CPU Chapter 2: Accounting for Inventories

Chapter 2
Accounting for Inventories
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
The Effect of an Error in the Determination Inventory on the Financial Statements

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.
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

Accounting Department 1
 CPU Chapter 2: Accounting for Inventories
 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 Actual Quantities in Inventory
In the determination of the quantities of inventory all goods owned by a business enterprise
on the date of physical inventory must be included. This includes:
 goods in the store room and warehouse places where merchandise are kept when they
received from the port
 goods in the shelves and sales counter (show room)
 goods purchased on terms of FOB shipping point agreement and still on transit
 consigned goods but not sold by the sales agent or consignee
Goods sold on FOB destination agreement are excluded from inventory determination
because once it counted sales. If it is included, it will be double counting. The sale is already
recorded. Thus, the goods should be excluded from the inventory count.
1.4 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.
1.5 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 merchandise are purchased at different costs. If identical goods

Accounting Department 2
 CPU Chapter 2: Accounting for Inventories
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. LIFO (Last In Fits Out)
3. AVERAGE Costing Method
4. 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 2003 for
one of its item called CD-RW.
Date Item Quantity Unit Cost Total Cost
January 1, 2003 Inventory 500 Units Br 10.50 Br 5,250
March 31, 2003 Sold 300 Units
April 1, 2003 Purchases 1,800 Units 12 21,600
June 30, 2003 Sold 600 Units
July 1, 2003 Purchases 500 Units 12.50 6,250
September 30, 2003 Sold 700 Units
October 1, 2003 Purchases 200 Units 13 2,600
December 31, 2003 Sold 800 Units
Required: For the CD-RW of BB Electronics compute the cost of inventory on hand as of
December 31, 2003 and cost of goods sold under the following three cost flow assumptions:
FIFO Costing Method; LIFO 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

Accounting Department 3
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. LIFO Cost Flow Assumption

LIFO cost flow is in the reverse order in which the expenditures were made. LIFO assumes
that items purchased last should be sold first. It charges or deducts the most recent costs
against or from revenue. Hence:
 The ending inventory assumed the oldest purchases or earliest costs and
 The cost of merchandise sold assumed the most recent costs.
Cost of Ending Inventory
 500 Units * Br 10.5 ..............................................Br 5,250
 100 Units * Br 12 ................................................. 1,200
 COEI ....................................................................Br 6,450
Cost of Goods Sold
 200 units * Br 13 .................................................. Br 2,600
 500 units * Br 12.5 ............................................... 6,250
 1,700 units * Br 12 ............................................... 20,400
 COGS ...................................................................Br 29,250
Cost of Goods Sold (The Alternative Method)
 COGS= COGAFS − COEI
 COGS=Br 35,700 − 6,450
 COGS=Br 29,250
LIFO Advantage and Disadvantage
 Advantage-it matches current costs with current revenue
 Disadvantage-the amount of inventory reported does not approximate its replacement costs
3. 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
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

Accounting Department 4
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 LIFO AVERAGE
COGAFS 35700 35700 35700
COEI 7600 6450 7140
COGS 28100 29250 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 Merchandise inventory has a debit
balance of Br 60,000 balance 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
I/Summary .......... 20,500

Accounting Department 5
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, LIFO and AVERAGE cost flow assumption.
A) FIFO Cost Flow Assumption
Date Purchases Sold Inventory
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) LIFO Cost Flow Assumption
Date Purchases Sold Inventory
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 30 600 12 7,200 200 10.5 2,100
1,200 12 14,400
July 1 500 12.5 6,250 200 10.5 2,100
1200 12 14,400
500 12.5 6,250
Sep.30 500 12.5 6,250 200 10.5 2,100
200 12 2,400 1,000 12 12,000
Oct.1 200 13 2,600 200 10.5 2,100
1,000 12 12,000
200 13 2,600
Dec. 31 200 13 2,600 200 10.5 2100
600 12 7,200 400 12 4800
Total Br 28,800 Br 6,900
C) 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.
Date Purchases Sold Inventory
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

Accounting Department 6
 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 Three Methods
COGAFS 35,700 35,700 35,700
COEI 7,600 6,900 7,298
COGS 28,100 28800 28,402
 The results of the FIFO method under both the periodic and perpetual inventory systems
produces 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.
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. Valuation at Lower of Cost or Market (LCM)

The LCM method requires that inventory should be valued at the lower of the two values:
Cost or Market.

