Chapter 1: Accounting for Inventories

CHAPTER 1
ACCOUNTING FOR INVENTORIES

Chapter Outlines
This chapter covers the following topics:
 Importance of Inventories
 Inventory Systems: Periodic versus Perpetual
 Determining Actual Quantities in Inventory
 Determining the Cost of Inventory
 Inventory Costing Methods under Periodic Inventory System
 Accounting for Inventory under Perpetual Inventory System
 Inventory Costing Methods under Perpetual Inventory System
 Valuation of Inventory at Other than Cost
 Estimating Inventory Cost
 Presentation of Merchandise Inventory on the Balance Sheet.

Chapter Learning Objectives

After studying this chapter, you should be able to:
 Describe the steps in determining inventory quantities
 Prepare the entries for purchases and sales of inventory under a periodic inventory
system
 Determine cost of goods sold under a periodic inventory system
 Identify the unique features of the income statement for a merchandiser using a periodic
inventory system
 Explain the basis of accounting for inventories, and describe the inventory cost flow
methods
 Explain the financial statement and tax effects of each of the inventory cost flow
methods
 Explain the lower of cost or market basis of accounting for inventories
 Indicate the effects of inventory errors on the financial statements
 Compute and interpret inventory turnover

1.1 Importance of Inventories

Definition: inventories are:
 Merchandise held for sale in the normal course of operation in merchandising businesses
 Materials in process of production or
 Materials held for production purpose (Raw Materials).
But in this chapter the emphasis is mainly on merchandises purchased and held for resale.
Objective-the major objective of accounting for inventories is the proper determination of
income through the process of matching appropriate cost against revenues.

The Importance of inventories includes:

 Merchandise inventory is one of the most active elements in the operation of a
merchandising business because it is continually purchased and sold.
 The sale of merchandise is the principal source of revenue in both merchandising and
manufacturing business.
 The cost of merchandise sold is the largest deduction from net sales in the determination
of net income or net loss.
 It is the largest portion in the current asset of merchandising businesses

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 Chapter 1: Accounting for Inventories

1.2 Inventory Systems

Inventory system is a system through which we can determine the cost of merchandise sold and
cost of merchandise on hand. Generally, there are two widely accepted inventory system.
1. Periodic Inventory System and
2. Perpetual Inventory System

Periodic Inventory System:

 Only revenue from sales is accounted for
 No effort is made to keep up to date records of either inventory or cost of goods sold
 Purchase of merchandise is debited to purchases account
 A physical inventory is taken at the end of the period to determine the merchandise on
hand i.e. counting merchandise on hand
 COGS is the difference between CMAS and cost inventory on hand
 It is used by small businesses which sale many items with low unit cost of merchandise.

Perpetual Inventory System:

 A separate account or record is maintained for both cost of goods sold and merchandise
inventory on hand
 The inventory account shows the increase, decrease and the balance in the account
 Provides up to date data about each type of product that the company sells
 Used by firms which sells relatively small number of item which have high unit cost
 Physical inventory is taken to compare the balance on the records with the balance on
hand
 Each time inventory is sold, it will be transferred to cost of merchandise sold account
 The appropriate inventory balance is adjusted to the quantities determined by the
physical count.
Note: a business may use different inventory system for different items of merchandise.
Illustration: recording transactions under periodic and perpetual inventory systems.

1.3 Determining the Cost of Inventory

From theoretical point of view the cost of merchandise includes:
 A purchase price or invoice price
 All other expenditures necessary to place the items in its proper condition and location
such as transportation cost, import duties (custom duties), insurance against loss while it
is in transit and store room, cost of receiving and inspection( checking the goods
whether it is damaged or not).
 Any costs which are difficult to associate with specific inventory but related to inventory
may be prorated on some equitable basis
 Any incidental cost which is not material may be excluded from the cost of merchandise
and treated as operating expenses.

