Chapter 5 & 6

Inventory Accounting andValuation

Types of Business & Its inventory
Services Merchandising Manufacturing
Service business provides Purchased finished Organization which
services to organization. goods and sell to next purchase raw material
chain or consumers. from suppliers and
convert the raw material
For example Insurance into any finished products
companies, Examples: through the use of labor
advertisement agencies, and production units.
hospitals etc. Distributor, Wholesaler,
Retailer.
Example: Toyota, Engro
Food, P&G etc.
There is no inventory in
Service sectors. Inventory includes
However, unfinished Finished Goods only. Inventory includes – Raw
projects may be termed Material, Work in process,
as Work in process. Finished goods
Inventory and Cost of Goods Sold
• Inventory and Cost of Goods Sold are closely interlinked with each
other. Business record expense in income statement only to those
inventories which are sold during the period.

• Remaining inventory is kept as asset in the balance sheet.

Equation to determine Cost of Goods Sold

Opening inventory + Inventory procured = Goods available for sales

Goods available for sales – Closing inventory = Cost of goods sold
Inventory – Learning Objectives

System of
Valuation
Recording
System of Recording
Periodic
Under periodic system of
recording, no entries are made
relating to cost of goods sold at
the time of booking sales.
At the period end, exercise of
inventory count has been
conducted and then find out the
amount of cost of goods sold.
Perpetual
Under perpetual system of
recording, inventory is updated
at the time of any receipt and
issuance. Entries of both sales
and cost of goods sold are
booked simultaneously.
Important terminology and concepts

Freight Cost
Purchase Return &
Purchase Price FOB Shipping point &
Allowances
Destination

Discounts
Trade and Purchase
Freight Cost - explanation
• Agreement between buyer and sell must mention the responsibility of
transportation charges.

• In case buyer is going to bear charges (Freight Inward), then it will be

cost of inventory. In case seller is going to bear the cost, then seller
needs to book it as delivery charges (Freight Outward).

• Freight terms are expressed as either FOB shipping point or FOB

destination. The letters FOB mean free on board. Thus, FOB shipping
point means that the seller places the goods free on board the carrier,
and the buyer pays the freight costs. Conversely, FOB destination means
that the seller places the goods free on board to the buyer’s place of
business, and the seller pays the freight.
Purchase Return and Allowance
• If buyer is dissatisfied with the products procured due to defects or
quality issue, he will return these goods to seller. This phenomena is
called Purchase return.

• Alternatively, the purchaser may choose to keep the merchandise if

the seller is willing to grant an allowance (deduction) from the
purchase price. This transaction is known as a purchase allowance.

• At the time of purchase, inventory was debited, therefore, when it

will returned same will be credited with the cost of purchase return.
Discounts

Trade Discount Purchase Discounts

At the time of early

At the time of purchase
payment

This discount
TD will reduce
will also reduce
inventory cost
inventory cost.
Credit Terms - Interpretation
• Credit terms specify the amount of the cash discount and
time period in which it is offered. Examples of terms are as
under:

- 2/10, n/30 means Normal credit period is 30 days whereas

2 percent discount if pay within 10 days.

• 1/10 EOM (end of month) - 1% discount is available if the

invoice is paid within the first 10 days of the next month
Entry Flow
• In perpetual system, single account of ‘Inventory’ has
been used in which all purchases, freight, returns and
discounts has been booked.

• In periodic system, separate accounts for purchases,

freight, returns and discounts has been opened. These are
temporary accounts which will be closed in cost of
goods sold at period end.
 Entry Flow
Transaction Perpetual Periodic
nature
Purchase of merchandise Inventory (Debit) ; A/Payable (Credit) Purchases (Debit) ; A/ Payable (Credit)
on credit.
Transactions
Purchase

Freight costs on Inventory (Debit); Cash or A/P Freight in (Debit); Cash or A/P (Credit)
purchases. (Credit)
Purchase returns and A/Payable (Debit); Inventory (Credit) A/Payable (Debit); Purchase Return (Credit)
allowances.
Payment on account A/Payable (Debit); Cash (Credit); A/Payable (Debit); Cash (Credit); Purchase
with a discount. Inventory (Credit) Discount (Credit)
Sale of merchandise on (1) A/R (Debit); Sales (Credit) (1) A/R (Debit); Sales (Credit)
credit. (2) COGS (Debit) ; Inventory (Credit) (2) No entry
Transaction

Return of merchandise (1) Sales Ret. (Debit); A/R (Credit) (1) Sales Ret. (Debit); A/R (Credit)
Sales

sold. (2) Inventory (Debit) ; COGS (Credit) (2) No entry

s

Cash received on Cash (Debit); Sales Discount (Debit) Cash (Debit); Sales Discount (Debit)
account with a discount. Account Receivables (Credit) Account Receivables (Credit)
Cost of goods Sold Statement
Income Statement
Cost of Goods Sold Statement
Important Point to remember !!!
It is important to note however, that it is not always the
case that ending inventory value and cost of goods sold
figure is same under both systems.

The combination of cost flow assumptions, inventory

recording system and measurement basis may change the
values.
Part 2

Inventories
Determining the Inventory Quantity
• Either period or perpetual system of recording, Companies
must determined the physical quantity for two obvious
reasons:

- Checking the accuracy of inventory records

- Record and investigate any wastage or loss of inventory

• Determining inventory quantities requires inventories physical

count as well as determining ownership of goods.
Ownership of Goods in transit
If risk transfer at the time of delivery (FOB
Destination) then no entry for ‘Goods in transit’
Goods purchased If risk transfer at the time of shipment (FOB
but not yet Shipping point) then ‘Goods in transit’ will be
debited and Accrued Liability (Credited)
received
Once goods received then Stock will be debited
and Stock in transit will be credited.

