CHAPTER ONE

ACCOUNTING FOR INVENTORIES

Definition:
The term Inventories is used to designate:
Any type of good that is held for sale in normal course of business which is termed as
Merchandise Inventory.
Materials in process of production or held for such use, Manufacturing Inventory.
In Merchandising Business inventory consists goods bought for resale.
In Manufacturing Business inventory consists three classes of inventories. Those are;
 Raw Material Inventory,
 Work In Process(WIP) Inventory, and
 Finished Goods Inventory.
Inventory is classified as a current asset since it usually converted in to cash within a year or
operating cycle of the business whichever is longer.
4.1 Importance of Inventories
- It is the largest current asset in amount. The sale of inventory is the principal source of
revenue of firms.
- It is the most active element in the operation of merchandising firms as many of the
transactions in merchandising firms are related to purchase and sale of inventories.
- It appears on financial statements of the business; on balance sheet as major current asset
and on income statement the Cost of Merchandise Sold (CMS) is the largest item deducted
from sales in determining the net income of the period.
- The accuracy of financial statement is affected by the amount reported as inventory.
Effect of Inventory Errors on Financial Statements
Any error in inventory count will affect both the balance sheet and the income statement.
 If CMS = BI + Net Purchase – EI, then CMS = CMAS – EI or CMS + EI = CMAS. This
implies that at the end of the period the CMAS is divided in to EI and CMS. Therefore, an
error in determining EI will cause misstatement on CMS. This in turn will affect Gross
Profit (GP) and Net Income (NI) on the income statement of the period; and asset and
capital reported on the balance sheet at the end of the period.
 EI of the current period becomes BI of the next period. Thus, if EI is incorrectly stated at
the end of the current period, the CMS, GP & NI of the current period will be misstated and
so will the CMS, GP & NI for the next period. The amount of the two misstatements will
be equal and in opposite directions. Therefore, the effect on CMS, GP & NI of an
incorrectly stated inventory, if not corrected, is limited to the period of the error (current
period) and the next period. At the end of the next period, assuming no additional errors,
both assets and owners equity (capital) will be correctly stated.
The Relationship of Inventory with Net Income:
1. If EI is Understated, CMS is Overstated, Net Income is Understated
2. If EI is Overstated, CMS is Understated, Net Income is Overstated
3. If BI is Understated, CMS is Understated, Net Income is Overstated
4. If BI is Overstated, CMS is Overstated, Net Income is Understated

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Please Note: BI is part of CMS where as EI is not part of CMS; Remember the Formula (CMS =
BI + Net Purchase – EI)
Illustrative Example:
Suppose Beginning inventory, January 1, 2004: Birr 10,000, Net purchase for the year 2004: Birr
130,000; Then, CMAS = 10,000 + 130,000 = 140,000
Assumption 1: EI as of December 31, 2004 is Birr 20,000; Correctly Stated
Assumption 2: EI as of December 31, 2004 is Birr 12,000; Understated by Birr 8,000
Assumption 3: EI as of December 31, 2004 is Birr 27,000; Overstated by Birr 7,000

Assumption 1 Assumption 2 Assumption 3

EI as of Dec. 31,2004 EI as of Dec. 31,2004 EI as of Dec.31,2004
Correctly stated Understated by Birr Overstated by Birr
8,000 7,000
CMAS………… Birr 140,000 Birr 140,000 Birr 140,000
Less: EI……….. (20,000) (12,000) (27,000)
CMS…………... Birr 120,000 Birr 128,000* Birr 113,000*

Effect of Inventory Error on Current and Next periods Financial Statements

1. If EI of the current period (2004) is understated by Birr 8,000 and no additional error in the
next period (2005).
On Current Period’s Income On Next Period’s Income Net effect of the error
Statement Statement over a two years
- CMS will be overstated by Birr - CMS will be understated period
8,000 by Birr 8,000 - Overstatement of
CMS is offset by
- GP & NI will be understated by - GP & NI will be overstated the
Birr 8,000 by Birr 8,000 Understatement.
- Understatement of
GP & NI is offset
by the
Overstatement.
On Current Period’s Balance On Next Period’s Balance
Sheet Sheet
- Asset & Capital will be - Asset & Capital will be
understated by Birr 8,000 due to stated correctly since the
the understatement of EI and NI. error offsets each other.