1.4 Inventory Costing Methods under a Periodic Inventory System

The term cost flow refers to the inflow of costs when goods are purchased or manufactured and
to the outflow of costs when goods are sold. The cost remaining in inventories is the difference
between the inflow and outflow of costs. The problem often faced by an accountant is
determining the cost of merchandise sold and the cost of remaining inventories or ending
inventories when merchandises are purchased at different costs. If identical goods are purchased
at different costs during the period, there should be an arbitrary assumption as to the cost flow of
merchandise through the business such as:
1. FIFO (First-In, First-Out)
2. Average Costing Method

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3. Specific Identification - which is rarely used unless it is large item

Illustration 1.3: You are given the following data for BB Electronics for the year 2020 for one
of the items is called CD-RW.
Date Item Quantity Unit Cost Total Cost
January 1, 2020 Inventory 500 Units Br 10.50 Br 5,250
March 31, 2020 Sold 300 Units
April 1, 2020 Purchases 1,800 Units 12 21,600
June 30, 2020 Sold 600 Units
July 1, 2020 Purchases 500 Units 12.50 6,250
September 30, 2020 Sold 700 Units
October 1, 2020 Purchases 200 Units 13 2,600
December 31, 2020 Sold 800 Units
Required: For the CD-RW of BB Electronics compute the cost of inventory on hand as of
December 31, 2020 and cost of goods sold under the following three cost flow assumptions:
FIFO Costing Method and Average Costing Method

1. FIFO Cost Flow Assumption

FIFO cost flow is in the order in which the expenditures were made. FIFO assumes that items
acquired first should be sold first to customers. FIFO charges costs against revenue in the order
in which they were incurred. Hence:
 Inventory on hand assumed the most recent costs
 Inventory sold assumed the oldest or earliest costs
Ending Inventory in Units= 3,000- 2,400= 600 units

Cost of Ending Inventory (COEI)

200 Units * Br 13...............................Br 2,600
400 Units * Br 12.50.......................... 5,000
COEI..................................................Br 7,600

Cost of Goods Sold (COGS)

500 units * Br 10.5............................. Br 5,250
1800 units * Br 12.............................. 21,600
100 units * Br 12.5............................. 1,250
COGS.................................................Br 28,100

Cost of Goods Sold (The Alternative Method)

COGS= Cost of Goods Available for Sale (COGAFS) − COEI
COGAS= Br 5,250 + 21,600 + 6,250 + 2,600= Br 35,700
COGS=Br 35,700 − 7,600
COGS=Br 28,100
FIFO-Advantage and Disadvantage
 Advantage-the merchandise inventory to be reported in the balance sheet approximates
its replacement cost
 Disadvantage-it matches old costs with current revenue

2. The Average Method (Weighted Average Costing Method)

This cost flow is an average of the expenditure. It charges costs against revenue applying the
weighted average unit cost of the goods available for sale.
Weighted Average Unit cost = (U1*C1 + U2*C2 + U3*C3 + U4*C4 + ….) / Total Units
Weighted Average Unit cost = 500*10.5 + 1800*12 + 500*12.5 + 200*13
500 + 1800 + 500 + 200

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Weighted Average Unit cost = Br 35,700 / 3,000 = Br 11.90

Cost of Ending Inventory
 COEI= Br 11.90* 600 units = Br 7,140
Cost of Goods Sold
 COGS= Br 11.90* 2,400 units = Br 28,560
Cost of Goods Sold (The Alternative Method)
 COGS= COGAFS − COEI
 COGS=Br 35,700 − 7,140 = Br 28,560

Comparison of the Three Methods:

Costing Method FIFO AVERAGE
COGAFS 35700 35700
COEI 7600 7140
COGS 28100 28560
The higher the unit cost of ending inventory, the higher the total cost of ending inventory is,
which means the lesser the COGS. The lesser the unit COEI, the lesser the total COEI is, which
means the higher the COGS.

