CHAPTER 4

ACCOUNTING FOR INVENTORIES

1. Nature and Classification of inventories

• Inventories are asset items that a company holds for sale in

the ordinary course of business, or goods that it will use or
consume in the production of goods to be sold. The
description and measurement of inventory require careful
attention. The investment in inventories is frequently the
largest current asset of merchandising (retail) and
manufacturing businesses.
• The major inventory account for merchandising
business is merchandise inventory (which means
stock of items purchased with intention to be sold).
Manufacturing companies have three major types of
inventories.
• Raw material inventories
• Work in progress inventories
• Finished goods inventories
• NB: All types of businesses have supplies inventories
which is collection of consumable items.
Goods and Costs Included in Inventory
Goods Included in Inventory
Legal ownership title determines which inventories are
to be included in accounting record of a given
organization. For items purchased or sold, legal
ownership depends on shipping agreements. There are
two shipping agreements
1. Free on Board Shipping: legal ownership is
transferred from seller to buyer at seller’s place of
business.
2.Free in Board Destination: legal ownership is
transferred from seller to buyer at buyer’s place of
business.
 Treatment for items on Transit

Items purchased and on transit under FOB Shipping

are included in inventories while items sold and on
transit under free on board shipping are not included
in inventories. Items purchased and on transit
under FOB destination are not included in
inventories while items sold and on transit under free
on board shipping are included in inventories.
Treatment for Goods Under consignment Contract

Consignment contract is a contract under which one party

transfers inventories to another party who acts as sales agent.
The party who is transferring inventories is known as consignor
and the party to whom inventories are transferred is known as
consignee. Legal ownership title for goods under consignment
contract belongs to the consignor. Therefore, items transferred to
another party under consignment contract are included in
accounting records while items received from another party
under consignment contract are not included.
 Costs Included in Inventory

Product Costs

Product costs are those costs that “attach” to the

inventory. As a result, a company records product
costs in the Inventory account. These costs are
directly connected with bringing the goods to the
buyer’s place of business and converting such goods
to a salable condition. Such charges generally include
1.costs of purchase, (2) costs of conversion, and
(3) “other costs” incurred in bringing the
inventories to the point of sale and in salable
condition.
Costs of purchase include:
1.The purchase price.
2.Import duties and other taxes.
3.Transportation costs.
4.Handling costs directly related to the acquisition
of the goods.
Conversion costs for a manufacturing company include
direct materials, direct labor, and manufacturing
overhead costs. Manufacturing overhead costs include
indirect materials, indirect labor, and various costs,
such as depreciation, taxes, insurance, and utilities.

“Other costs” include those incurred to bring the

inventory to its present location and condition ready to
sell, such as the cost to design a product for specific
customer needs.
 Period Costs

Period costs are those costs that are indirectly

related to the acquisition or production of goods.
Period costs such as selling expenses, general and
administrative expenses are therefore not
included as part of inventory cost.
 Inventory Systems
•Periodic inventory system

A periodic inventory system can be defined as a system of

accounting for inventory in which the cost of goods sold is
determined and ending inventory balance is adjusted at the end of
the accounting period, not when merchandise is purchased or
sold.

Under this system, the quantity of inventory on hand is

determined only periodically. Hence, under a periodic inventory
system, the cost of goods sold is a residual amount that is
 Perpetual inventory System
A perpetual inventory system can be defined as a
system of accounting for inventory which involves
detailed and continuous recording of the number of
units of inventories and the costs of each inventory
purchase and sales transaction throughout the
accounting period. system, a continuous record of
changes in inventory is maintained in the inventory
account and the cost of goods sold account
 Valuation of inventories
Inventory cost flow assumptions
The term cost flow refers to the inflow of costs when
goods are purchased or manufactured and to the
outflow of costs when goods are sold. The cost
remaining in inventories is the difference between the
inflow and outflow of costs.
During a specific accounting period such as a year or a
month, identical goods may be purchased or
manufactured at different costs. Accountants then face
the problem of determining which costs apply to items
in inventories and which applies to items that have
In selecting an inventory valuation method (or cost
flow assumption), accountants are based on the basis
of matching costs with revenue, and the ideal choice
is the method that “most clearly reflects periodic
income.”
 On the basis of this, the most widely used methods of inventory valuation are

1.First-in, First-out (FIFO) Method

2.Last-in, First-out (LIFO) Method (not
recommendable under IFRS)
3.Weighted-Average Method
4.Specific Identification Method
First-In, First-out method (FIFO)

