Dire Dawa University

COLLEGE OF BUSINESS AND ECONOMICS

DEPARTMENT OF ACCOUNTING AND FINANCE

FUNDAMENTAL OF ACCOUNTING II
by
MIKIYAS NIGUSSIE
Contact Address:
mikiyasnigussie8@gmail.com

MAY , 2022

MIKIYAS NIGUSSIE 1
 Chapter 1

INVENTORY
Chapter
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 Preview of CHAPTER 1

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Inventory Issues
Classification

Inventories are:
items held for sale, or
goods to be used in the production of goods to be sold.

Businesses with Inventory:

Merchandiser or Manufacturer

LO 1 Identify major classifications of inventory.

 Classifying Inventory

Merchandising Manufacturing
Company Company

One Classification: Three Classifications:

 Inventory  Raw Materials

 Work in Process
 Finished Goods

Regardless of the classification, companies report all inventories under

Current Assets on the balance sheet.

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Inventory Issues
Inventory Cost Flow
Illustration 1-2

LO 1 Identify major classifications of inventory.

Inventory Issues
Inventory Cost Flow
Illustration 1-3

Companies use one of two types of systems for maintaining

inventory records — perpetual system or periodic system.

LO 1 Identify major classifications of inventory.

Inventory Cost Flow
Perpetual System
1. Purchases of merchandise are debited to Inventory.
2. Freight-in is debited to Inventory. Purchase returns and
allowances and purchase discounts are credited to
Inventory.
3. Cost of goods sold is debited and Inventory is credited for
each sale.
4. Subsidiary records show quantity and cost of each type of
inventory on hand.

The perpetual inventory system provides a continuous

record of Inventory and Cost of Goods Sold.

LO 2 Distinguish between perpetual and periodic inventory systems.

Inventory Cost Flow
Periodic System

1. Purchases of merchandise are debited to Purchases.

2. Ending Inventory determined by physical count.
3. Calculation of Cost of Goods Sold:

Beginning inventory

$ XX
Purchases, net

XX
Goods availablebetween
LO 2 Distinguish for sale
perpetual and periodic inventory systems.
Inventory Cost Flow
Illustration: Fesmire Company had the following
transactions during the current year.

Record these transactions using the Perpetual and Periodic

systems.

LO 2 Distinguish between perpetual and periodic inventory systems.

Inventory Cost Flow
Illustration: Illustration 1-4

LO 2 Distinguish between perpetual and periodic inventory systems.

Costs Included in Inventory
Treatment of Purchase Discounts

Illustration 1-11

**

* $4,000 x 2% = $80
** $10,000 x 98% = $9,800

LO 4 Understand the items to include as inventory cost.

 Determining Inventory Quantities

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.

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 Inventory Costing

Cost Flow
Assumptions

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 Inventory Costing

First-In-First-Out (FIFO)
 Earliest goods purchased are first to be sold.

 Often parallels actual physical flow of merchandise.

 Generally good business practice to sell oldest units

first.

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 Inventory Costing

Illustration: Data for Houston Electronics’ Astro condensers.

(Beginning Inventory + Purchases) - Ending Inventory = Cost of Goods Sold

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 Inventory Costing

First-In-First-Out (FIFO)

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 Inventory Costing

First-In-First-Out (FIFO)

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 Inventory Costing

Average Cost
 Allocates cost of goods available for sale on the basis
of weighted-average unit cost incurred.

 Assumes goods are similar in nature.

 Applies weighted-average unit cost to the units on

hand to determine cost of the ending inventory.

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 Inventory Costing

Average Cost

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 Inventory Costing

Average Cost

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 Inventory Costing

Financial Statement and Tax Effects

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 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.

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Cost Flow Assumptions and the Perpetual and
periodic Inventory Systems

Illustration: Call-Mart Inc. had the following transactions

in its first month of operations.

Calculate Goods Available for Sale

Beginning inventory (2,000 x $4)

$ 8,000
Purchases:
6,000 x $4.40

26,400 LO 5
 Specific Identification
Illustration: Assume that Call-Mart Inc.’s 6,000 units of inventory
consists of 1,000 units from the March 2 purchase, 3,000 from the
March 15 purchase, and 2,000 from the March 30 purchase.
Compute the amount of ending inventory and cost of goods sold.
Illustration 1-12
 Average Cost
Weighted-Average Illustration 1-13

LO 5 Describe and compare the cost flow assumptions

used to account for inventories.
 Average Cost
Moving-Average
Illustration 1-14

In this method, Call-Mart computes a new average unit

cost each time it makes a purchase.

LO 5 Describe and compare the cost flow assumptions

used to account for inventories.
 First-In, First-Out (FIFO)
Periodic Method
Illustration 1-15

Determine cost of ending inventory by taking the cost of the most recent
purchase and working back until it accounts for all units in the inventory.

LO 5 Describe and compare the cost flow assumptions

used to account for inventories.
 First-In, First-Out (FIFO)
Perpetual Method
Illustration 1-16

In all cases where FIFO is used, the inventory and cost of goods sold
would be the same at the end of the month whether a perpetual or
periodic system is used.

LO 5 Describe and compare the cost flow assumptions

used to account for inventories.
 Inventory Errors

Common Cause:
 Failure to count or price inventory correctly.
 Not properly recognizing the transfer of legal title to
goods in transit.
 Errors affect both the income statement and balance
sheet.

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 Inventory Costing

Income Statement Effects

Inventory errors affect the computation of cost of goods
sold and net income.

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 Inventory Costing

Income Statement Effects

Inventory errors affect the computation of cost of goods
sold and net income in two periods.
 An error in ending inventory of the current period will have a
reverse effect on net income of the next accounting
period.

 Over the two years, the total net income is correct because
the errors offset each other.

 Ending inventory depends entirely on the accuracy of taking

and costing the inventory.

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 Inventory Costing
2011 2012
Incorrect Correct Incorrect Correct
Sales $ 80,000 $ 80,000 $ 90,000 $ 90,000
Beginning inventory 20,000 20,000 12,000 15,000
Cost of goods purchased 40,000 40,000 68,000 68,000
Cost of goods available 60,000 60,000 80,000 83,000
Ending inventory 12,000 15,000 23,000 23,000
Cost of good sold 48,000 45,000 57,000 60,000
Gross profit 32,000 35,000 33,000 30,000
Operating expenses 10,000 10,000 20,000 20,000
Net income $ 22,000 $ 25,000 $ 13,000 $ 10,000

Combined income for ($3,000) $3,000

2-year period is correct. Net Income Net Income
understated overstated

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 Inventory Costing

Question
Understating ending inventory will overstate:

a. assets.

b. cost of goods sold.

c. net income.

d. owner's equity.

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 Inventory Costing

Balance Sheet Effects

Effect of inventory errors on the balance sheet is determined
by using the basic accounting equation:.

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Estimating Inventories

Gross Profit Method

Estimates the cost of ending inventory by applying a gross profit
rate to net sales.

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 Estimating Inventories

Illustration: Kishwaukee Company’s records for January show net

sales of $200,000, beginning inventory $40,000, and cost of goods
purchased $120,000. The company expects to earn a 30% gross
profit rate. Compute the estimated cost of the ending inventory at
January 31 under the gross profit method.

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 Estimating Inventories

Retail Inventory Method

Company applies the cost-to-retail percentage to ending
inventory at retail prices to determine inventory at cost.

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 Estimating Inventories

Illustration:

Note that it is not necessary to take a physical inventory to

determine the estimated cost of goods on hand at any given time.

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 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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