CHAPTER ONE

1. INVENTORIES

At end of this chapter the learners should be able to:

Identify the nature and definition of inventories

Understand the Internal control of inventories
Identify the effect of inventory errors on the financial statements
Understand Inventory cost flow assumptions
Methods of Inventory costing methods under a perpetual and periodic inventory system
understand the Valuation of inventory at other than cost (LCNRV)
Methods of Estimating inventory costs
Presentation of merchandise inventory in the financial statements
1.1. Nature and definition of inventories

Inventories are those assets which are held for sale in the normal course of business, are in the process of
being produced for such purpose, or are to be used in the production of such items.

They are mainly divided into two major categories:

 Inventories of merchandising businesses; and

 Inventories of manufacturing businesses
1. Inventories of merchandising businesses: are merchandise purchased for resale of business.
2. Inventories of manufacturing businesses: manufacturing businesses are businesses that produce
physical output. They normally have three types of inventories.
These are:
Raw material inventory
Work in process inventory
Finished goods inventory
1) Raw material inventory- is the cost assigned to goods and materials on hand but not yet placed into
production. Raw materials include the wood to make a chair or other office furniture’s, the steel to
make a car etc.

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2) Work in process inventory- is the cost of raw material on which production has been started but not
completed, plus the direct labor cost applied specifically to this material and allocated manufacturing
overhead costs.
3) Finished goods inventory- is the cost identified with the completed but unsold units on hand at the end
of each period.
In this unit only the determination of the inventory of merchandise purchased for resale commonly called
merchandise inventory will be discussed.
Inventories are typically classified as current assets on the balance sheet. The accounting problems
associated with inventory are complex; this chapter discusses the basic issues involved in recording,
valuing, and reporting merchandise inventory.
Importance of Inventories
Why do we need to have proper accounting for inventories? The description and measurement of
inventories demand careful attention because:

Merchandises are source of revenues for merchandising business.

The frequency of transactions involving inventory are high.
CGS is the largest deduction in the income statement and CGS determination depend on balance of
merchandise inventory.
Higher investments made on inventories.
1.2. The Internal control of inventories

Internal inventory controls are intended to help a company verify that it has sufficient resources to: produce
and sell goods to meet demand, avoid maintaining excess products, and eliminate costs associated with
purchasing, producing, and holding excess.

Techniques of Internal control over inventories:

 Use perpetual inventory system

 Physical count at any time
 Preparation of interim reports
 Maintaining inventory quantities using subsidiary ledger
 Frequent comparison of balances with maximum and minimum level

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  Avoiding both excess inventory and loss of sales.
1.3. The effects of Inventory Errors on the Financial Statements
1. The effects of Ending inventory on the current period‘s statement

Ending inventory is the cost of merchandise on hand at the end of the accounting period. Let us see its
effect on current period’s financial statements.

The effect of ending inventory is reflected in both income statements and balance sheets. First let’s see its
effect on the income statement:

A. Income Statement
i. Ending inventory is used in calculating cost of goods sold in the income statement.

Cost of goods (merchandise) sold =Beginning inventory + Net purchase – Ending inventory

As you see, ending inventory is a deduction in calculation cost of merchandise sold. So, it has an indirect
(negative) relationship to cost of merchandise sold, i.e. if ending inventory is understated, the cost of
merchandise sold will be overstated, and if ending inventory is overstated, the cost of merchandise sold
will be understated. This shows us the inverse relationship.

ii. The cost of the merchandises sold will then subsequently be used in calculating the gross profit of the
enterprise. Gross Profit = Net sales – Cost of merchandise sold

Here, the cost of merchandise sold had indirect relationship to gross profit. So, the effect of ending
inventory on gross profit is the opposite of the effect on cost of merchandise sold. That is, if ending
inventory is understated, the gross profit will be understated and if ending inventory is overstated, the gross
profit will be overstated. There exists a direct (positive) relationship between ending inventory and gross
profit.

iii. Operating income = Gross Profit – Operating Expenses

Gross profit and operating income have direct relationships. Thus, the effect of ending inventory on net
income is the same as its effect on gross profit. There exists a direct (positive) relationship between ending
inventory and gross profit.

B. Balance Sheet

A balance sheet is a financial statement that lists all assets, liabilities and capitals of an organization on a
specific date. The ending inventory of an organization affects the two major components of a balance
sheet:

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1) Current assets - Ending inventory is part of current assets, even the largest. So, it has a direct
(positive) relationship to current assets. If ending inventory balance is understated (overstated), the total
current assets will be understated (overstated).
2) Liabilities- No effect on liabilities. Inventory misstatement has no effect on liabilities.
3) Owners’ equity– The net income will be transferred to the owners‟ equity at the end of accounting
period. Closing income summary account does this. So, net income has direct relationship with
owners‟ equity at the end of accounting period. The effect-ending inventory on owners‟ equity is the
same as its effect on net income, i.e. if ending inventory is understated (Overstated), the owners‟ equity
will be understated (Overstated).