2. If EI of the current period (2004) is overstated by Birr 7,000 and no additional error in the
next period (2005).
On Current Period’s Income On Next Period’s Income Net effect of the error
Statement Statement over a two years
- CMS will be understated by Birr - CMS will be overstated by period
7,000 Birr 7,000 - Understatement of

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 CMS is offset by
- GP & NI will be overstated by - GP & NI will be the Overstatement.
Birr 7,000 understated by Birr 7,000 - Overstatement of
GP & NI is offset
by the
Understatement.
On Current Period’s Balance On Next Period’s Balance
Sheet Sheet
- Asset & Capital will be - Asset & Capital will be
overstated by Birr 7,000 due to stated correctly since the
the overstatement of EI and NI. error offsets each other.

Example: As a result of an error in the physical count of Merchandise on December 31, 1999, XYZ
Company overstated the merchandise on hand (EI) by Birr 25,000. Assume no additional error was
committed in the year 2000. Illustrate the effect of the error on the financial statements prepared by
XYZ Company during the year 1999 & 2000.
Solution:

Financial statement items 1999 2000

CMS Understated by Birr 25,000 Overstated by Birr 25,000
GP & NI Overstated by Birr 25,000 Understated by Birr 25,000
Total Assets as of December 31 Overstated by Birr 25,000 Not affected
Capital as of December 31 Overstated by Birr 25,000 Not affected

4.2 Inventory Systems

There are two principal systems of inventory accounting, Periodic and Perpetual.
Periodic Inventory System
- Under this system, increases in merchandise inventory (purchase of merchandise) are
accumulated in an account titled “Purchase”.
Dr. Purchase………………xxx
Cr. A/P/Cash………………xxx
- Decrease in merchandise inventory is not recorded after each sale; thus there is no
determination of the CMS and the EI after each sale. The only entry recorded at time of
sale is:
Dr. A/R/Cash…………..xxx
Cr. Sales……………………..xxx
- Periodically, usually at the end of the accounting period, for the purpose of preparing
balance sheet and income statement, the merchandise inventory on hand is determined
by physical count. Then, the CMS is determined by deducting the EI from CMAS. i.e.
CMS = CMAS* - EI
*CMAS = BI + Net Purchase
- This system is often used by firms having variety of merchandise with low unit price.
Examples: Retail Stores, Drug Stores, Groceries etc.
Perpetual Inventory System

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 - Under this system, increases in merchandise inventory (purchase of merchandise) are
accumulated in a control account titled “Merchandise Inventory” and subsidiary
ledgers are maintained for each item.
Dr. Merchandise Inventory………………xxx
Cr. A/P/Cash………………xxx
- The Cost of Merchandise Sold is recorded after each sale and the inventory account is
updated for the decrease in inventory balance as a result of the sales. Two entries are
recorded at time of sale:
Dr. A/R/Cash…………………………….xxx
Cr. Sales…………………………………………..xxx
Dr. Cost of Merchandise Sold…………...xxx
Cr. Merchandise Inventory……………………xxx
Thus, accounting records perpetually (continuously) show the EI & the CMS.
- Under this method, physical inventory is conducted for controlling purpose; just to
compare book inventory (Merchandise inventory balance per record) with the actual
count.
- This system is frequently used by companies that sell items of high unit price like office
equipments, automobiles etc.
4.3 Determining Actual Quantities in the Inventory
The physical count of inventory is needed under both inventory systems. Under periodic
inventory system, it is needed to determine the cost of merchandise inventory on hand (EI) and the
cost of merchandise sold (CMS). The inventory account under a perpetual inventory system is always
up to date. Yet events can occur where the inventory account balance is different from inventory on
hand. Such events include theft, loss, damage, and errors. The physical count (sometimes called
“taking an inventory” is used to adjust the inventory account balance to the actual inventory on
hand.
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. However, regardless of the location, all items that
belong to the business must be included in the inventory.
Generally, the quantity of ending inventory includes:
1. Physical Inventory: items available and counted in the warehouse/store (inventory on hand
that are owned by the company on inventory date)
2. Goods in Transit: goods purchased but not yet received by the company. Here, 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/next accounting period. The legal title to the merchandise in transit on the
inventory date depends on shipping terms (agreements). If the agreement is FOB shipping
point, the ownership passes to the buyer when the goods are shipped (when the goods are
loaded on the means of transportation, i.e. at the seller’s point). Hence, 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. But if the agreement is FOB destination, the
title passes to the buyer when the goods arrive at their destination, i.e. at the buyer’s point.
Therefore, goods in transit purchased on FOB destination terms are included in the
inventories of the seller and excluded from the inventories of the buyer.