Goods Sold but not Sales will be recorded once risk and ownership has
yet delivered been transferred to customer.
Consigned Goods
• In some lines of business, it is common to hold the goods of other parties and try
to sell the goods for them for a fee, but without taking ownership of the goods.
These are called consigned goods.

• For example, you might have a used car that you would like to sell. If you take the
item to a dealer, the dealer might be willing to put the car on its lot and charge
you a commission if it is sold. Under this agreement, the dealer would not take
ownership of the car, which would still belong to you. Therefore, if an inventory
count were taken, the car would not be included in the dealer’s inventory.
• Many car, boat, and antique dealers sell goods on consignment to keep their
inventory costs down and to avoid the risk of purchasing an item that they won’t
be able to sell. Today even some manufacturers are making consignment
agreements with their suppliers in order to keep their inventory levels low.
Quick Check
Solution
Inventory
Inventory Cost
• Inventory is accounted for at cost. Cost includes all expenditures
necessary to acquire goods and place them in a condition ready for sale.

• In our previous example, we the procurement price of inventory was

same. But in practical it is not possible. Inventory cost will be different
due to difference in procurement timing and source of supply.

• Therefore, there are certain rules for inventory valuation we must

understand for accurate inventory valuation.
Inventory Cost – Framework

Inventory Valuation Method

Concept of Net Realizable Value
Specific Identification Method
and its implication on Inventory
First in First Out (FIFO)
Valuation
Last in First Out (LIFO)
Weighted Average Cost Method
 Inventory Valuation Method
Specific identification requires that companies keep records of the
Specific original cost of each individual inventory item. Historically, specific
Identification identification was possible only when a company sold a limited
Method variety of high-unit-cost items that could be identified clearly
from the time of purchase through the time of sale.
Cost Flow Assumptions

First in First Out Under FIFO method, it is assumed that inventory purchased first will be sold
(FIFO) out first. Therefore, closing inventory will be valued at most recent rates.

Under Weighted Average Method, cost of goods sold and inventory is

Weighted Average determined by using Weighted Average rate by formula as under:
Cost Method
Goods Available for sales / Total Units available for sales
Illustration – Periodic
First in First Out - Periodic
Weighted Average Cost Method - Periodic
Illustration - Perpetual
FIFO – Perpetual
Moving Average Method -
Perpetual
Quick Check - Perpetual
Consistency Rule
• Company must chose the consistency principles for using inventory
valuation assumption. It means that Company should use same
accounting methods from year to year.

• However, Consistency principles preferred but Company change

assumption of inventory cost method. But for this, company
should disclose its effect on income statement and net profit.
 Owner’s Drawing

Periodic
Drawings by the business owner in the Drawing (Debit)
form of inventory should be accounted Purchases (Credit)
for as drawings (withdrawals of capital).

The cost of sales should exclude the Perpetual

items taken by the owner as drawings. Drawing (Debit)
Inventory (Credit)
Inventory valuation
Lower of Cost or Net RealizableValue
Concept
• The valuation of inventory can be extremely important for financial
reporting, because the valuations affect both the cost of sales (and
profit) and also total asset values in the statement of financial
position.

• Inventory must be measured in the financial statements at the

lower of:
- cost, or
- net realisable value (NRV).
Net Realizable Cost
• Net realisable value is the amount that can be obtained from
disposing of the inventory in the normal course of business, less
any further costs that will be incurred in getting it ready for sale or
disposal.
• Net realisable value is usually higher than cost. Inventory is
therefore usually valued at cost.
• However, when inventory loses value, perhaps because it has been
damaged or is now obsolete, net realisable value will be lower than
cost.
Illustration
Quick Check 1
• The closing stock in hand of XYZ Ltd on June 30, 2017 was Rs. 1
million. A sample of 20 percent of stock was examined and finding
are as under:
- 60% of the stock could be sold at a usual selling price which yields 33
percent of gross profit on sales
- 20 percent stock was not in a saleable condition and requires an
expenditure of 25 percent of the selling values to make it saleable at
normal selling price
- 20 percent of the stock was expected to fetch 40 percent of the
normal cost of the stock.
Solution
Quick Check 2
• Mr. Arif’s books are being closed each year on December 31 2017.
The cost of stock physically counted to Rs. 60,000. Included in this
figure is a stock costing Rs. 12,000 which is slightly damaged.
Estimated repair cost of Rs. 2,000 and selling cost of Rs. 1,000 will
enable the stock to be sold at Rs. 12,500 after the balance sheet
date.

Calculate the value of stock at balance sheet date.

Practice Question No. 1

Compute the value of closing inventory using: (a) Weighted average cost (b) FIFO
Practice Question No. 2
Techniques to Estimate
Inventory Value in case of fire
and other circumstances
Gross Profit Method
• The gross profit method estimates the cost of ending inventory by
applying a gross profit rate to net sales. This method is relatively
simple, but effective.
Practice Question Gross Profit Method
Answer
Retail Inventory Method
• A retail store which has thousands of different types of
merchandise at low unit costs. In such cases, it is difficult and time-
consuming to apply unit costs to inventory quantities. An
alternative is to use the retail inventory method to estimate the
cost of inventory.

• Under the retail inventory method, a company’s records must show

both the cost and retail value of the goods available for sale.
Calculation Step Retail Inventory Method
Practice Question – Retail Method
Answer -