2. The effects of Ending inventory on Income Statement of the Following Period

a) Ending inventory is used in calculating cost of goods sold in the income statement.

Cost of goods (merchandise) sold =Beginning inventory + Net purchase – Ending inventory

As you see, ending inventory of the previous period will become beginning inventory of the following
period. Therefore, when ending inventory of the current period increases, it means that beginning inventory
of the next period increases too. Due to this cost of goods sold of the next period increases. There exists a
direct or positive relationship between ending inventory of the previous period and cost of merchandises.

b) The cost of the merchandises sold of the following period will then subsequently be used in calculating
the gross profit of that period.

Gross Profit = Net sales – Cost of merchandise sold

In this case you have to note that, ending inventory of the previous period has increased cost of goods sold
of the following period. Therefore, gross profit of the following period will decrease as cost of the goods
sold increase.

c) Operating income = Gross Profit – Operating Expenses

The effect of ending inventory on the following periods operating income is the same with that of gross
profit.

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3. The effects of Ending 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. At the end of this following
period, assuming no additional errors, both assets and owners’ equity will be correctly stated.

In the illustration, the $10,000 understatement of inventory at the end of period 1 resulted in an
overstatement of the cost of merchandise sold and thus an understatement of gross profit by $10,000. On
the balance sheet, merchandise inventory and owner’s equity would both be understated by $10,000.
Because the ending inventory of period 1 become the beginning inventory for period 2, the cost of
merchandise sold was understated and gross profit was overstated by $10,000 for period 2. Both
merchandise inventory and owner’s equity will be correct at the end of period 2.

4. Balance sheet of the following period

The ending inventory of the current period will not have an effect on the following period’s balance sheet
items. This is because the balance sheet of the following period reports only ending inventory of that
period instead of ending inventory of the previous period.

Inventory Systems: Periodic vs Perpetual

Inventory records may be maintained on a perpetual or periodic inventory system. The essential
difference between these two systems from an accounting point of view is the frequency with which the
physical flows are assigned a value.

Here are the major differences between the two:

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 perpetual inventory system
The inventory value and COGS are determined
only at important point in time .e.g. end of
reporting period
Only revenue is recorded at time of sale
Purchase & purchase related accounts are used
More appropriate for low unit cost items
Physical inventory is undertaken to determine EI
cost. Units sold are determined indirectly by
subtracting the units on hand from the sum of the
units available for sale during the period.
This makes preparation of interim financial
statements. more costly unless inventory
estimation technique is used.
Weaker for internal control.
periodic inventory system
Continuous record of both the physical flow and
the cost of inventories and COGS. Every point in
time you determine the level of inventory
Both revenue and COGS are recorded
No purchase and purchase related accounts
For high unit cost items (not economical for low
unit cost items)
Physical inventory should be undertaken to test
accuracy, to discover any shortage or overage b/c
of waste, breakage , theft, improper entry, failure
to record acquisitions etc.
Facilitates the preparation of interim financial
statements.
Stronger for internal control.

Example:

Sep.1 Goods were purchased for $10,000 terms 2/10,n/30

Periodic Perpetual
Sep.1 Purchases---------------10,000 Sep.1 Merchandise inventory-------10,000
Accounts Payable-----10,000 Accounts Payable----------10,000
Sep.2 Paid freight charge of $250 on merchandise purchased
Sep.2 Freight in------------250 Sep.2 Merchandise Inventory-------250
Cash 250 Cash 250
Sept.5 Returned $1000 of merchandise previously bought.
Sep.5 Accounts Payable-------1000 Sep.5 Accounts Payable------------1000
Purch. ret & allow-------1000 Merchandise Inventory-----1000
Sept. 6 Goods costing $6000 were sold for $10,000 terms 2/10,n/30
Sep.6 Accounts receivable-----10,000 Sep.6 Accounts receivable-------10,000
Sales------------------10,000 Sales------------------10,000
COGS 6,000
Merchandise inventory-----6,000
Sept. 11 Paid for the September 1 purchases
Sep.11 Accounts payable-----9,000 Sep.11 Accounts payable-------9,000
Cash 8,820 Purchase Cash 8,820
Discount (2%*$9000) 180 Merchandise inventory-------180
Sept. 13 Issued a credit memo. for merchandise returned $2,000 with a cost of $1,200.
Sep.13 Sales ret.& allow------2,000 Sep.13 Sales ret.& allow----------2,000

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 Accounts Receivable --- 2,000 Accounts Receivable------2,000
Merchandise inventory----1,200
COGS 1,200

Determining Inventory

 The two most important functions/objectives of accounting for inventories are to determine:
i. the quantities of goods to be included in inventory
ii. the cost of inventories on hand

i) Determining Which Goods to Include In Inventory

Companies take physical inventories to count how many (or measure how much) of each item the
company owns. Inventory is easier to count when sales and deliveries are not occurring, so many
companies take inventory when the business is closed.
But which item should be included in inventory during the physical count? The general rule is that all
goods the company OWNS at the inventory date should be included, regardless of their location.