1.6 Accounting for Inventory under a Perpetual Inventory System

Under perpetual inventory system, all merchandises increases and decreases are recorded in a
manner somewhat similar to the recording of increases and decreases in Cash account. The
merchandise inventory account at the beginning of an accounting period reflects the
merchandise on hand on that date. Then purchases of merchandise is debited to merchandise
inventory account each time purchase was made and sales are recorded in the sales account and
the cost of each sale is recorded by debiting CMS account and crediting merchandise inventory.
Illustration 1.4:
January 1: Merchandise Inventory Br 60,000
January: Purchases 28,000
January: Sales at Selling Price 30,000
January: Sales at Cost 21,000
February: Sales at Selling Price 40,000
February: Sales at Cost 32,000
March: Sales at Selling Price 20,000
March: Sales at Cost 14,300
Instruction: Record the above transactions assuming that the physical inventory shows Br
20,500 ending inventory.
Date Transaction Periodic System Perpetual System
January Merchandise inventory has a debit balance Merchandise inventory has a debit balance
of Br 60,000 of Br 60,000
January Purchases Purchases 28,000 Inventory 28,000
Cash/A/Pay 28,000 Cash/A/Pay 28,000
January Sales A/Rec/Cash 30,000 A/Rec/Cash 30,000
Sales 30,000 Sales 30,000
Cost No Entry COGS 21,000
Inventory 21,000
February Sales A/Rec/Cash 40,000 A/Rec/Cash 40,000
Sales 40,000 Sales 40,000
Cost No Entry COGS 32,000
Inventory 32,000
March Sales A/Rec/Cash 20,000 A/Rec/Cash 20,000
Sales 20,000 Sales 20000
Cost No Entry COGS 14,300
Inventory 14,300
March Adjusting I/ Summary 60,000 COGS 200
Inventory 60,000 Inventory 200
Inventory 20,500

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I/Summary 20,500
1.7 Inventory Costing Methods under Perpetual Inventory System
It is customarily to use the inventory cost flow assumption under perpetual inventory system,
too. Illustration 1.5: take the data For BB Electronics above and compute the cost of Ending
inventory and cost of goods sold assuming that the company uses perpetual inventory system
under: FIFO and Average cost flow assumption.

A) FIFO Cost Flow Assumption

Purchases Sold Inventory Balance
Date
Qty UC TC Qty UC TC Qty UC TC
Jan.1 500 10.5 5,250
Mar.31 300 10.5 3,150 200 10.5 2,100
Apr.1 1,800 12 21,600 200 10.5 2,100
1,800 12 21,600
June 30 200 10.5 2,100
400 12 4,800 1,400 12 16800
July 1 500 12.5 6,250 1,400 12 16,800
500 12.5 6,250
Sep.30 700 12 8,400 700 12 8,400
500 12.5 6,250
Oct.1 200 13 2,600 700 12 8,400
500 12.5 6,250
200 13 2,600
Dec. 31 700 12 8,400 400 12.5 5,000
100 12.5 1,250 200 13 2,600
Total Br 28,100 Br 7,600

B) Average (Moving Average Cost)

Each time a purchase is made, new average cost will be computed and sales after that are made
at this new average unit cost.
Purchases Sold Inventory Balance
Date
Qty UC TC Qty UC TC Qty UC TC
Jan.1 500 10.5 5,250
Mar.31 300 10.5 3,150 200 10.5 2,100
Apr.1 1,800 12 21,600 2,000 11.85 23,700
June 30 600 11.85 7,110 1,400 11.85 16,590
July 1 500 12.5 6,250 1,900 12.02 22,840
Sep.30 700 12.02 8,414 1,200 12.02 14,426
Oct.1 200 13 2,600 1,400 12.16 17,026
Dec. 31 800 12.16 9,728 600 12.16 7,298
Total Br 28,402 Br 7,298

Comparison of the Methods

COGAFS 35,700 35,700
COEI 7,600 7,298
COGS 28,100 28,402

 The results of the FIFO method under both the periodic and perpetual inventory systems
produce the same result for cost of EI and Merchandise sold
 The perpetual inventory system provides the most effective means of control over this
important asset-merchandise inventory
 An automated perpetual inventory system facilitates the processing in the case of large
number of inventory items.

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1.8 Valuation of Inventory at Other than Cost

Cost is the primary basis for the valuation of inventory. However, when the cost of replacing
items in inventory is below recorded cost and when the inventory is not salable at normal selling
price because of some reason such as imperfections, shop wear, style changes, or other causes,
inventory may be valued at other than the cost. I.e. departures from Cost Valuation Methods
may be allowed. There are two valuation methods other than the cost: valuation at lower of cost
or market and valuation at net realizable value.

