FUNDAMENTALS OF

ACCOUNTING II
CHAPTER ONE:
INVENTORIES

BY: ASHENAFI GEMECHU

2014 E.C
1
 1.1 Nature of Inventories:
Inventory is used to indicate:
1. Asset items held for sale in the ordinary course of business,
2. Merchandise held for resale purpose in the normal operation of
business and
3. Materials in the process of production or held for production.
They are mainly divided into two major:
(A) Inventories of merchandising businesses: are merchandise
purchased for resale in the normal course of business. These
types of inventories are called merchandise inventories.
(B) Inventories of manufacturing businesses: manufacturing
businesses are businesses that produce physical output. They
normally have three types of inventories. These are; raw material
inventory, work in process inventory and finished goods inventory
Note: In this chapter, we focus primarily on inventory of merchandise
purchased for resale. by: Ashenafi G. 2
 1.2 Internal Control of Inventories
The cost of inventory is a significant item in many businesses’
financial statements. Not only must the cost inventory be
determined, but good internal control over inventory must also
be maintained.
Two primary objectives of internal control over inventory are
(1) Safeguarding the inventory and
(2) Properly reporting it in the financial statement (Balance
sheet).
These internal controls can be either preventive or detective in
nature.
 A preventive control is designed to prevent errors or
misstatements from occurring.
 A detective control is designed to detect an error or
misstatement after it has occurred. by: Ashenafi G. 3
 1.3 Effect of Inventory Errors on Financial
Statements:
• Any errors in the inventory count will affect both
the balance sheet and the income statement. For
example, an error in the physical inventory will
misstate the ending inventory, current assets, and
total assets on the balance sheet.
• This is because the physical inventory is the basis
for recording the adjusting entry for inventory
shrinkage.

by: Ashenafi G. 4
• Also, an error in taking the physical inventory
misstates the cost of goods sold, gross profit, and
net income on the income statement.
• In addition, because net income is closed to the
owner’s equity at the end of the period, owner’s
equity will also be misstated on the balance sheet.
• This misstatement of owner’s equity will equal the
misstatement of the ending inventory, current
assets, and total assets.

by: Ashenafi G. 5
 Summary of Inventory Errors on Financial Statements
If inventory is: CGS is GP & NI are Ending owner’s
equity is
Overstated Understated Overstated Overstated
Understated Overstated Understated Understated

by: Ashenafi G. 6
• Any errors in merchandise inventory will affect the
balance sheet and income statement. Some
reasons that inventory errors may occur include
the following:
(1) Physical inventory on hand was miscounted.
(2) Costs were incorrectly assigned to inventory. For
example, the FIFO or average cost method was
incorrectly applied.
(3) Inventory in transit was incorrectly included or
excluded from inventory.
(4) Consigned inventory was incorrectly included or
excluded from inventory.
by: Ashenafi G. 7
Example-1:

• Assume that in taking the physical inventory on

December 31, 2001, Yahoo Company incorrectly
recorded its physical inventory as Birr 115,000
instead of Birr 125,000. What should be the effect
of misstatement of the inventory on Dcecember-
31, 2001 financial statements?

by: Ashenafi G. 8
 Solution: The Effect of Inventory Error on the Financial Statement
will be:
Balance sheet:
Merchandise Inventory understated (Birr 10,000)
Current assets understated (10,000)
Total assets understated (10,000)
Owner’s equity understated (10,000)

Income Statement:

Cost of merchandise sold overstated Birr 10,000

Gross profit understated (10,000)
Net income understated (10,000)

by: Ashenafi G. 9
Example-2: Assume ABC Company incorrectly
counted its December 31, 2002, inventory as Birr
250,000 instead of the correct amount of Birr
220,000. What should be the effect of the
misstatement on ABC’s December 31, 2002, balance
sheet and income statement for the year ended
December 31, 2002?