Some areas which create a question as to proper ownership are:

Goods in transit-

At the time of taking an inventory, all the merchandise owned by the business on the inventory date, and
only such merchandise, should be included in the inventory. The merchandise owned by the business may
not necessarily be in the warehouse. They may be in transit.

The legal title to the merchandise in transit on the inventory date is known by examining purchase and
sales invoices of the last few days of the current accounting period and the first few days of the following
accounting period. This legal title depends on shipping terms (agreements).

There are two main types of shipping terms.

FOB shipping point and FOB destination

1) FOB shipping point- the ownership title passes to the buyer when the goods are shipped (when the
goods are loaded on the means of transportation, i.e. at the sellers point). The purchaser is responsible
for freight charges.
2) FOB destination – the title passes to the buyer when the goods arrive at their destination, i.e. at the
buyers point.

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 So, in general, goods in transit purchased on FOB shipping point terms are included in the inventories of
the buyer and excluded from the inventories of the seller. And goods in transit purchased on FOB
destination terms are included in the inventories of the seller and excluded from the inventories of the
buyer.

There are also problems with goods on consignment at the time of taking inventory.

Consignment sale is a marketing arrangement whereby the consignor (the owner of the goods) ships
merchandise to another party, known as a consignee, who acts a sales agent only. Goods out on
consignment, because they are owned by the consignor until sold, should be excluded from the inventory
of the consignee and included in the inventory of the consignor. If we have goods in on consignment, we
should exclude them from our inventory.

 So the physical units to be included (counted) are:

Number of units in warehouse + Units out on consignment + Goods in transit purchased
(FOB shipping point) + Goods in transit sold FOB destination - Goods in on consignment

ii) Cost Determination

Remember that cost of ending inventory is a critical factor in determining income as it is deducted from the
cost of goods available for sale to determine cost of goods sold, a major income statement item. In earlier
chapters, the dollar amount for inventory was simply given. Not much attention was given to the specific
details about how that cost was determined. In this part, we will see which costs are included in inventory
(inventoriable costs) and how cost of inventory is determined (costing methods).

Inventoriable costs:
What costs should be included in inventory?

After the quantity of goods owned has been determined, the starting point in inventory valuation
process is to ascertain the costs to be included in inventory.
Generally, inventory should include all costs incurred to bring them to a condition and place ready for
sale or converting such goods to a salable condition.
Thus, inventory (inventoriable) cost would include the invoice price, less discounts that are taken, plus
any duties and transportation costs paid by the purchaser.
Technically, inventory costs include warehousing and insurance expenses associated with storing
unsold merchandise. However, the cost of tracking this information often outweighs the benefits of
allocating these costs to each unit of inventory, so many companies expense these costs as incurred.
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 1.4. Inventory cost flow assumptions

Inventory cost is determined by multiplying number of units on hand and unit cost. We face here a major
accounting problem: which unit costs to use.

This arises when identical units of a single inventory item, because of inflation or deflation, are acquired at
different price at different time.

 For example, if a company purchases item X in three different dates, say on January 1, 50 units at 12
birr each, on January 10,40 units at 12 birr each and on January 31, at 12 birr each. What is the cost of
any amount of inventory remaining at hand at the end of the period?
 In the above case, it is simple whether it is from the January1, 10 or 31 purchase the cost of any unit
remaining at hand or sold during the period is 12 birr per unit.
 But when identical items are purchased at different costs, a question arises as to what amounts are
included in the cost of merchandise sold and what amounts remain in inventory.
 There are four methods commonly used in assigning costs to inventory and cost of merchandise sold.
These are:
a) Specific identification
b) First-in first-out (FIFO)
c) Last-in first-out (LIFO)
d) Weighted average

Let us see these costing methods under periodic inventory system based on the following illustration.

Units Unit cost Total cost

Jan. 1 Inventory 6 $10 $60
10 Purchase 10 12 120
30 Purchase 8 15 120
24 $300

Units SP per unit

Jan. 3 Sale 5 $15
20 Sale 4 18
28 Sale 2 22
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Additional information:
1. The physical count shows only one unit in the warehouse
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 2. One unit is placed on a display shelf in the firm's own shop
3. Three units are held by an agent(consignee)
4. Two of the units from the above items belong to the beginning Inventory and three
are from Jan.10 purchase
5. Eight (8) units purchased on Jan. 30 being shipped FOB shipping point are in transit
Required: Determine Ending inventory and COGS under each of the costing methods.

