INVENTORY ACCOUNTING

Inventories
• Inventories are assets:
• held for sale in the ordinary course of
business;
• in the process of production for such sale; or 
• in the form of materials or supplies to be
consumed in the production process or in the
rendering of services
Objectives of Inventory Accounting
The objectives of inventory accounting are:

• to match the cost of goods sold, an expense,

with the revenue earned from the sale of
those goods in an accounting period, and

• to measure the cost of inventory on hand at

the end of the period which is an asset.
 Merchandising Companies
• A merchandising company has one inventory
account.

• The cost of goods available for sale is divided

into the cost of goods sold and closing
inventory by using either periodical inventory
method or a perpetual inventory method.
 Periodic Inventory System
• In the periodic inventory method, the ending
inventory is found by a physical count and the
cost of goods sold is obtained by deducting the
cost of inventory from the cost of goods
available for sale.
• Under the periodic inventory system, all
purchases are transferred to a purchase
account which is closed by transfer to trading
account (income statement/cost of goods sold).
 Perpetual Inventory System
• Under the perpetual inventory method, a record is
maintained of each item carried in the inventory.
• Purchases are entered directly in this record and
also added to the Merchandise Inventory.
• Deliveries of goods to customers are also entered
in this record
• Goods delivered to customers are reduced from
merchandise inventory and included in the cost of
goods sold.
 Perpetual Inventory System
• Perpetual Inventory System involves additional record keeping .
However, it offers several advantages.

• It helps determine the reorder quantity and reorder level

depending on demand. This helps avoid both stock-outs and excess
inventories of various items carried by the firm.

• Shrinkage can thus be separately identified rather than being

included in cost of goods sold.

• An income statement can be prepared without taking a physical

inventory at any time interval.
 Retail Method
• A firm that does not maintain perpetual inventory records can
prepare reasonably accurate monthly income statements
without taking a physical inventory by using the retail method.

• Purchases are recorded both at their cost and retail-selling price.

• From these records, the gross margin percentage is calculated.

• The complement of this percentage is applied to the sales figure

to find the approximate cost of goods sold.
 Retail Method
• In applying the retail method, adjustments
are made for markdowns made from the
initial selling prices.
• A variation of the above method is the Gross
Profit Method in which a gross profit
percentage is used to calculate cost of goods
sold while no record is kept to arrive at the
sale value of goods available for sale.
 Manufacturing Companies
• Manufacturing companies have three types of inventory,
Material Inventory, Work-in-Process Inventory and Finished
Goods Inventory.
• To account for these a periodic inventory method as in case of
merchandising business may be used.
• If perpetual inventory system is followed, it is called Product
Costing System.
• In such a system, the cost of each product is accumulated as it
flows through the production process. The information for
passing the entries is obtained directly from cost records.
 Service Companies
• In personal service organizations (such as barber shops,
beauty parlors, medical and dental practices) there are no
inventories except that of supplies.

• Supplies are tangible items that will be consumed in the

course of normal operations for example office supplies,
lubricants and repair parts for machinery.

• Supplies are not accounted for separately as an element of

the cost of goods manufactured.

• In such organizations all costs are period costs.

 Service Companies
• In case of building trade firms, plumbing and electrical firms
and repair businesses, the repair parts and building materials
are analogous to the material inventories of manufacturing
firms.

• Even though repair jobs are completed in a short period of

time, the job costs cannot be treated as period costs because
they flow through a work-in-process inventory account.
 Service Companies
• In case of professional service firms such as
law and accounting firms, there are labour
product costs.

• The costs incurred on various jobs add to wok-

in-process until they are billed by adding a
markup for office overheads and profit.
 Inventory Costing Methods

• When the per unit cost of one or more items in the inventory
changes during the accounting period, the division between
inventory and cost of goods sold can be done by following one
of the following methods:
 
• (i) Specific Identification Method
• (ii) Average Cost Method
• (iii) First-in-first-out method (FIFO)
• (iv) Last-in-first-out method (LIFO)
 Specific Identification Method:
This method is used when it is possible to
ascertain the actual cost of each item sold.

For example, in the case of automobiles,

expensive jewellery and custom made
furniture.

This method becomes unsatisfactory when a

large number of similar items are sold.
 Average Cost Method

• In the case of periodic inventory method, the average is

calculated for the whole period.

• It is a weighted average; the number of units weights each

unit cost.