The FIFO method assumes flows of costs based on

the assumption that the oldest goods on hand are
sold first. To illustrate the application of the
inventory costing methods, consider the following
data related to candy inventories of Sheger
Merchandising Company for the month of January,
2020.
 Sheger Company
Record of Purchases of Item candy
For the month January 2020

Date Purchases Sales Balance (units on Hand)

January 1 200

January 9 300 units @ Br 1.10 500

January 10 400 100

January 15 400 @ Br 1.16 500

January 18 300 200

January 24 100 @ Br 1.26 300

• The beginning inventory on January 1 is acquired at
Br. 1.00 each. Based on the information in the
schedule, the cost of goods available for sale is
determined as follows:
Beginning inventory cost……………………………..200 x Br. 1.00 = Birr 200
Add: Purchases……………………………….300 x Br. 1.10 = Birr 330
400 x Br. 1.16 = Birr 464
100 x Br. 1.26 = Birr 126 920
Cost of goods available for sale…………………………………………..Birr 1, 120
Using the above data, under the periodic inventory
system, the cost of ending inventory and the cost of
goods sold using FIFO is determined as follows:
Beginning inventory (200 units at Birr 1.00)……………………………..……………….Birr 200
Add: purchases during the period…………………………………………………………...….920
Cost of goods available for sale………………………………………………………....Birr 1, 120
Deduct: Ending inventory (300 units per physical inventory count):
100 units at Br. 1.26 (most recent purchases –Jan. 24)………… Br. 126
200 units at Br. 1.16 (next most recent purchase –Jan15)…………...232
Total ending inventory cost………………….………………………………………….……...358
Cost of goods sold (or issued)……………………………………………………………..Birr 762
 Similarly, under the perpetual inventory system, the
cost of ending inventory and cost of goods sold using
FIFO inventory costing is determined as follows:
Date Purchases Cost of Merchandise Sold Balance (Units on Hand)
Units Unit cost Total cost Units Unit cost Total cost Units Unit cost Total cost
January 1 200 Br. 1.00 Br. 200
January 9 300 Br.1.10 Br.330 200 1.00 Br. 200
300 1.10 330
January 10 200 Br.1.00 Br. 200
200 1.10 220 100 1.10 110
January 15 400 1.16 464 100 1.10 110
400 1.16 464
January 18 100 1.10 110
200 1.16 232 200 1.16 232
January 24 100 1.26 126 200 1.16 232
100 1.26 126
 Last-In, First-Out (LIFO)
•The LIFO method is an inventory cost flow
assumption whereby the goods purchased during the
last period are assumed to be the goods sold firstly so
that the ending inventory consists of the first goods
purchasedUsing the data for Sheger Company, the
cost of ending inventory and cost of goods sold under
the periodic system using LIFO is determined as
follows:
Beginning inventory (200 units at Birr 1.00)……………………………..…………...…..Birr 200
Add: purchases during the period………………………………………………………...…….920
Cost of goods available for sale……………………………………….………………....Br. 1, 120
Deduct: Ending inventory (300 units per physical inventory count):
200 units at Br. 1.00 (oldest costs available, form Jan 1. inventory) ………Br. 200
100 units at Br. 1.10 (next oldest costs available, from Jan 9 purchase)…… 110
Ending inventory...................................................................................................................…...310
Cost of goods sold..................................................................................................………....Br. 810
Date Purchases Cost of Merchandise sold Inventory balance
Units Unit cost Total Units Unit cost Total Units Unit cost Total
cost cost cost
January 1 200 Br. 1.00 Br. 200

January 9 300 Br.1.10 Br.330 200 1.00 200

300 1.10 330

January 300 Br.1.10 Br. 330

10 100 1.00 100 100 1.00 100

January 400 1.16 464 100 1.00 100

15 400 1.16 464

January 300 1.16 348 100 1.00 100

18 100 1.16 116

January 100 1.26 126 100 1.00 100

24 100 1.16 116
100 1.26 126
 Special inventory valuation methods

•inventory Valuation at Lower-of-Cost-or-Net Realizable Value

(LCNRV)

Inventories are recorded at their cost. However, if inventory declines

in value below its original cost, a major departure from the historical
cost principle occurs. Whatever the reason for a decline obsolescence,
price-level changes, or damaged goods a company should write down
the inventory to net realizable value to report this loss. A company
abandons the historical cost principle when the future utility
(revenue- producing ability) of the asset drops below its original cost.
Net realizable value (NRV)