1.5. Inventory costing methods under a perpetual and periodic inventory system
I. Inventory Costing Methods under Periodic Inventory System
a) Specific Identification
- It does not depend on a cost flow assumption.
- Instead it requires that each item of inventory is marked, tagged, or coded so that the actual
(specific) unit cost of each item sold and remaining on hand can be identified at any time
easily. This method tracks the actual physical flow of the goods.
Solution
Ending Inventory Cost (13 units):
2 units @ $10----------------------$20
3 units @ $12 ----------------- 36
8 units @ $15----------------------120
$176
Cost of Goods Sold:
Cost of Goods Available for Sale------------$300
Less: Ending Inventory Cost (above)---------------176
$124
Advantage
 Gives the accurate cost information. The method is consistent with the physical flow of
goods
Disadvantage
 It is costly and requires tedious recordkeeping and is typically only used for small
inventories of uniquely identifiable goods (e.g., automobiles, fine jewelry, works of art, and
so forth).
 Income manipulation is possible as the seller has the flexibility of selectively choosing
specific items of higher/lower-costing inventory depending on particular income goals at
the time of sale.
- The SI method gives the same result for ending inventory and COGS under both a periodic and
perpetual system. The only difference between the systems is that the value of inventory and
the cost of goods sold are determined every time a sale occurs under the perpetual system, and
these amounts are calculated at the end of the accounting period under the periodic system.
- Companies that sell a large number of inexpensive items generally do not track the specific
cost of each unit in inventory. Instead, they use one of the other three methods to allocate
inventoriable costs (FIFO, LIFO, and AC).
b) First-in, First-out (FIFO)

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- This method assumes that goods are sold in the order in which they are purchased. Therefore,
the goods that were bought first (first-in) are the first goods to be sold (first-out), and the goods
that remain on hand (ending inventory) are assumed to be made up of the latest costs.
Solution
Under FIFO, the 13 units on hand on January31 would be costed as
follows: Ending Inventory Cost (13 units):
Most recent purchase(Jan. 30) 8 units @$15 = $120
Next most recent purchase(Jan.10) 5 units @$12 = 60
13 units $180
The cost of goods sold would be calculated as follows:
Cost of Goods Available for Sale------------$300
Less: Ending Inventory Cost(above)-----------------180
$120
Advantages
o Tends to be consistent with the actual flow of costs, since merchandisers attempt to sell
their old stock first.(perishable items and high fashion items are examples).
o FIFO best approximates the current replacement value of ending inventory in the balance sheet
o No manipulation of income is possible because the cost attached to units sold is always the
oldest cost
Disadvantage
o For income determination, earlier costs are matched with current revenue resulting poor
matching in the income statement.
o Does not exclude inventory profit - a major criticism cited by opponents of this method.
Inventory profit arises as a result of holding inventories during periods of rising inventory
costs and are measured by the difference between the historical cost of goods sold and their
current cost at the time the goods are sold.
c) Last-in, First-out (LIFO) (prohibited under IFRS)
- The LIFO method of inventory measurement assumes that the most recently purchased items
are to be the first ones sold and that the remaining inventory will consist of the earliest items
purchased.
- In other words, the order in which the goods are sold is the reverse of the order in which they
are bought. This is the opposite of the FIFO system. Remember that FIFO assumes that costs
flow in the order in which they are incurred.
Solution
Under LIFO, the 13 units on hand on January31 would be costed as follows:
Ending Inventory Cost(13 units):
Beginning inventory (Jan.1) 6 units @$10 = $60
Earliest purchase (Jan.10) 7 units @$12 = 84
13 units $144
The cost of goods sold would be calculated as follows:
Cost of Goods Available for Sale------------$300
Less: Ending Inventory Cost(above)-----------------144
$156
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 Advantages
o It is best at matching the most recent costs against the current revenue, thereby keeping
earnings from being greatly distorted by any fluctuating increases or decreases in prices.
o Tends to excludes inventory/paper profit.
Disadvantage
o Does not approximate the physical flow of goods except in special situations such as for
items to be sold out of a stockpile. eg packages of nails or screws
o The oldest purchase costs are assigned to inventory, which may result in inventory
becoming grossly understated in terms of current replacement costs.
o Income manipulation is possible. This may cause poor buying habits
d) Weighted-average Method
- Some merchandise is nearly identical (homogenous) and is carried in large quantities, like
lumber, nails, nuts and bolts or gasoline. Companies use the average cost method to account
for things like this.
- No assumption is made about the sale of specific units. Rather, all sales are assumed to be of
the ―average‖ unit at the average cost per unit.
- Weighed-average is a periodic inventory costing method where ending inventory and COGS
are priced at a single weighted-average cost of all items available for sale.
Weighted Average unit cost = COGSAFS
Total units available for sale
Solution
Under WA method, the 13 units on hand on January31 would be costed as follows:

