise that is out of date, spoiled, or damaged can often be sold only at a price below its
original cost. Such merchandise should be valued at its net realizable value.
Net realizable value is determined as follows:
Net Realizable Value = Estimated Selling Price - Direct Costs of Disposal

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Direct costs of disposal include selling expenses such as special advertising or sales commissions
on sale. To illustrate, assume the following data about an item of damaged merchandise:
Original cost $1,000
Estimated selling price 800
Selling expenses 150
The merchandise should be valued at its net realizable value of $650 as shown below.
Net Realizable Value = $800 - $150 = $650
Example: Assume that damaged merchandise costing 1,500 can be sold for only $ 1,250, and
direct selling expenses are estimated to be $ 175. This inventory should be valued at $ 1075 ($
1,250-$ 175)
Presentation of Merchandise inventory on the balance sheet
Merchandise inventory is usually presented in the current asset section of the balance sheet,
following receivables. Both the method of determining the cost of inventory (fifo, lifo, or
average) and the method of valuing the inventory (cost or the lower of cost or market) should be
show. The details may be disclosed in parentheses on the balance sheet or in a foot note to the
financial statements. The company may change its inventory costing methods for valid reason. In
such cases, the effect of the change and the reason for the change should be disclosed in the
financial statements for period in which the change occurred.
Estimating Inventory Cost
In practical an inventory amount may be need in order to prepare an income statement when it is
impractical or impossible to take a physical inventory or to maintain perpetual inventory records,
the amount of inventory on hand can be estimated.
The two commonly used methods of estimating inventory cost are
1. The retail method
2. The gross profit method.
Retail method of inventory costing
A business may need to estimate the amount of inventory for the following reasons:
1. Perpetual inventory records are not maintained.
2. A disaster such as a fire or flood has destroyed the inventory records and the inventory.
3. Monthly or quarterly financial statements are needed, but a physical inventory is taken
only once a year.

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The two widely used methods of estimating inventory cost.
1. Retail Method of Inventory Costing
The retail inventory method of estimating inventory cost requires costs and retail prices to be
maintained for the merchandise available for sale. A ratio of cost to retail price is then used to
convert ending inventory at retail to estimate the ending inventory cost.
The retail inventory method is applied as follows:
Step 1. Determine the total merchandise available for sale at cost and retail.
Step 2. Determine the ratio of the cost to retail of the merchandise available for sale.
Step 3. Determine the ending inventory at retail by deducting the net sales from the merchandise
available for sale at retail.
Step 4. Estimate the ending inventory cost by multiplying the ending inventory at retail by the
cost to retail ratio.
Example: on the basis of the following data, estimate the cost of the merchandise inventory at
June 30 by the retail method
Cost Retail
June 1. Merchandise inventory $ 428,300 $ 670,500
1-30 purchasers (net) 608,500 949,500
1-30 sales (net) 1,140.000
Solution:
Cost Retail
Merchandise inventory June 1 $ 428,300 $ 670,500
Purchases in June (net) 608,500 949,500
Merchandise available for sale $1,036,800 1,620,000
Ratio of cost to retail price: 1,036,800 = 64%
1,620,000
Sales for June (net) 1,140,000
Merchandise inventory, June 30, at retail 480,000
Merchandise inventory, June 30, at estimated cost
(480.000*64%)…………………................................................................................307,200
When estimating the cost to retail ratio, the mix of items in the ending inventory is assumed to be
the same as the merchandise available for sale. If the ending inventory is made up of different
classes of merchandise, cost to retail ratios may be developed for each class of inventory.

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An advantage of the retail method is that it provides inventory figures for preparing monthly
statements. Department stores and similar retailers often determine gross profit and operating
income each month, but may take a physical inventory only once or twice a year. Thus, the retail
method allows management to monitor operations more closely.
Gross Profit Method of Estimating Inventories
The gross profit method uses the estimated gross profit for the period to estimate the inventory at
the end of the period. The gross profit is estimated from the preceding year, adjusted for any
current-period changes in the cost and sales prices.
The gross profit method is applied as follows:
Step 1. Determine the merchandise available for sale at cost.
Step 2. Determine the estimated gross profit by multiplying the net sales by the gross profit
percentage.
Step 3. Determine the estimated cost of merchandise sold by deducting the estimated gross profit
from the net sales.
Step 4. Estimate the ending inventory cost by deducting the estimated cost of merchandise sold
from the merchandise available for sale.
Example: The merchandise inventory was destroyed by fire on October 20. The following data
were obtained from the accounting records.
Jan 1. Merchandise inventory $ 160,000
Jan 1. Oct purchases (net) 850,000
Sales (net) 1,080,000
Estimated gross profit rate 36%
Required: Estimate the cost of merchandise destroyed:
Solution:
Merchandise inventory, January $160.000
Purchase (net) 850,000
Merchandise available for sales $1,010,000
Sales (net) $1,080,000
Less estimated gross profit
(1,080,000*36%) (388,800)
Estimated cost of merchandise sold ($691,200)
Estimated merchandise inventory, Oct 20 $318,800
The gross profit method is useful for estimating inventories for monthly or quarterly financial
statements. It is also useful in estimating the cost of merchandise destroyed by fire or other
disasters.

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