The LCM works as follows:

 Determine the cost of inventory using FIFO, LIFO or AVERAGE
 Determine the market value or the replacement cost
 Compare the cost with the market value and take the lower of the two as a value of
inventory
Illustration 1.6: BB Electronics Compile the following data concerning items in its
inventory on December31, 2004
Category Items Quantity Unit Cost Unit Market Price
A CD-R 10,000 Br 4 Br 3.50
CD-RW 4,000 12 13
B Walkman-Sony 20 150 140
Discman-Sony 50 200 200
C VCD Player-Sony 100 500 520
DVD Player-Sony 50 650 640
Instruction: determine the total cost inventory to appear in the balance sheet of BB
Electronics as of December 31, 2004 assuming that LCM is applied to

Accounting Department 7
 I. To the inventory as a whole
II. To a major category of inventory
III. To each item in the inventory or item by item basis
Items Cost Market LCM-II LCM-III
A CD-R Br 40,000 Br 35,000 35,000
CD-RW 48,000 52,000 87,000 48,000
B Walkman-Sony 3,000 2,800 2,800
Discman-Sony 10,000 10,000 12,800 10,000
C VCD Player-Sony 50,000 52,000 50,000
DVD Player-Sony 32,500 32,000 82,500 32,000
LCM-I 183,500 183,800 182,300 177,800
 If LCM is applied to the inventory as a whole, the lower is the total cost Br 183,500 and
this amount has to be reported in the balance sheet.
 If LCM is applied to a group of inventory, it is resulted in Br 182,300 value and this
amount has to be reported in the balance sheet.
 If LCM is applied to each item of inventory, it is resulted in Br 177,800 value and this
amount has to be reported in the balance sheet.
The application of the LCM rule of item by item basis resulted in the lowest inventory value
where as the inventory as a whole basis resulted in the highest value of inventory. Many
authors recommended that:
 Item by item basis shall be used for income tax purposes because it will result in lower
income tax
 The inventory as whole should be applied for financial accounting purpose to know the
actual profit of the businesses.
A restriction to the LCM method is inventory should never be carried at an amount that is
greater than its net realizable value (NRV)

2. Valuation at Net Realizable Value (NRV)

The NRV is the difference between the estimated selling price and any direct cost of
disposition (i.e. any anticipated or forecasted selling expense such as sales commissions).
Obsolete, spoiled, or damaged merchandise and other merchandise that may be sold at a price
below cost should be valued at Net Realizable Value.
Illustration 1.7: on December 31, 2003 the following data is given for the inventory of item
x of AA Company:
100 Units on hand (Cost under FIFO) .......................Br 5,000
Replacement Cost of the items .................................. 4,500
Selling Price............................................................... 4,500
Sales Commission to dispose the inventory .............. 200
Required: at what amount should the item be presented in the balance sheet on Dec.31, 2003?
 NRV = Selling Price – Cost of Disposition
 NRV = Br 4500 – 500
 NRV = Br 4,000
What if the replacement cost of the item is Br 3,900- take the lower of the two values that is
the lower of the NRV or its current replacement cost
 NRV = Br 4,000 vs. Br 3,900 = Br 3,900

Accounting Department 8
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. Therefore, 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
 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 from 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%

Accounting Department 9
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
1.10 Presentation of Merchandise Inventory on the Balance Sheet
 Ending inventory is reported under Current Asset section of Balance sheet
statement.

Accounting Department 10