Weighted Average unit cost = $300 = $12.50

24 units
Ending Inventory Cost = 13 units @$12.50---------------$162.50

The cost of goods sold would be calculated as follows:

Cost of Goods Available for Sale---------------$300
Less: Ending Inventory Cost(above)---------------162.50
$137.50
Advantages
 Relatively simple to implement
 It can be supported as realistic and as paralleling the physical flow of goods, particularly
where there is an intermingling of identical inventory units(e.g gasoline)
 Income manipulation is possible by buying or failing to buy goods near year end but its
effect is lessened because of the averaging process.
Disadvantage
 Inventory values may lag significantly behind current prices in periods of rapidly rising or
falling prices.

II. Inventory Costing Methods under Perpetual Inventory System

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- All of the preceding examples were based on the periodic inventory system. In other words,
the ending inventory was counted and costs were assigned only at the end of the period.
- With a perpetual system, a running count of goods on hand is maintained at all times and a
continuous record of inventory and COGS is maintained as discussed earlier.
- All the costing methods: SI, FIFO, LIFO, AC can be used under the perpetual system.
- Let us compute ending inventory and COGS using our data.

Solution
FIFO – Perpetual Inventory Ledger account for Item X
Inventory Item X
Purchases COGS Inventory
Date Qty Unit Total Qua. Unit Total Qty Unit Total
Cost Cost Cost Cost Cost Cost
Jan. 1 6 $10 $60
3 5 $10 $50 1 10 10
10 10 $12 $120 1 10 10
10 12 120
20 1 10 10 7 12 84
3 12 36
28 2 12 24 5 12 60
30 8 15 120 5 12 60
8 15 120

COGS = $50 + $10 + $36 + $36 + $24 = $120

Ending Inventory = $60 + $120 = $180
NB. The FIFO method gives the same result whether the periodic or perpetual system is
used. This occurs because each withdrawal of goods is from the oldest stock.
- We can record the purchase and sale information as follows.
Journal Entries: Debit Credit
Jan. 3 Accounts Receivable/Cash ---- 75
Sales ------------------------------ 75
COGS ----------------------- 50
Merchandise Inventory --------- 50
10 Merchandise Inventory ------- 120
A/P or Cash --------------------- 120
20 Accounts Receivable/Cash ---- 72
Sales ------------------------------ 72
COGS ----------------------- 46

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 Merchandise Inventory --------- 46
28 Accounts Receivable/Cash ---- 44
Sales ------------------------------ 44
COGS ----------------------- 24
Merchandise Inventory --------- 24
30 Merchandise Inventory ------- 120
A/P or Cash --------------------- 120
- Realize that this type of data must be captured and maintained for each item of inventory if the
perpetual system is to be utilized; a task that was virtually impossible before cost effective
computer solutions became commonplace. Today, the method is quite common, as it provides
better "real-time" data needed to run a successful business.

Solution
LIFO – Perpetual Inventory Ledger account for Item X
Inventory Item X
Purchases COGS Inventory
Date Qty Unit Total Qua. Unit Total Qty Unit Total
Cost Cost Cost Cost Cost Cost
Jan. 1 6 $10 $60
3 5 $10 $50 1 10 10
10 10 $12 $120 1 10 10
10 12 120
20 1 10 10
4 12 48 6 12 72
28 2 12 24 1 10 10
4 12 48
30 8 15 120 1 10 10
4 12 48
8 15 120

COGS = $50 + $48 + $24 = $122

Ending Inventory = $10 + $48 + $120 = $178
NB. When LIFO is used the periodic and perpetual systems do not have the same value for
inventory and COGS. This is because the "last-in" layers are constantly being peeled
away, rather than waiting until the end of the period.
- The journal entries are not repeated here for the LIFO approach. Do note, however, that the
accounts would be the same (as with FIFO); only the amounts would change.
Average Method
- The average cost method in a perpetual inventory system is called the moving average method.
Under this method a new average unit cost for each type of commodity is computed each time
a purchase is made rather than at the end of the period. This unit cost is used to determine the
cost of each sale until another purchase is made and a new average is computed.
- Goods sold and remaining still on hand (in inventory) are costed at the most recent moving
average cost.
- Since the average cost method is rarely used in perpetual inventory system, we do not illustrate