Example-3: Assume on December-31, 2003, the

physical ending inventory of Macha Company was
overstated by Birr 25,000. What is the effect of this
error on the financial statements?
by: Ashenafi G. 10
 1.4 Inventory Systems and Inventory
Cost Flow Assumptions:
• There are two principal inventory systems. These
are; periodic and perpetual.
(A)Periodic inventory system;
 Purchases of merchandise are debited to
Purchases.
 Ending Inventory determined by physical count.
 At the time of sale no need of recording CGS.
 Calculation of Cost of Goods Sold;
by: Ashenafi G. 11
 Beginning Inventory ------------------ XX
Add: Cost of Purchase (Net) --------------- XX
Goods Available for Sale ------------ XXX
Less: Ending Inventory ---------------------- (XX)
Cost of Goods Sold ------------------- XXX

by: Ashenafi G. 12
 (B) Perpetual inventory system
 Provides a continuous record of Inventory and Cost of Goods Sold
to disclose the amount of the inventory.
 Purchases of merchandise and Freight-in should be debited to
Inventory.
 Purchase returns and allowances and purchase discounts are
credited to Inventory.
 Cost of goods sold is debited and Inventory is credited for each
sale.
 Subsidiary records show quantity and cost of each type of
inventory on hand.
 The cost of merchandise sold will be recorded each time a sale is
made.
 Physical inventory is taken to compare the records with the actual
quantities on hand.
by: Ashenafi G. 13
 Journal entries to be prepared are the following:
 Date Explanation Debit Credit
1. At the time of purchase of merchandise Merchandise inventory XX
(at cost)
A/P (Cash) XX
2. At the time of sale of merchandise (at A/R (Cash) XX
retail price)
Sales XX
Cost of Goods Sold
Merchandise inventory
3. To record purchase returns and A/P (Cash) XX
allowances
Merchandise inventory XX
4. No adjusting entry or closing entry for merchandise inventory is needed at the end of each
accounting period.

by: Ashenafi G. 14
There are three cost flow assumptions. These are:
(1) Specific Identification Method
(2) FIFO Method, and
(3) Weighted Average Method.

by: Ashenafi G. 15
 (1) Specific Identification Method
• A major accounting issue arises when identical units of
merchandise are acquired at different unit costs during a
period.
• In such cases, when an item is sold, it is necessary to
determine its unit cost so that the proper accounting entry
can be recorded.
• The specific identification method is not practical unless
each unit can be identified accurately. An automobile dealer,
for example, may be able to use this method, since each
automobile has a unique serial number.
• For many businesses, however, identical units cannot be
separately identified, and a cost flow must be assumed. That
is, which units have been sold and which units are still in
16
inventory must be assumed.by: Ashenafi G.
 (2) FIFO Method

• This method of costing inventory is based on the

assumption that costs should be charged against
revenue in the order in which they were incurred.

• Hence, the inventory remain is assumed to be

made up of the most recent costs and the cost of
inventory sold is made up of the earliest costs.

by: Ashenafi G. 17
 (3) Average Cost Method
• The average cost method is sometimes called the weighted
average method.
• When this method is used, costs are matched against
revenue according to an average of the unit cost of goods
sold.
• The same weighted average unit cost are used in determine
the cost of the merchandise inventory at the end various
purchase of identical items, the average method
approximates physical flow of goods.
• The weighted average unit cost is determined by dividing the
total cost of the units of each item available for sale during
the period by the related number of units of that item.
• The weighted average unit cost is then multiplied with the
by: Ashenafi G. 18
units on hand to determine the cost of the ending inventory.
• Average unit cost will be determined as follows

Average Unit Cost Calculation Formula

Average Unit Cost =

by: Ashenafi G. 19
Example-4:
Assume three identical units of item X are purchased
during May 2004, as shown below and assume one
unit is sold on May 30 for Birr 20. Using the
identification method, what should be the cost of
goods sold, gross profit and cost of ending inventory,
if the item sold is from May-10, May-18 or May-24?

by: Ashenafi G. 20
 Solution: Using Specific Identification Method
Items May-10 May-18 May-24
Sales Birr 20 Birr 20 Birr 20
Cost of Goods Sold ( 9) (13) (14)
Gross Profit Birr 11 Birr 7 Birr 6
Ending Inventory Birr 27 (13 +14) Birr 23 (9 +14) Birr 22 (13 +9)
Solution: Using First In First Out (FIFO) Solution: Using Average Cost Method
Method
Sales Birr 20 Sales Birr 20
Cost of Goods Sold (9) Cost of Goods Sold (12)
Gross Profit Birr 11 Gross Profit Birr 8

by: Ashenafi G. 21
 Inventory Costing Methods Under a
Periodic Inventory System
• When the periodic inventory system is used, only
revenue is recorded each time a sale is made.
• No entry is made at the time of the sale to record
the cost of the merchandise sold.
• At the end of the accounting period, a physical
inventory is taken to determine the cost of the
inventory and the cost of the merchandise sold.