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 3. Goods on Consignment: it is a case where merchandises are sold through agent. The owner
of the merchandise is the consignor; the agent is consignee. Therefore, unsold merchandises
in the hands of the consignee (consignment out) should be included in Ending Inventory
(EI) of the consigner (the owner of the merchandise).
4.4 Inventory Costing Methods Under a Periodic System
The prices of many kinds of merchandises are subject to frequent change. At various date during
a period, an identical item can be acquired at deferent price. The question is which unit price is used
to determine the cost of merchandise inventory on hand (EI) and the cost of merchandise sold
(CMS); the earliest, the latest or average? What should be the cost of EI and the CMS that will
appear on yearend balance sheet and income statement respectively? To determine these figures
there are three most widely accepted inventory costing methods. Those are:
1. First in First out(FIFO) Method
2. Last in First out(LIFO) Method
3. The Average Cost Method
1. First in First out (FIFO) Method
- It is based on the assumption that items acquired first are to be sold first; or each sale is
made out of the oldest goods in stock and ending inventory consists the most recently
acquired goods.
- The cost of merchandise sold is computed by the oldest unit costs, this implies the cost
flow is in the order expenditures were made. Ending inventory cost is computed by
recent unit costs.
2. Last in First out (LIFO) Method
- It is based on the assumption that items acquired last are to be sold first; or each sale is
made out of the recent goods in stock and ending inventory consists the oldest goods.
- The cost of merchandise sold is computed by recent unit costs, this implies the cost flow
is in the reverse order of the expenditures on goods. Ending inventory cost is computed
by earlier/oldest unit costs.
3. The Average Cost Method
- It is sometimes called, the weighted average method.
- It is based on the assumption that the cost flow is an average of expenditure on goods.
- Both the cost of merchandise sold and ending inventory are computed by using the
weighted average unit cost. There are steps to apply this method:
Step 1: Compute the Weighted Average Unit Cost (WAUC) as follows:
WAUC = Total cost of merchandise available for sale (CMAS)
Total units available for sale
Step 2: Applying the weighted average unit cost on both units on hand and units sold.

Illustration:
The following data referring to the beginning inventory and purchase of “Item A” is taken from
the records of ABC Company that uses Periodic inventory system

January 1 Inventory (BI)………………………………. 200 units @ 9/unit = Birr 1,800

March 10 Purchase- 1st Purchase…………………….. 300 units @ 10/unit = 3,000
September 21 Purchase- 2nd Purchase ……………… 400 units @ 11/unit = 4,400
November 18 Purchase- 3rd Purchase……………….. 100 units @ 12/unit = 1,200
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 Units available for sale = 1000 units CMAS= 10,400

Assume units on hand at the end of the year were 300 units.
Required: - Determine the cost of Ending Inventory (EI) and the Cost of Merchandise Sold
(CMS), under the following inventory costing methods
1. First in First out (FIFO) Method
2. Last in First out (LIFO) Method
3. The Average Cost Method