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 it in this chapter. But if we do the computation you will have the following results:
COGS = $50 + $47.27 + $23.64 = $120.91
Ending Inventory = $179.09
- Note that the Average cost method gives different results under the periodic and the perpetual
system. This is because the perpetual system uses a continuously changing (moving) average
cost to determine inventory and COGS while the periodic system uses only a single average
cost at the end of the period.
Comparison of Inventory Methods
- Although the cost of goods available for sale is the same under each cost flow method, each
method allocates costs to ending inventory and cost of goods sold differently. Compare the
values found for ending inventory and cost of goods sold under the various assumed cost flow
methods in the previous examples and their effect on income.
Periodic Perpetual
Income Statement Income Statement
FIFO LIFO AC FIFO LIFO AC
Sales $191 $191 $191 Sales $191 $191 $191
Cost of goods sold 120 156 137.5 Cost of goods sold 120 122 120.91
Gross profit $71 $35 $53.50 Gross profit $71 $69 $70.09

Balance Sheet Balance Sheet

Ending inventory $180 $144 $162.50 Ending inventory $180 $178 $179.09

- As shown above, 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 the ending inventory. On the other hand, the LIFO method yielded the highest amount for
the cost of merchandise sold, the lowest amount for gross profit (and net income), and the
lowest amount for ending in inventory. The average cost method yielded results that were
between those of FIFO and LIFO.
Inventory Costing Methods and Price Changes
Costing Method
FIFO LIFO Weighted Average
Economic Condition
− Higher inventory, − Lower inventory,
Inflation GP, NI, Tax GP, NI, Tax − The average
− Lower COGS − Higher COGS between the two
− Lower inventory, − Higher inventory,
Deflation GP, NI, Tax GP, NI, Tax − The average
− Higher COGS − Lower COGS between the two

- Note that in a period of inflation, LIFO will yield the highest amount of COGS resulting in
lower reported profits and a tax advantage (lower income taxes) than the other methods. With

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 reduced taxes, cash flow is improved.
- As you might have already noticed, the average cost method takes a ―middle-of-the
road approach. This method also averages price fluctuation (up or down), in determining both
gross profit and inventory cost, and the results will be the same regardless of whether price
trends are rising or falling.
1.6. Valuation of Inventories at Other Than Cost
- Cost is the primary basis for the valuation of inventories like all assets. This is prescribed by
the cost principle the objective of which is to provide objectively verifiable information that is
free from bias. In spite of these efforts accountants do employ a degree of conservatism.
Conservatism dictates that assets and income be understated, when in doubt (there is a decline
in utility) justifying departure from cost principle.
- Two such circumstances arise with regard to inventory when:
1) the cost of replacing items in inventory is below the recorded cost—LCM method and
2) the inventory is not salable at normal sales prices—NRV method. This latter case may
be due to imperfections, shop wear, style changes, or other causes.
1. Valuation at Lower of Cost or Market
- If inventory declines in value (loses its utility) below its original cost for whatever reason the
inventories should be written down to reflect this loss.
- The utility of the goods in question is generally considered to be their market value, thus the
term lower of cost or market.
- But what is market? Market value of an inventory is its replacement cost (not sales price!). RC
is the amount that it would cost for the company to acquire or reproduce the inventory (by
purchase or by reproduction based on current material prices, labor rate and current OH costs).
- How can RC show utility? Declines in RC usually indicate declines in sales values, though
such declines in sales values do not necessarily occur with the same immediacy or
proportionality. In general for a loss to be recognized under the LCM method, both a decline in
RC and in the final sales value must have occurred. In businesses where technology changes
rapidly (e.g.., microcomputers and televisions), market declines are common.
- When LCM is used inventories are valued either at cost or at market value; whichever is less.
- Applying the lower-of-cost-or-market method involves the following
steps: Step 1: Determine Cost(SI, FIFO etc)
Step 2: Determine Market -- which is replacement cost*
Step 3: Compare the ―market value‖ and the ―historical cost‖ and report inventory at
the lower of its cost or market.
- * RC may not always be market (covered in advanced courses).
Example:
Suppose a retail computer store purchases ten computers for $3,000 each. After the store sells
eight of them each for $3,900, the manufacturer decreases the computer's price, enabling the
store-as well as the store's competitors-to purchase the same type of computer for $2,500.
Now the retailer has two unsold computers the selling price of which has been reduced to
$3,250 each.
Required: At what amount should the two remaining computers be reported (valued)?