1. Lower of Cost or Net Realizable Value (LCNRV)

A company abandons the historical cost principle when the future utility (revenue-producing
ability) of the asset drops below its original cost.

Net Realizable Value

Estimated selling price in the normal course of business less
 Estimated costs to complete and estimated costs to make a sale.
Methods of Applying LCNRV: there are three alternative applications of LCNRV. These are
A. Individual item: First compute the NRV of each item then compare the cost and NRV
of each item, finally by taking the lower under each item and the total of each value
under each item is the value of the inventory.
B. Major groups: First compute the NRV of each major groups then compare that amount
with their respective costs or cost of each group, finally by taking the lower under each
group and the total of each value under each group is the value of the inventory.
C. Total inventory: First compute the total NRV then compare that with the total cost, the
lower one becomes the value of the inventory.
Out of those methods item by item basis is the preferable one.

1.9 Estimating Inventory Cost

For companies using a periodic inventory system taking physical inventory to prepare interim
financial reports is both expensive and time consuming. There fore, such companies may use
estimated amount inventory balance in preparing monthly or quarterly financial statements.
There are two methods of inventory estimation: the retail method and the gross profit method.

1. Retail Method
It is used by retailers to estimate the cost of inventory on hand. Under this method:
 Records are kept for goods available for sale at both selling price (Retail Price) and at
Cost
 Sales are recorded and total sales for accounting period are deducted from the total value
of goods available for sale to determine the ending inventory at selling price.
 The EI valued at selling price is changed to estimated cost by multiplying by the cost to
retail ratio

Illustration 1.8: the following data was extracted from MM Corporation for the month of
March.
Items @ Cost @ Selling Price
Beginning Inventory Br 60,000 Br 100,000
Net Purchases 96,000 160,000
CMAS 156,000 260,000
Sales 180,000
Instruction: Estimate the cost of Ending Inventory by the Retail Method
 Cost to Retail Ratio = 156,000 / 260,000 = 60%
 Beginning Inventory......................................… 100,000

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 Net Purchases.................................................… 160,000

 CMAS............................................................… 260,000
 Less: Sales......................................................…(180,000)
 Ending Inventory@ Selling Price…..............… 80,000
 Ending Inventory@ Cost = 60% * 80,000 = Br 48,000

2. The Gross Profit Method

When the GP rate or percentage is known, the ending inventory can be estimated by the
following procedures:
 Determine the CMAS from the accounting records.
 Estimate the gross profit by multiplying the net sales by the GP rate.
 Determine CMS by deducting the gross profit form the net sales
 Determine the estimated ending inventory by deducting CMS from the CMAS
Illustration 1.9: the following data is taken from MM Corporation as to one of its inventory
 Beginning Inventory...................................................... Br 20,000
 Net Purchases................................................................. 80,000
 Sales …………………………………………………. 90,000
 Estimated Gross Profit Rate........................................... 25%
Instruction: determine the estimated ending inventory
 Beginning Inventory...................................................... Br 20,000
 Net Purchases................................................................. 80,000
 Cost of Merchandise Available for Sales.......................Br 100,000
 Less: COGS = Sales – Est. GP Rate
(Br 90,000 – 25% * 90,000)................................ (67,500)
 Estimated Cost of Ending Inventory.............................. Br 32,500

The Effect of an Error in the Determination Inventory on the Financial Statements

Inventory determination plays an important role in matching expired costs with revenues of the
period. An error in the determination of the inventory amount at the end of the period will cause
the following errors:
 Misstatement of gross profit and net income
 The incorrect amount of inventory i.e. the inventory to be reported in the balance sheet is
incorrect amount.

