Oda Bultum University, College of Business and

Economics
Department of Accounting & Finance
Fundamental of Accounting II

Chapter 1

INVENTORY
By: Abdurahman A. (MSc. In Accounting and Finance)
After studying this chapter, you 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:
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:
a) Raw material inventory
b) Work in process inventory
c) Finished goods inventory
 Manufacturing Company

Three Classifications of manufacturing inventory:

 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.
 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.
 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.
 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
 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.
 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.
 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 EI on gross profit is the
opposite of the effect on cost of merchandise sold.
 If EI is understated, the gross profit will be understated and
if EI 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:
1. Current assets - Ending inventory is part of current
assets, even the largest. So, it has a direct (positive)
relationship to current assets.
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.
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 EI of the previous period will become BI of the following
period.
 Therefore, when EI of the current period increases, it means
that BI 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 EI 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.
 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:
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. 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 ending inventory of the previous period will become
beginning inventory of the following period. Therefore,
when EI 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.
 Con’t…
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.
 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.
 Con’t…
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 EI 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 EI 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:
periodic inventory system perpetual inventory system
The inventory value and COGS are determined Continuous record of both the physical flow and the cost of
only at important point in time .e.g. end of inventories and COGS. Every point in time you determine the
reporting period level of inventory
Only revenue is recorded at time of sale Both revenue and COGS are recorded
Purchase & purchase related accounts are used No purchase and purchase related accounts
More appropriate for low unit cost items For high unit cost items (not economical for low unit cost items)
Physical inventory is undertaken to determine Physical inventory should be undertaken to test accuracy, to
EI cost. Units sold are determined indirectly by discover any shortage or overage b/c of waste, breakage , theft,
subtracting the units on hand from the sum of improper entry, failure to record acquisitions etc.
the units available for sale during the period.
This makes preparation of interim financial Facilitates the preparation of interim financial statements.
statements. more costly unless inventory
estimation technique is used.
Weaker for internal control. 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 Cash ------------------------ 8,820
Purchase 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
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
Taking a Physical Inventory
Involves counting, weighing, or measuring each kind of
inventory on hand.
Taken,
 when the business is closed or business is slow.
 at end of the accounting period.
 Determining Inventory

Determining Ownership of Goods

Goods in Transit
 Purchased goods not yet received.
 Sold goods not yet delivered.

Goods in transit should be included in the inventory of

the company that has legal title to the goods. Legal title
is determined by the terms of sale.

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 Determining Inventory Quantities

Goods in Transit

Ownership of the goods

passes to the buyer when the
public carrier accepts the
goods from the seller.

Ownership of the goods

remains with the seller until
the goods reach the buyer.

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 Determining Inventory Quantities

Question
Goods in transit should be included in the inventory of the
buyer when the:
a. public carrier accepts the goods from the seller.

b. goods reach the buyer.

c. terms of sale are FOB destination.

d. terms of sale are FOB shipping point.

6-22
 Determining Inventory Quantities

Determining Ownership of Goods

Consigned Goods
 Goods held for sale by one party.
 Ownership of the goods is retained by another
party.
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
6-23
 Cost Determination
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.
 Inventory Costing

Unit costs can be applied to quantities on hand using

the following costing methods:
 Specific Identification
 First-in, first-out (FIFO)
 Last-in, first-out (LIFO) Cost Flow
Assumptions
 Average-cost

6-25
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
11
Additional information:
1. The physical count shows only one unit in the warehouse
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 Cost of Goods Sold:
Cost of Goods Available for Sale $300
Ending Inventory Cost (13 Less: Ending Inventory Cost (above) 176
units): $124
2 units @ $10 OR

$20 Sold from Jan 1, 4*$10= $40

3 units @ $12 --------- Sold from Jan 10, 7*$12=$84
Cost of Goods sold = $124
 Advantage and Disadvantage of SI
Advantage
 Gives the accurate cost information. The method is
consistent with the physical flow of goods
Disadvantage
 It is costly and requires tedious record keeping 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.
 b) First-in, First-out (FIFO)
 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 January 31 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
 
Cost of Ending Inventory 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
Cost of goods sold = $120
Advantages and Disadvantage Using FIFO Costing assumption
 Advantages
 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).
 FIFO best approximates the current replacement value of ending
inventory in the balance sheet.
 No manipulation of income is possible because the cost attached
to units sold is always the oldest cost.
 Disadvantage
 For income determination, earlier costs are matched with current
revenue resulting poor matching in the income statement.
 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/Ending 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
Advantages and Disadvantage Using LIFO Costing assumption
 Advantages
 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.
 Tends to excludes inventory/paper profit.
 Disadvantage
 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
 The oldest purchase costs are assigned to inventory, which may
result in inventory becoming grossly understated in terms of
current replacement costs.
 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.
• 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
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 and Disadvantage Weighted-average Method

 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/mixture 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.
 Inventory Costing

Question
The cost flow method that often parallels the actual
physical flow of merchandise is the:
a. FIFO method.
b. LIFO method.
c. average cost method.
d. gross profit method.

6-35
 Inventory Costing

Question
In a period of inflation, the cost flow method that results
in the lowest income taxes is the:
a. FIFO method.
b. LIFO method.
c. average cost method.
d. gross profit method.