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 Solution
Step 1: Cost = $6,000
Step 2: RC = $5,000
Step 3: Inventory at LCM = $5,000
This $1,000 write-down is recorded by debiting the loss on inventory write-down account
and by crediting inventory. The loss may be reported as a separate item on the income
statement or included in the COGS the effect of both of which is to reduce net income.
- If market value is less than historical cost, the use of LCM provides two advantages:
1. The gross profit and net income are reduced for the period in which the decline
occurred, not in the period in which it is sold. So LCM is also supported by the
matching principle, and
2. An approximately normal gross profit is realized during the period in which the item
is sold.
- If a company has different types of inventories (e.g. computers, printers etc), how do we
determine total inventory value under the LCM method? We have three alternatives. LCM can
be applied: Item -by–item; To Major categories of inventories; or To Inventory as a whole
Example:
Based on data about four items included in the inventories of ABC Co., calculate the value of
the inventory assuming LCM is applied on an
i) item-by-item basis
ii) major categories(assume A & B are in one category and B & C in a second
category)
iii) Inventory as a whole

LCM Rule applied to

Commodity Qty Unit Cost Unit RC Cost Market Items Group As a whole
A 400 $10.25 $9.50 $4,100 $3,800 $3,800
B 120 22.55 24.1 2,700 2,892 2,700
Total 6,800 6,692 6,692
C 600 8 7.75 4,800 4,650 4,650
D 280 14 14.75 3,920 4,130 3,920
Total 8,720 8,780 8,720
Total Inv. $15,520 $15,472 $15,070 15,412 $15,472

- The item-by-item basis produces the most conservative (lowest) inventory value because units
whose market value exceeds cost are not allowed to offset items whose market value is less
than cost. Valuation of inventory as a whole produces the highest inventory amount. It results
in low COGS and high profit resulting in higher tax
- Note that regardless of which of the three methods is adopted, each inventory item should be
priced at cost and at market as a first step in the valuation process
2. Valuation at Net Realizable Value
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- What if merchandise is out of date (obsolete), spoiled, or damaged and can be sold only at
prices below cost? Do we report it at cost? No!
- The inventory should not be reported above its maximum utility (NRV). Such inventories
should be written down to their NRV value as there is a decline in utility (profit generating
capacity). This is also application of the conservatism principle.
- Net realizable value is the estimated selling price less any direct cost of disposal, such as sales
commission, advertising, repairs etc.
- The valuation rule is cost or NRV whichever is lower.
Example:
Assume that damaged merchandise that had a cost of $1,500 can be sold for only $1200. Direct
costs of disposal are estimated as $150 for maintenance and $200 for sales commission.
Required: At what amount should the items be included in the inventory?

Solution:
NRV = $1200 - ($150 + $200) = $850

The inventory should be reported at its NRV ($850) because it is lower than cost ($1500).
The expected loss of $650 is recognized by recorded as follows:
Loss due to obsolescence----------650
Merchandise inv. --------------------- 650
To write down inventory to NRV
1.7. Estimating Inventory Costs
- The basic purpose in taking a physical inventory is to verify the accuracy of the perpetual
inventory records or, if no records exist, to arrive at an inventory amount. Some times, taking a
physical inventory is impractical or very costly or an independent check on the validity of
inventory figures is sought. Then, estimation methods are employed.
- Reasons of estimation:
o To prepare interim financial statements when the periodic system is used without having
physical count. In a perpetual system there is no need to estimate inventory because we
have current information about inventory. In periodic system inventory is determined
only through physical count which is very costly to undertake for more often than
annually making estimation invaluable.
o To verify the reasonableness of the EIC reported in the body of the financial statements
as a result of the physical count- any significant discrepancy should be investigated.
o To know the amount inventory that has been lost, stolen, or destroyed. These are
conditions in which taking physical inventory is impossible. Even if perpetual inventory
records have been kept, if the documents which could be referred to have been destroyed
together with the inventory, estimation techniques are the only option to determine
inventory destroyed/lost.
- Two estimation techniques are commonly used: (1) the retail method or (2) the gross profit
method.
1. Retail Method
- This method is often used by retail stores, particularly department stores that sell a wide variety

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 of items. In such situation, perpetual inventory procedures may be impractical, and it is unusual
to take a complete physical inventory count for more often than annually.
- To use this method, dual records for goods available for sale should be maintained by the
company:
□ One record at cost, and
⭬ record separate from the
accounting records kept for the purpose of estimating inventory.
- At time of sale the store records only the amount of the sale not the costs of the items sold. So
the company cannot compute directly the cost of ending inventory. However, the company can
estimate the cost of ending inventory by using the ratio of cost to retail price assuming
existence of an observable pattern between the two.
- It is appropriate when items sold within a department have essentially the same markup rate,
and articles purchased for resale are priced immediately.
- Three steps involved in the retail method are:
1. Determine the retail value of EI
BI at RP
+ Purchases at RP
= RP of goods available for sale
- Net sales at RP
EI at RP
The term at retail means the amount of inventory at the marked selling prices
2. Compute the cost-to-retail ratio
Cost ratio (%ge) = Cost of goods available for sale × 100%
RP of goods available for sale
= [BI + NP] at cost × 100%
[BI + NP]at RP
3. Estimate EIC ( 1 × 2)
EIC = C%ge × EI at RP
i.e., EI at RP is converted into a cost value by applying the computed cost ratio