Illustration 1.5: the effect of an error in the determination of ending inventory on the current
period for BB Company. You are given the following data for year I.
Net Sales for year I Br 450,000
Beginning Inventory (January 1, Year I) 75,000
Net Purchases 420,000
Other Assets (December 31, Year I) 310,000
Liabilities (December 31, Year I) 225,000
Operating Expenses 135,000

Instruction: Prepare Income Statement and Balance Sheet under the following assumption:
1. Ending Inventory is correctly stated at Br 220,000
2. Ending Inventory is incorrectly stated at Br 210,000
3. Ending Inventory is incorrectly stated at Br 225,000

Assumption 1: Ending Inventory is correctly stated at Br 220,000

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Income Statement
BB Company
Income Statement
For the year ended December 31, Year I
Net Sales Br 450,000
Less: Cost Goods Sold
Beginning Inventory 75,000
Net Purchases 420,000
CMAS 495,000
Less: Ending Inventory (220,000)
Cost of Goods Sold (275,000)
Gross Profit 175,000
Less: Operating Expenses (135,000)
Net Income Br 40,000

Balance Sheet
BB Company
Balance Sheet
December 31, Year I
Merchandise Inventory 220,00 Liabilities 225,000
0
Other Assets 310,00 Capital 305,000
0
Total Assets 530,00 Liabilities and OE 530,000
0

Assumption 2: COEI is incorrectly stated as Br 210,000 (Understated by Br 10,000)

Income Statement
BB Company
Income Statement
For the year ended December 31, Year I
Net Sales Br 450,000
Less: Cost Goods Sold
Beginning Inventory 75,000
Net Purchases 420,000
CMAS 495,000
Less: Ending Inventory (210,000)
Cost of Goods Sold (285,000)
Gross Profit 165,000
Less: Operating Expenses (135,000)
Net Income Br 30,000

Balance Sheet
BB Company
Balance Sheet
December 31, Year I
Merchandise Inventory 210,00 Liabilities 225,000
0
Other Assets 310,00 Capital 295,000

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0
Total Assets 520,00 Liabilities and OE 520,000
0

The effects of understating Ending Inventory by Br 10,000 were as follows:

1. In the income statement
 It increases Cost of Goods Sold by Br 10,000
 It decreases Gross Profit by Br 10,000
 It decreases Net Income by Br 10,000 or increases Net Loss by Br 10,000
2. In the balance sheet
 It understates total assets by Br 10,000
 It understates Capital by Br 10,000

Assumption 3: COEI is incorrectly stated as Br 225,000 (Overstated by Br 5,000)

Income Statement
BB Company
Income Statement
For the year ended December 31, Year I
Net Sales Br 450,000
Less: Cost Goods Sold
Beginning Inventory 75,000
Net Purchases 420,000
CMAS 495,000
Less: Ending Inventory (225,000)
Cost of Goods Sold (270,000)
Gross Profit 180,000
Less: Operating Expenses (135,000)
Net Income Br 45,000

Balance Sheet
BB Company
Balance Sheet
December 31, Year I
Merchandise Inventory 225,00 Liabilities 225,000
0
Other Assets 310,00 Capital 310,000
0
Total Assets 535,00 Liabilities and OE 535,000
0

The effects of overstating Ending Inventory by Br 5,000 were as follows:

1. In the income statement
 It decreases Cost of Goods Sold by Br 5,000
 It increases Gross Profit by Br 5,000
 It increases Net Income by Br 5,000 or decreases Net Loss by Br 5,000
2. In the balance sheet
 It overstates total assets by Br 5,000

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 It overstates Capital by Br 5,000

Summary of error in ending inventory on the financial statement of the period in which the error
occurs are as follows:
Ending Inventory Correctly Stated Understated Overstated
Cost of Goods Sold Unaffected Overstated Understated
Gross Profit Unaffected Understated Overstated
Net Income Unaffected Understated Overstated
Total Assets Unaffected Understated Overstated
Capital Unaffected Understated Overstated
The understatement or overstatement of ending inventory does not only affect the financial
statement of one accounting period but also the financial statement of the subsequent period.