by: Ashenafi G. 22
 Example-5
Assume the following information for ABC Merchandise
Company; a physical count on December 31, 2005 reveals
that 450 inventory.
Date Explanation Units Total Cost
January-1 Beginning Inventory 100 Units at Birr 10 Birr 1,000

March-15 Purchase 200 Units at Birr 11 2,200

September-24 Purchase 300 Units at Birr 12 3,600

November-27 Purchase 400 Units at Birr 13 5,200

Available for sale during the year 1,000 Units Birr 12,000

Required: Compute Cost of Goods Sold and Cost of Ending

Inventory; using FIFO and Average
by: Ashenafi G. cost methods. 23
 Example-6:
Assume the following data for Printing Press Company
for the period of December-31, 2006; physical
counting shows that 150 units were on hand at end of
the period.
Date Item Units Total Cost
September-10, 2006 Beginning inventory 100 Units at Birr 20 Birr 2,000
September-16, 2006 Purchase 80 Units at Birr 21 1,680
September-20, 2006 Purchase 100 Units at Birr 22 2,200
Total 280 Units Birr 5,880

Required: Determine Cost of Goods Sold and Cost of

Ending Inventory, using FIFO and Average cost
methods. by: Ashenafi G. 24
 Example-7
Assume the following information for Techno
Company; those 16 units of the item in the physical
inventory at December-31, 2007 reveals on hand
Date Explanation Units Total Cost
January-1, 2007 Beginning Inventory 6 Units at Birr 50 Birr 300
March-20, 2007 Purchase 14 Units at Birr 55 770
October-30, 2007 Purchase 20 Units at Birr 62 1,240
Total 40 Units Birr 2,310

Required: Determine Cost of Goods Sold and Cost of

Ending Inventory, using FIFO and Average cost
methods.
by: Ashenafi G. 25
 Example-8
Assume three identical units of Item WH4 are purchased
during June, 2008 by Jaffe Company as shown below:

Date Explanation Units Total Cost

June-3, 2008 Purchase 1 Unit at Birr 30 Birr 30

June-13, 2008 Purchase 1 Unit at Birr 36 36

June-23, 2008 Purchase 1 Unit at Birr 42 Birr 42

Total 3 Units Birr 108

Required: Determine Cost of Goods Sold and Cost of

Ending Inventory, using FIFO and Average cost methods;
if one unit is sold on June-23, 2008 for Birr 53, on June-
30, 2008.
by: Ashenafi G. 26
 Inventory Costing Method Under Perpetual
System
• In a perpetual inventory system, all merchandise
increases and decreases are recorded in a manner
similar to recording increases and decreases in
cash.
• The merchandise inventory account at the
beginning of an accounting period indicates the
merchandise in stock on that date.
• Purchases are recorded by debiting Merchandise
Inventory and crediting Cash or Accounts Payable.
by: Ashenafi G. 27
 Inventory Costing…
• On the date of each sale, the cost of the
merchandise sold is recorded by debiting Cost of
Merchandise Sold and crediting Merchandise
Inventory.

• Like the periodic inventory system, a cost flow

assumption must be made when identical units
are acquired at different unit costs during a
period. In such cases, the FIFO, or Average
method is used.
by: Ashenafi G. 28
 Example-9
Assume the following information for XYZ merchandise
Company for the month of January, 2009:
Date Items Units Unit Costs
January-1, 2009 Beginning inventory 20 Units Birr 20
January-4, 2009 Sales 14 Units 30
January-10, 2009 Purchase 16 Units 12
January-22, 2009 Sales 8 Units 20
January-28, 2009 Sales 4 Units 16
January-30, 2009 Purchase 20 Units Birr 22