The term net realizable value (NRV) refers to the

net amount that a company expects to realize from
the sale of inventory. Specifically, net realizable
value is the estimated selling price in the normal
course of business less estimated costs to complete
and to make a sale.
To illustrate, assume that ABC Corporation has
unfinished inventory with a sales value of Br. 1,000,
estimated cost of completion of Br. 300. The net
realizable value can be determined as follows.
•Inventory—sales value………………… Br. 1,000
•Less: Estimated cost of completion and………..
………………… 300
Netrealizablevalue………………………..;. 700
•A company estimates net realizable value based on
the most reliable evidence of the inventories’
realizable amounts (expected selling price, expected
costs of completion, and expected costs to sell).

•To illustrate, ABC Restaurant computes its

inventory at LCNRV.
 Food Cost Net Realizable Value Final Inventory Value
Spinach ¥ 80,000 ¥120,000 ¥ 80,000
Carrots 100,000 110,000 100,000
Cut beans 50,000 40,000 40,000
Peas 90,000 72,000 72,000
Mixed vegetables 95,000 92,000 92,000
¥384,000

Final Inventory Value:

Spinach Cost (¥80,000) is selected because it is lower than net realizable value.
Carrots Cost (¥100,000) is selected because it is lower than net realizable value.
Cut beans Net realizable value (¥40,000) is selected because it is lower than cost.
Peas Net realizable value (¥72,000) is selected because it is lower than cost.
Mixed vegetables Net realizable value (¥92,000) is selected because it is lower than cost.
 Methods of Applying LCNRV
•LCNRV can be applied for:

1.Each individual items

2.Major groups

3.Total items
The above illustration indicates the case when
LCNRV is applied for each individual item. If a
company follows a similar-or-related-items or
total-inventory approach in determining LCNRV,
increases in market prices tend to offset decreases
in market prices. To illustrate, assume that ABC
Restaurant separates its food products into two
major groups, frozen and canned.
 LCNRV by:

Cost LCNRV Individual Items Major Groups Total Inventory

Frozen

Spinach ¥ 80,000 ¥120,000 ¥ 80,000

Carrots 100,000 110,000 100,000

Cut beans 50,000 40,000 40,000

Total frozen 230,000 270,000 ¥230,000

Canned

Peas 90,000 72,000 72,000

Mixed vegetables 95,000 92,000 92,000

Total canned 185,000 164,000 164,000

Total ¥415,000 ¥434,000 ¥384,000 ¥394,000 ¥415,000

•If ABC Restaurant applies the LCNRV rule to
individual items, the amount of inventory is
•¥384,000. If ABC Restaurant applies the rule to
major groups, it jumps to ¥394,000. If the company
applies LCNRV to the total inventory, it totals
¥415,000. Why this difference? When a company
uses a major group or total-inventory approach, net
realizable values higher than cost offset net realizable
values lower than cost.
Recording Net Realizable Value Instead of Cost
One of two methods may be used to record the income effect
of valuing inventory at net realizable value. One method,
referred to as the cost-of-goods-sold method, debits cost of
goods sold for the write-down of the inventory to net
realizable value. As a result, the company does not report a
loss in the income statement because the cost of goods sold
already includes the amount of the loss. The second method,
referred to as the loss method, debits a loss account for the
write-down of the inventory to net realizable value.
Assume that the following data is for XYZ
Company
Cost of goods sold (before adjustment to net realizable€108,000
value)

Ending inventory (cost) 82,000

Ending inventory (at net realizable value) 70,000

The cost-of-goods-sold method hides the loss in the
Cost of Goods Sold account. The loss method, by
identifying the loss due to the write-down, shows
the loss separate from Cost of Goods Sold in the
income statement.
 Cost-of-Goods-Sold Method
Sales revenue €200,000
Cost of goods sold (after adjustment to net realizable value*) 120,000
Gross profit on sales € 80,000

Loss Method

Sales revenue €200,000

Cost of goods sold 108,000
Gross profit on sales 92,000
Loss due to decline of inventory to net realizable value 12,000
€ 80,000
*Cost of goods sold (before adjustment to net realizable value)
€108,000

Difference between inventory at cost and net realizable value (€82,000 − 12,000
€70,000)
Cost of goods sold (after adjustment to net realizable value) €120,000