Illustration 1.2: The effect of an error in the determination of Ending Inventory in year I will
have the following impact on the financial statements of the subsequent accounting period. You
are given the following data for Year II:
Net Sales for Year II Br 600,000
Net Purchases 375,000
Ending Inventory 150,000
Operating Expenses 105,000
Other Assets (December 31, Year II) 300,000
Total Liabilities (December 31, Year II) 110,000

Instruction: Prepare Income statement and balance sheet assuming that ending inventory of
year I are reported under the three assumptions above for BB Company
1. Beginning Inventory is Correctly Stated at Br 220,000
2. Beginning Inventory is incorrectly stated Br 210,000
3. Beginning Inventory is incorrectly stated at Br 225,000
Assumption 1: Beginning Inventory is correctly stated as Br 220,000

Income Statement
BB Company
Income Statement
For the year ended December 31, Year II
Net Sales Br 600,000
Less: Cost Goods Sold
Beginning Inventory 220,000
Net Purchases 375,000
CMAS 595,000
Less: Ending Inventory (150,000)
Cost of Goods Sold (445,000)
Gross Profit 155,000
Less: Operating Expenses (105,000)
Net Income Br 50,000

Balance Sheet
BB Company
Balance Sheet
December 31, Year II
Merchandise Inventory 150,00 Liabilities 110,000
0

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Other Assets 300,00 Capital 340,000

0
Total Assets 450,00 Liabilities and OE 450,000
0

Assumption 2: Beginning Inventory is incorrectly stated at Br 210,000

Income Statement
BB Company
Income Statement
For the year ended December 31, Year II
Net Sales Br 600,000
Less: Cost Goods Sold
Beginning Inventory 210,000
Net Purchases 375,000
CMAS 585,000
Less: Ending Inventory (150,000)
Cost of Goods Sold (435,000)
Gross Profit 165,000
Less: Operating Expenses (105,000)
Net Income Br 60,000

Balance Sheet
BB Company
Balance Sheet
December 31, Year II
Merchandise Inventory 150,00 Liabilities 110,000
0
Other Assets 300,00 Capital 340,000
0
Total Assets 450,00 Liabilities and OE 450,000
0

The effects of understating Beginning Inventory by Br 10,000, on the income statement, were as
follows:
 It understates CMAS by Br 10,000
 It understates Cost of Goods Sold by Br 10,000
 It overstates Gross Profit by the Same amount Br 10,000
 It overstates Net Income by Br 10,000 or understates net loss by the same amount

Assumption 3: Beginning Inventory is incorrectly stated at Br 225,000

Income Statement
BB Company
Income Statement

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For the year ended December 31, Year II

Net Sales Br 600,000
Less: Cost Goods Sold
Beginning Inventory 225,000
Net Purchases 375,000
CMAS 600,000
Less: Ending Inventory (150,000)
Cost of Goods Sold (450,000)
Gross Profit 150,000
Less: Operating Expenses (105,000)
Net Income Br 45,000

Balance Sheet
BB Company
Balance Sheet
December 31, Year II
Merchandise Inventory 150,00 Liabilities 110,000
0
Other Assets 300,00 Capital 340,000
0
Total Assets 450,00 Liabilities and OE 450,000
0

The effects of understating Ending Inventory by Br 5,000 on the income statement were as
follows:
 It overstates CMAS by Br 5,000 during year II
 It overstates Cost of Goods Sold by Br 5,000
 It understates Gross Profit by Br 5,000
 It understates Net Income by Br 5,000 or decrease Net Loss by Br 5000

Summary of errors in Beginning Inventory (Ending Inventory of the previous accounting period)
on the financial statement of the current of period are as follows:
Beginning Inventory Correctly Stated Understated Overstated
CMAS Unaffected Understated Overstated
Cost of Goods Sold Unaffected Understated Overstated
Gross Profit Unaffected Overstated Understated
Net Income Unaffected Overstated Understated

 If inventory amount is stated incorrectly in one period, the effect is limited to the period
of the error and the following period only.
 If there is no additional error, both total assets and owner’s equity will be correct during
the following period.
 The balance sheet will not be affected by the error of the previous period
 The error of one accounting period set-off against the error of the subsequent period. The
overstatement of items in the income statement of one accounting period will result in
understatement of items in the subsequent in the subsequent period-set off.

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