Required: Determine Cost of Goods Sold and Cost of

Ending Inventory, using FIFO and Average cost
methods. by: Ashenafi G. 29
 Example-10
Assume the following information for XYZ
Merchandise Company for the month of November,
2010:
Date Items Units
November-1, 2010 Beginning inventory 40 Units at Birr 5
November-5, 2010 Sales 32 Units at Birr 8
November-11, 2010 Purchase 60 Units at Birr 7
November-21, 2010 Sales 45 Units at Birr 9

Required: Determine Cost of Goods Sold and Cost of

Ending Inventory using FIFO and Average cost
methods.
by: Ashenafi G. 30
 Example-11
Assume information regarding the beginning
inventory, purchases, and sales for Item CJ10 for
Yardstick Company for the period of April 2011 are
as follows:
Date Item Units
April-1, 2011 Beginning inventory 300 Units at Birr 70
April-8, 2011 Sales 185 Units at Birr 80
April-15, 2011 Purchase 25 Units at Birr 72
April-24, 2011 Sales 135 Units at Birr 85

Required: Determine Cost of Goods Sold and Cost of

Ending Inventory, using FIFO and Average cost
methods. by: Ashenafi G. 31
 Example-12
Assume the following information for FDF
Merchandise Company for the year of 2012:
Date Items Units Unit Costs
January-1, 2012 Beginning inventory 1,000 Units Birr 50
March-10, 2012 Purchase 1,200 Units 52.5
June-25, 2012 Sales 800 Units 60
August-30, 2012 Purchase 800 Units 55
Octeber-5, 2012 Sales 1,500 Units 65
November-26, 2012 Purchase 2,000 Units 58
Deemberc-31, 2012 Sales 1,000 Units 66.5

Required: Determine Cost of Goods Sold and Cost of

Ending Inventory, using FIFO and Average methods.
by: Ashenafi G. 32
 Quiz
a. True/ False
1. Any errors in the inventory count will affect only
the income statement.
2. A preventive control is designed to detect errors
or misstatements that already occurred.
3. Misstatement of owner’s equity will never be
equal the misstatement of the ending inventory,
current assets, and total assets.

by: Ashenafi G. 33
1. One of the following is not true about inventory, which one is it?
A. Inventory is any asset item held for sale in the ordinary course of
business.
B. Inventory is only merchandise held for resale purpose in the
normal operation of business.
C. Materials in the process of production or held for production
D. The known and the only inventories are raw materials used in the
manufacturing companies.
2. The following are not reasons that inventory errors may occur
except
E. Physical inventory on hand was counted correctly.
F. Costs were correctly assigned to inventory.
G. Inventory in transit was incorrectly included or excluded from
inventory.
H. Consigned inventory was correctly included or excluded from
inventory. by: Ashenafi G. 34
 Workout
1. Assume ABC Company incorrectly counted its
December 31, 2002, inventory as Birr 250,000
instead of the correct amount of Birr 220,000.
What should be the effect of the misstatement
on ABC’s December 31, 2002, balance sheet and
income statement for the year ended December
31, 2002?

by: Ashenafi G. 35
 Inventory Valuation Methods
• Goods sold (used) during an accounting period
seldom correspond exactly to the goods bought
(produced) during that period.

• As a result, inventories either increase or decrease

during the period.

• Companies must then allocate the cost of all the

goods available for sale (use) between the goods
that were sold or used and those that are still on
hand. by: Ashenafi G. 36
 Inventory Valuation …
• The cost of goods available for sale or use is the sum of:
(1) the cost of the goods on hand at the beginning of the period,
and
(2) the cost of the goods acquired or produced during the period.
• The cost of goods sold is the difference between:
(1) the cost of goods available for sale during the period, and
(2) the cost of goods on hand at the end of the period. The
following table shows these calculations
Beginning Inventory ---------------------------------- XX
Add: Cost of Goods Purchased (Produced) ------------ XX
Cost of Goods Available for Sale ------------------- XXX
Less: Ending Inventory --------------------------------------- XX
Cost of Goods Sold ------------------------------------
by: Ashenafi G.
XXX 37
 Inventory Valuation …
• Cost is the primary basis for valuing inventories.
In some cases, however, inventory is valued at
other than cost. Two such cases arise when;
(A)The cost of replacing items in inventory is below
the recorded cost and
(B) The inventory is not salable at normal sales prices
and this case may be due to imperfections, shop
wear, style changes, or other causes. Thus,
inventory can be valued

by: Ashenafi G. 38
1. Net Realizable Value: 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 difference
between estimated selling price in the normal
course of business and estimated costs to
complete and estimated costs to make a sale.
• NRV is the estimated selling price less any direct
cost of disposals such as sales commissions.
by: Ashenafi G. 39
2. 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.