Solutions:
Units sold = 700 units (1000 units available for sale – 300 units on hand)

1. Under the Periodic FIFO Method, the EI and CMS are computed as follows:
Cost of Ending Inventory, 300 units Cost of 700 units sold (CMS)
From 3rd Purchase :100 *12 = Birr 1200 Sold-From Beg. Inventory: 200 * 9 = Birr 1800
From 2ndPurchase :200 *11 = 2200 Sold-From 1st Purchase : 300 *10 = 3000
nd
Total Cost of EI, 300 units = Birr 3,400 Sold-From 2 Purchase : 200 *11 = 2200
Total Cost of 700 units sold(CMS)=Birr 7,000
Or, CMS = CMAS – EI; 10,400 – 3,400 = Birr 7,000
2. Under the Periodic LIFO Method, the EI and CMS are computed as follows:
Cost of Ending Inventory of 300 units Cost of 700 units sold(CMS)
Beg. Inventory: 200 * 9 = Birr 1800 Sold- From 3rd Purchase : 100 *12 = Birr 1200
st
From 1 Purchase : 100 *10 = 1000 Sold- From 2nd Purchase :400 *11 = 4400
st
Total Cost of EI, 300 units = Birr 2,800 Sold- From 1 Purchase : 200 *10 = 2000
Total Cost of 700 units sold(CMS)=Birr 7,600
Or, CMS = CMAS – EI; 10,400 – 2,800 = Birr 7,600
3. Under the average cost method, the EI and CMS are computed as follows:
Step 1: Computing the Weighted Average Unit Cost (WAUC)
WAUC = Total cost of merchandise available for sale (CMAS)
Total units available for sale
WAUC = Birr 10,400
1,000 units
WAUC = 10.40 per unit

Step 2: Applying the WAUC on both units on hand and units sold.
Cost of Ending Inventory of 300 units Cost of 700 units sold
Total Cost of EI = 300 * 10.40 = Birr 3,120 Total CMS = 700 * 10.40 = Birr 7,280
Or, CMS = CMAS – EI; 10,400 – 3,120 = Birr 7,280
Comparison of Inventory Costing Methods
Refer to the data that pertains to ABC Company to its “Item A” in the above illustration, each of
the three assumptions to cost flow provides deferent ending inventory and CMS figures. The
method that provides highest ending inventory provides lowest CMS and vice versa.

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 FIFO Method Average Cost Method LIFO Method
CMAS………….. Birr 10,400 Birr 10,400 Birr 10,400
EI……………….. 3,400 3,120 2,800
CMS……………. 7,000 7,280 7,600

Weighted Average Method:

 Under this method, the effect of price trend is averaged. However, the time required to
collect and organize purchase data of each item is more than other methods.
4.5 Inventory Costing Methods Under a Perpetual System
Under Perpetual Inventory System, We will apply the inventory costing methods each time sale of
merchandise is made. We will calculate the Cost of Merchandise Inventory on hand (EI) and the Cost
of Merchandise Sold (CMS) at the time of each sale. This means the merchandise inventory account
is continually updated to reflect purchase and sales. Perpetual records may be maintained based on
the First in, First out (FIFO), the Last in, First out (LIFO), and Moving Average Methods.

Illustration:
The Beginning Inventory, Purchases and Sales of ABC Company for its “Item B” during the month
of January were as follows:
Units Cost
Jan. 1 Inventory 15 Birr 10
6 Sale 5
10 Purchase 10 12
20 Sale 8
25 Purchase 8 12.5
27 Sale 10
30 Purchase 15 14

Required: - Determine the Cost of Ending Inventory (EI) as of January 31 and the Cost of
Merchandise Sold (CMS) for the month, under the following inventory costing methods:

1. Perpetual FIFO Method

2. Perpetual LIFO Method
3. Perpetual Moving Average Method
Solutions:
1. Perpetual FIFO Method

Purchases Cost of Merchandise Sold Inventory

Date Qty. U.Cost T. Cost Qty. U.Cost T. Cost Qty. U.Cost T. Cost
Jan. 1 15 10 Birr 150
6 5 10 50 10 10 100
10 10 100
10 10 12 120 10 12 120
2 10 20
20 8 10 80 10 12 120
2 10 20

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 10 12 120
25 8 12.5 100 8 12.5 100
2 10 20 2 12 24
27 8 12 96 8 12.5 100
2 12 24
8 12.5 100
30 15 14 210 15 14 210
Total 33 Birr 430 23 Birr 246 25 Birr 334

So, the Cost of EI and CMS under Perpetual FIFO Method are Birr 334 & Birr 246 respectively

2. Perpetual LIFO Method

Purchases Cost of Merchandise Sold Inventory

Date Qty. U.Cost T. Cost Qty. U.Cost T. Cost Qty. U.Cost T. Cost
Jan. 1 15 10 Birr 150
6 5 10 50 10 10 100
10 10 100
10 10 12 120 10 12 120
10 10 100
20 8 12 96 2 12 24
10 10 100
2 12 24
25 8 12.5 100 8 12.5 100
8 12.5 100
27 2 12 24 10 10 100
10 10 100
30 15 14 210 15 14 210
Total 33 Birr 23 Birr 270 25 Birr
430 310

So, the Cost of EI and CMS under Perpetual LIFO Method are Birr 310 & Birr 270 respectively.

3. Perpetual Moving Average Method

Purchases Cost of Merchandise Inventory

Date Sold
Qty U.Cos T. Qty U.Cos T. Cost Qty U.Cost T. Cost
. t Cost . t .
Jan. 1 15 10 Birr
150
6 5 10 50 10 10 100
10 10 12 120 20 *220/20= 11 220

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 20 8 11 88 12 11 132

25 8 12.5 100 20 *232/20=11. 232

6

27 10 11.6 116 10 11.6 116

30 15 14 210 25 *326/25=13. 326

04
Total 33 Birr 23 Birr 25 Birr
430 254 326

So, the Cost of EI and CMS under Perpetual Moving Average Method are Birr 326 & Birr 254
respectively.
Assume the periodic inventory system is used: the Cost of Ending Inventory (EI) and CMS of
“Item B” for January using FIFO, LIFO, and Average cost methods are as follows:
Remember 25 units on hand as of January 31.
Solutions:
First arrange the data as follows.
Jan. 1 Inventory……………..15 units @ 10 ………. Birr 150
10 Purchase……………...10 units @ 12 ………… 120
25 Purchase…………….. 8 units @ 12.5 ……….. 100
30 Purchase……………...15 units @ 14………… 210
Units Available for sale = 48 units CMAS = Birr 580
1. EI & CMS under Periodic FIFO

Value of EI, 25 units CMS =CMAS –EI

15 units *14 = Birr 210 CMS = Birr 580 -334
8 units *12.5 = 100 CMS = Birr 246
2 units *12 = 24
Cost of EI=Birr 334

2. EI & CMS under Periodic LIFO

Value of EI, 25 units CMS =CMAS -EI

15 units *10 = Birr 150 CMS = Birr 580 -270
10 units *12 = 120 CMS = Birr 310
Cost of EI=Birr 270

3. EI & CMS under Periodic Weighted Average

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Value of EI, 25 units CMS =CMAS -EI
WA unit cost = Birr 580/48units CMS = Birr 580 -302
= Birr 12.08 per unit CMS = Birr 278
EI Cost= 25 units * 12.08 = Birr 302

Periodic FIFO Perpetual FIFO

EI Birr 334 Birr 334
CMS 246 246
Periodic LIFO Perpetual LIFO
EI Birr 270 Birr 310
CMS 310 270
Periodic Weighted Average Perpetual Moving Average
EI Birr 302 Birr 326
CMS 278 254

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