• In the perpetual inventory method, a new average unit cost is

calculated after each purchase.

• Some companies use a predetermined unit cost for all

transactions during the period which is called the standard
cost system.
 FIFO Method
• This method assumes that the oldest goods
are sold first and that the most recently
purchased goods are in the ending inventory.

• Under FIFO, cost of goods sold reflects the

usual physical flow of merchandise
 LIFO Method

• Under this method, cost of goods sold is based on the most

recent purchases and the ending inventory is valued at the
cost of the oldest units available.

• Under LIFO, cost of goods sold does not reflect the usual
physical flow of merchandise and the ending inventory may
be cost valued at amounts prevailing several years ago which,
in an era of inflation, are far below current costs.
 Lower of Cost or Market Value
• FIFO and LIFO methods are used to determine
the cost of inventory on hand.

• But for balance sheet reporting purposes, the

principle is lower of cost or market value (net
realizable value)
 Example
The following particulars are given in respect of a stores item by a company:

2005
Jan 1 Opening stock 100 units @ Rs. 30 per unit
1 Purchases 200 units @ Rs.31 per unit
10 Issued for production 100 units
12 Purchases 400 units @ Rs.32 per unit
15 Issued for production 200 units
18 Issued for production 200 units
23 Purchases 300 units @ Rs. 34 per unit
31 Issued for production 200 units

Find out the value of stock as on 31 January 2005 if the company follows:

(i) First-in-first-out method

(ii) Last-in-first-out method
(iii) Weighted Average method.
 Example-FIFO
First-in-First-out Method:

Computation of Value of Stock as on 31 January, 2005

Date Receipts Issues Balance

Units Rate Amount Units Rate Amount Units Rate Amount
Rs. Rs. Rs. Rs. Rs. Rs.

2005
1-Jan 100 30 3,000
1-Jan 200 31 6,200 100 30 3,000
200 31 6,200
10-Jan 100 30 3,000 200 31 6,200
12-Jan 400 32 12,800 200 31 6,200
400 32 12,800
15-Jan 200 31 6,200 400 32 12,800
18-Jan 200 32 6,400 200 32 6,400
23-Jan 300 34 10,200 200 32 6,400
300 34 10,200
31-Jan 150 32 4,800 50 32 1,600
300 34 10,200

The value of stock on 31 January 2005 under FIFO is Rs. 11,800 comprising 50 units @ Rs.
32 and 300 units @ Rs.34
 Example-LIFO
Last-in-First-out Method
Computation of Value of Stock as on 31 January, 2005

Date Receipts Issues Balance

Units Rate Amount Units Rate Amount Units Rate Amount
Rs. Rs. Rs. Rs. Rs. Rs.

2005
1-Jan 100 30 3,000
1-Jan 200 31 6,200 100 30 3,000
200 31 6,200
10-Jan 100 31 3,100 100 30 3,000
100 31 3,100
12-Jan 400 32 12,800 100 30 3,000
100 31 3,100
400 32 12,800
15-Jan 200 32 6,400 100 30 3,000
100 31 3,100
200 32 6,400
18-Jan 200 32 6,400 100 30 3,000
100 31 3,100
23-Jan 300 34 10,200 100 30 3,000
100 31 3,100
300 34 10,200
31-Jan 150 34 5,100 100 30 3,000
100 31 3,100
150 34 5,100

The value of stock on 31 January 2005 under LIFO is Rs. 11,200 comprising 100
units @ Rs. 30, 100 units @ Rs.31 and 150 units @ Rs.34.
 Example-Weighted Average Method

Weighted Average Method

Computation of Value of Stock as on 31 January, 2005

Date Receipts Issues Balance

Units Rate Amount Units Rate Amount Units Rate Amount
Rs. Rs. Rs. Rs. Rs. Rs.

2005
1-Jan 100 30 3,000
1-Jan 200 31 6,200 300 30.67 9,200
10-Jan 100 30.67 3,067 200 30.67 6,133
12-Jan 400 32 12,800 600 31.56 18,933
15-Jan 200 31.56 6,312 400 31.56 12,621
18-Jan 200 31.56 6,312 200 31.56 6,309
23-Jan 300 34 10,200 500 33.02 16,509
31-Jan 150 33.02 4,953 350 33.02 11,556
The value of stock under the weighted average method as on 31 January 2005 is Rs.
11,556 comprising 350 units @ Rs. 33.02.