by: Ashenafi G. 40
 2. Lower-of-Cost-or …
• A company abandons the historical cost principle
when the future utility (revenue-producing ability)
of the asset drops below its original cost.

• Cost and replacement cost can be determined for

(1) each item in the inventory
(2) major classes or categories of inventory and
(3) the inventory as a whole.

by: Ashenafi G. 41
 Example-13:
Assume that ABC Company’s damaged merchandise
costing Birr 1,000 can be sold for only Birr 800 during
July-10, 2013, and direct selling expenses are
estimated to be Birr 150. What should be the value
of inventory, using NRV?
Value of Inventory Using NRV
NRV = estimated selling price - cost of disposals
Estimated sales price of inventory----- Birr 800
Less: Estimated direct selling expenses ------ (150)
Net Realizable Value ----------------------- Birr 650
by: Ashenafi G. 42
 Example-14

• Assume ABC Company’s damaged merchandise

costing Birr 1,500 can be sold for only Birr 1,250 as
of August-21, 2014, and direct selling expenses are
estimated to be Birr 175. What should be the
accurate value of the inventory?

by: Ashenafi G. 43
 Example-15
Assume the following data of inventory of ABC
Company on May-31, 2015.
Inventory Items (A) Cost NRV
X Birr 750,000 Birr 700,000
Y Birr 180,000 Birr 190,000
Inventory Items (B) Cost NRV
W Birr 100,000 Birr 112,000
Z Birr 96,000 Birr 87,000

Required: What should be the accurate value of the

inventory, using lower of cost or net realizable value
(LCNRV) method; under (1) each item in the inventory;
(2) major classes or categories of inventory; and (3) the
by: Ashenafi G. 44
 Solution: Inventory Valuation Based on LCNRV Under 3
Sections
Inventory Value by LCNRV
Inventory Cost NRV Individual Major Total
Items (A) Items Groups Inventory
X Birr 750,000 Birr 700,000 Birr 700,000
Y Birr 180,000 Birr 190,000 Birr 180,000
Total Items (A) Birr 930,000 Birr 890,000 Birr 890,000

Inventory
Items (B)
W Birr 100,000 Birr 112,000 Birr 100,000
Z Birr 96,000 Birr 87,000 Birr 87,000
Total Items (B) Birr 196,000 Birr 199,000 Birr 196,000
Total Items Birr 1,126,000 Birr Birr Birr Birr
(A&B) 1,089,000 1,067,000 1,086,000 1,089,000

by: Ashenafi G. 45
 Estimating Methods of Inventory Costs
• A business may need to estimate the amount of inventory
for the following reasons:
(1) Perpetual inventory records are not maintained;
(2) a disaster such as a fire or flood has destroyed the
inventory records and the inventory; and
(3) monthly or quarterly financial statements are needed, but
a physical inventory is taken only once a year.
• It may be necessary for a business to know the amount of
inventory when perpetual inventory records are not
maintained and it is impractical to take a physical inventory.
• There are methods of estimating inventory that;
(1) gross profit method, and
(2) retail method. by: Ashenafi G. 46
 Estimating Methods of …
(1) Gross Profit Method: Companies take a physical inventory
to verify the accuracy of the perpetual inventory records or,
if no records exist, to arrive at an inventory amount.
• Sometimes, however, taking a physical inventory is
impractical. In such cases, companies use substitute
measures to approximate inventory on hand.
• The gross profit method relies on three assumptions:
A. The beginning inventory plus purchases equal total goods to
be accounted for.
B. Goods not sold must be on hand.
C. The sales, reduced to cost, deducted from the sum of the
opening inventory plus purchases, equal ending inventory.
by: Ashenafi G. 47
 Estimating Methods of …
• The gross profit method is applied as follows:

(1) Determine the merchandise available for sale at cost;

(2) Determine the estimated gross profit by multiplying
the net sales by the gross profit percentage;
(3) Determine the estimated cost of merchandise sold by
deducting the estimated gross profit from the net
sales; and
(4) Estimate the ending inventory cost by deducting the
estimated cost of merchandise sold from the
merchandise available for sale. The formula should
be as follow:
by: Ashenafi G. 48
 Estimating Methods of …
1. Merchandise Available for Sale at Cost = Beginning
Inventory (at Cost) + Purchases (at Cost)

2. Estimated Gross Profit = Estimated Gross Profit

Percent X Net Sales

3. Estimated Cost of Merchandise Sold = Net Sales -

Estimated Gross Profit

4. Estimate the ending inventory cost = Merchandise

available for sale at cost - Estimated
by: Ashenafi G. CGS 49
 Example -16

Assume that Central Company has a beginning

inventory of Birr 60,000 and purchases of Birr
200,000, both at cost on December-31, 2016. Sales at
selling price amount to Birr 280,000. The gross profit
on selling price is 30 percent. What should be the
cost of ending inventory; using gross profit method?

by: Ashenafi G. 50
Solution: Determining Estimated Ending
Inventory Cost
Beginning inventory (at cost) Birr 60,000

Add: Purchases (at cost) 200,000

Goods available (at cost) Birr 260,000

Sales (at selling price) Birr 280,000

Less: Gross profit (30% X 280,000) (84,000)

Less: Sales (at cost) (Birr 196,000)

Approximate inventory (at cost) Birr 64,000

by: Ashenafi G. 51
 Example-17
• Assume the merchandise inventory of XYZ
Company was destroyed by fire on October-20,
2017 and the following data were obtained from
the accounting records; and based on the following
data determine the estimated cost of ending
inventory:
Date Items Amounts
January-1, 2017 Merchandise Inventory Birr 160,000

January-1, 2017 - October- Purchase (net) Birr 850,000

20, 2017
January-1, 2017 - October- Sales (net) Birr 1,080,000
20, 2017
Estimated Gross Profit 36%
by: Ashenafi G. 52
 Solution: Determining Estimated
Ending Inventory Cost
Beginning Merchandise Inventory Birr 160,000

Add: Purchase (net) Birr 850,000

Merchandise Available for Sale Birr 1,010,000

Less: CGS (Birr 1,080,000 X 64%) (Birr 691,200)

Estimated Ending Merchandise Inventory Birr 318,800

by: Ashenafi G. 53
 Example-18
Assume the merchandise inventory of Yoon
Company was destroyed by earth quake on June- 27,
2018 and the following data were obtained from the
accounting records; and based on the data
determine the estimated ending inventory cost;
using gross profit method;
Date Items Amounts
January-1, 2018 Merchandise Inventory Birr 57,000
January-1, 2018 – June-27, 2018 Purchase (net) Birr 180,000
January-1, 2018 – June-27, 2018 Sales (net) Birr 250,000
Estimated Gross Profit 30%

by: Ashenafi G. 54
 (2) Retail Method
• The retail inventory method of estimating inventory cost requires
costs and retail prices to be maintained for the merchandise
available for sale.
• A ratio of cost to retail price is then used to convert ending
inventory at retail to estimate the ending inventory cost.
• The retail inventory method is applied as follows;
(1) Step-1: Determine the total merchandise available for sale at cost
and retail.
(2) Step-2: Determine the ratio of the cost to retail of the
merchandise available for sale.
(3) Step-3: Determine the ending inventory at retail by deducting the
net sales from the merchandise available for sale at retail. (
(4) Step-4: Estimate the ending inventory cost by multiplying the
ending inventory at retail byby:the cost to retail ratio.
Ashenafi G. 55
1) Merchandise available for sale = Beginning
inventory + Purchases (net)
2) Cost to Retail Ratio = Merchandise available for
sale at cost/at retail
3) Ending inventory at retail = Merchandise available
for sale at retail – Sales (net)
4) Ending inventory at cost = Cost to Retail Ratio X
Ending inventory at Retail

by: Ashenafi G. 56
 THE
END!!
by: Ashenafi G. 57