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 Example:
Data for the month of January is given below:
BI at cost, $18,000
BI at retail, 27,000
Purchases: at cost, $122,000
at retail, 173,000
Sales revenue $165,000

Required: Estimate EIC using the retail method

Solution
At Cost At Retail
Goods available for sale:
BI ---------------------------- $18,000 $27,000
+ Purchases --------------------- 122,000 173,000
Total goods available for sale ------ $140,000 $200,000

Cost ratio = $140,000 = 70%

$200,000
Deduct January sales at retail------------------------------------165,000
EI at retail $35,000
Estimated EI at cost ($7500×0.7) =
$24,500

How much is COGS?

COGS = COGAFS - EIC = $140,000 - $24,500 = $115,500

OR Net Sale x Cost ratio = $165,000 x 70% = $115,500

- The above is an estimate of the amount of goods that should be on hand and does not reveal
any shortage due to breakage, loss, or theft. However, we can estimate the amount of such
shortage by comparing the amount of inventory that should be available on hand at retail with
the actual result of the physical count. For example, if actual count of goods showed EI at retail
of $30,000, the company must have had an inventory shortage at retail of $5,000 ($35,000 –
$30,000). Stated in terms of cost, the shortage is $5,000 × 70% = $3,500.
- The retail method has also the advantage of expediting the physical inventory count at the end
of the year. The physical inventory taking crew need only record the retail prices of each item
and convert the total value to cost using the retail method without the need for reference to
specific purchase invoices, thereby saving time and expenses
2. Gross Profit Method
- This method is used in place of the retail method when records of the retail prices of beginning
inventory and purchases are not kept
- It is an inventory estimation technique, based on a relationship between Sales, COGS and
Gross Profit that is assumed to be fairly stable from year to year.
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- Four steps are involved in the GP method:
1. Determine the GP %ge― based on past experience adjusted as appropriate to reflect
current conditions. GP can be expressed as a %ge of sale or cost. But it is common to
quote it based on sales.
2. Compute the estimated COGS during the current year:
o If GP is expressed as a %ge of sales:
Estimated COGS = current year's sale to date × (1 - GP %ge)
o If GP is expressed as a %ge of cost, it is necessary to restate it as a %ge of
sales before using the GP method. We can convert a markup percentage from
one based upon cost to one based on sales price, or vise-versa.
GP %ge on the basis selling price = GP %ge on the basis of cost
(100% + GP %ge on the basis of cost)

GP %ge on the basis of cost = GP %ge on the basis of selling price

(100% – GP %ge on the basis of cost)

3. Compute the COGAFS in the current

year: COGAFS = BI + Purchases to
date
4. Compute the estimated cost of EI:
Estimated EI = COGAFS - Estimated COGS
- Note that very often different products have different markups, in these situations, a blanket
ratio should not be applied across the board. The accuracy of the estimate can be improved by
grouping inventory into pools of products that have similar gross profit relationships rather
than using one gross profit ratio for the entire inventory.

Example:
Given BIC ------------------------ $9,000
NP 30,000
Freight-in ----------------- 2,000
Net sales ------------------ 48,000
GP%ge on sales ---------- 25%

Required: Compute EIC using GP method

Solution:
BIC $9,000
NP 30,000

Freight-in ---------------------- 2,000

COGAFS $41,000
Less: Estimated COGS
(75%× $48,000) -------------- 36,000
Estimated EIC-----------------------$5,000

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 Exercise
On December 31, a fire at ABC Co's store caused serious damage to its inventories. Only
$84,000 worth of inventories was saved. Given the following information
compute thetotal cost of inventories destroyed by fire. And ending inventory cost
to be reported.

Given
BIC $20,000
Goods purchased during the period and received as of the date of fire 950,000
Goods purchased FOB ship. point but in transit to date of fire 35,500
Net sales for the period 700,000
GP on the basis of cost 25%
Solution
BIC $20,000
Goods purchased and received 950,000
COGAFS $970,000
Less: Estimated COGS (80%× $700,000) 560,000
Estimated inventory that should be available before fire 410,000
Less: Inventories saved 84,000
Inventory destroyed $326,000

EIC = $84,000 + 35,500 = $119,500

1.8. Presentation of merchandise inventory in the financial statements

Balance Sheet Presentation - Merchandise inventory is usually presented on the balance sheet
immediately following receivables. Both the method of determining inventory cost (SI, FIFO,
LIFO, or AC) and the method of valuing inventory (cost or LCM) should be shown either in
parenthesis or footnote.

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