6-36
II. Inventory Costing Methods under Perpetual Inventory
System

• 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
            6 $10 $60
Jan. 1
      5 $10 $50 1 10 10
3
10 10 $12 $120       1 10 10
10 12 120

20       1 10 10 7 12 84
3 12 36
      2 12 24 5 12 60
28
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.
 Journal entries

- 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
    Merchandise Inventory --------- 46
  28 Accounts Receivable/Cash ---- 44 
    Sales ------------------------------ 44
    COGS ----------------------- 24 
    Merchandise Inventory --------- 24
             

  30 Merchandise Inventory ------- 120 

    A/P or Cash --------------------- 120
 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 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

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 AC   FIFO LIFO AC
LIFO
Sales $191 $191 Sales $191 $191 $191
$191
Cost of goods sold 120 137.5 Cost of goods sold 120 122 120.91
156
Gross profit $71 $53.50 Gross profit $71 $69 $70.09
$35
Balance Sheet     Balance Sheet    
• As shown above, the
Ending inventory $180 FIFO method
$162.50 yielded
Ending the lowest
inventory $180 amount for the cost of
$178 $179.09
merchandise sold and $144
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
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:
 the cost of replacing items in inventory is below the recorded cost—
LCM method and
 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
When the value of inventory is lower than its cost
 Companies can “write down” the inventory to its
market value in the period in which the price decline
occurs.
 Market value = Replacement Cost
 Example of conservatism.
 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.
 Example of LCM
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)?
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.
 con’t…
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 C& D 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 $15,47 $15,070 15,412 $15,472
2

• 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
o 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!
o 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.
o Net realizable value is the estimated selling price less any
direct cost of disposal, such as sales commission,
advertising, repairs etc.
o The valuation rule is cost or NRV whichever is lower.
 Example: NRV

• 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:
• To prepare interim financial statements when the periodic system is
used without having physical count.
• To verify the reasonableness of the EIC reported in the body of the
financial statements.
• 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

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

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
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

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
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.
 Key Points
 The requirements for accounting for and reporting
inventories are more principles-based under IFRS. That is,
GAAP provides more detailed guidelines in inventory
accounting.
 The definitions for inventory are essentially similar under
IFRS and GAAP. Both define inventory as assets held-for-
sale in the ordinary course of business, in the process of
production for sale (work in process), or to be consumed in
the production of goods or services (e.g., raw materials).

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 Key Points
 Who owns the goods—goods in transit or consigned goods
—as well as the costs to include in inventory, are accounted
for the same under IFRS and GAAP.
 Both GAAP and IFRS permit specific identification where
appropriate. IFRS actually requires that the specific
identification method be used where the inventory items are
not interchangeable (i.e., can be specifically identified). If the
inventory items are not specifically identifiable, a cost flow
assumption is used. GAAP does not specify situations in
which specific identification must be used.

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 Key Points
 A major difference between IFRS and GAAP relates to the
LIFO cost flow assumption. GAAP permits the use of LIFO
for inventory valuation. IFRS prohibits its use. FIFO and
average-cost are the only two acceptable cost flow
assumptions permitted under IFRS.
 IFRS requires companies to use the same cost flow
assumption for all goods of a similar nature. GAAP has no
specific requirement in this area.

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 Key Points
 In the lower-of-cost-or-market test for inventory valuation,
IFRS defines market as net realizable value. Net realizable
value is the estimated selling price in the ordinary course of
business, less the estimated costs of completion and
estimated selling expenses. In other words, net realizable
value is the best estimate of the net amounts that
inventories are expected to realize. GAAP, on the other hand,
defines market as essentially replacement cost.

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 Key Points
 Under GAAP, if inventory is written down under the lower-of-
cost-or-market valuation, the new value becomes its cost
basis. As a result, the inventory may not be written back up
to its original cost in a subsequent period. Under IFRS, the
write-down may be reversed in a subsequent period up to
the amount of the previous write-down. Both the write-down
and any subsequent reversal should be reported on the
income statement as an expense. An item-by-item approach
is generally followed under IFRS.

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 Key Points
 Unlike property, plant, and equipment, IFRS does not permit
the option of valuing inventories at fair value. As indicated
above, IFRS requires inventory to be written down, but
inventory cannot be written up above its original cost.
 Similar to GAAP, certain agricultural products and mineral
products can be reported at net realizable value using IFRS.

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 Looking to the Future

One convergence issue relates to the use of the LIFO cost flow
assumption. IFRS specifically prohibits its use. Conversely, the
LIFO cost flow assumption is widely used in the United States
because of its favorable tax advantages. With a new conceptual
framework being developed, it is highly probable that the use of
the concept of conservatism will be eliminated. Similarly, the
concept of “prudence” in the IASB literature will also be
eliminated. This may ultimately have implications for the
application of the lower-of-cost-or-net realizable value.

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 IFRS Self-Test Questions

Which of the following should not be included in the

inventory of a company using IFRS?
a) Goods held on consignment from another company.
b) Goods shipped on consignment to another company.
c) Goods in transit from another company shipped FOB
shipping point.
d) None of the above.

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 IFRS Self-Test Questions

Which method of inventory costing is prohibited under

IFRS?
a) Specific identification.
b) FIFO.
c) LIFO.
d) Average-cost.

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 IFRS Self-Test Questions

Specific identification:
a) must be used under IFRS if the inventory items are not
interchangeable.
b) cannot be used under IFRS.
c) cannot be used under GAAP.
d) must be used under IFRS if it would result in the most
conservative net income.

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 END
Chapter 1

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