UNIT ONE

INVENTORIES

1.1 INTRODUCTION

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. In a merchandising
company, inventory consists of many different items. For example, in a grocery
store, canned goods, dairy products, meats, and produce are just a few of the
inventory items on hand. These items have two common characteristics:

1. They are owned by the company

2. They are in a form ready for sale to customers in the ordinary course of business.

Thus, merchandisers need only one inventory classification, merchandise inventory, to describe
the many different items that make up the total inventory.

In a manufacturing company, some inventory may not yet be ready for sale. As a result,
manufacturers usually classify inventory into three categories: finished goods, work in process,
and raw materials.

A. Finished goods inventory is manufactured items that are completed and ready for sale.
B. Work in process is that portion of manufactured inventory that has been placed
into the production process but is not yet complete.
C. Raw materials are the basic goods that will be used in production but have not yet been
placed into production.

1.2 IMPORTANCE OF INVENTORIES

Merchandise purchased and sold is the most active elements in merchandising business, i.e. in
wholesale and retail type of businesses. This is due to the following reasons:

1. The sale of merchandise is the principal source of revenue for them.

2. The cost of merchandise sold is the largest deductions from sales.
3. Inventories (ending inventories) are the largest of the current assets or those firms.

Because of the above reasons inventories, have effects on the current and the following
period’s financial statements. If inventories are misstated (understated of overstated), the
financial statements will be distorted.
1.3 THE EFFECTS OF INVENTORIES ON CURRENT AND FOLLOWING
PERIOD’S FINANCIAL STATEMENTS.

By using the following illustration, let us examine the effects of inventories on current and
following period’s financial statements.

Illustration – 1

The following amounts were reported in Belay Company’s

Company’s financial statements for three
consecutive fiscal year ended December 31.

In making the physical counts of inventory, the following errors were made:

 Inventory on December 31,2000, under stated by Br. 12,000

 Inventory on December 31, 2001, overstated by Br. 6000

Required:
Determine the correct amount of the items listed above.

Effect of ending inventory on current period’s financial statements

1. Income statement
A. Cost of goods (merchandise) sold =Beginning inventory + Net purchase –
Ending inventory
Therefore, there is 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.
The over/understatement of the ending inventory can be done in the following
way:
 B. Gross Profit = Net sales – Cost of merchandise sold
Here, the cost of merchandise sold had indirect relationship to gross profit. So, the
effect of ending inventory on gross profit is the opposite of the effect on cost of
merchandise sold.
C. Net income = Gross Profit – Operating Expenses(including tax and interest
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, i.e. direct
(positive) effect (relationship).

2. Balance Sheet
A. 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).
Since current assets are part of total assets, ending inventory has direct
relationship to total assets.
 B. Owners’ equity- If the effect comes from the previous year, the beginning
inventory will not have an effect on ending owners‟‟ equity since the positive or
negative effect of the previous year will be netted off by the negative or positive
effect of the current year. But if the error is made in the current period, it will
have indirect effect on ending owners‟ equity.

Effect of ending inventory on the following period’s financial statements

By referring the above solutions for the given questions, you can understand that tthe ending
inventory of the current period will become the beginning inventory for the followin
following period. So,
it will have the same effect as beginning inventory of the current period.

A. Income statement of the following period

Cost of merchandise sold direct relationship

Gross profit indirect relationship

Net income indirect relationship

B. Balance sheet of the following period

The ending inventory of the current period will not have an effect on the following period’
period’s
balance sheet items.

1.4 INVENTORY SYSTEMS: PERIODIC VS PERPETUAL

1. PERIODIC SYSTEM
 There is no continuous record of merchandise inventory account. The inventory bbalance
remains the same throughout
through the accounting period, i.e. the beginning inventory balance.
 A company determines the quantity of inventory on hand only periodically
 The company records all acquisitions of o inventory during the accounting period by
debiting the Purchases account.
 No entry is made for the cost of goods sold during sales. The he cost of goods sold is a
residual amount that depends on a physical count of ending inventory. This process is
referred to as “taking a physical inventory.”
  Companies that use the periodic system take a physical inventory at least once a year.
 Freight-in is debited to purchases.
 The periodic inventory system is less costly to maintain than the perpetual inventory
system, but it gives management less information about the current status of merchandise.
 It is often used by retail enterprises that sell many kinds of low unit cost merchandise
such as groceries, drugstores, hardware etc.

The journal entries to be prepared are (Periodic Inventory System):

1. At the time of purchase of merchandise:

Purchases XX at cost

Accounts payable or cash XX

2. At the time of sale of merchandise:

Accounts receivable or cash XX at retail price

Sales XX

3. To record purchase returns and allowance:

Accounts payable or cash XX

Purchase returns and allowance XX

4. To record adjusting entry or closing entry for merchandise inventory:

Income Summary XX

Merchandise inventory (beginning) XX

To close beginning inventory

Merchandise inventory (ending) XX

Income summary XX

To record ending inventory

2. PERPETUAL SYSTEM
 A company records all purchases and sales (issues) of goods directly in the Inventory
account as they occur.
 Purchases of merchandise for resale or raw materials for production are debited to
Inventory rather than to Purchases.
 Freight-in is debited to Inventory, not Purchases.
  There are no purchases and purchase returns and allowances accounts in this system.
Purchase returns and allowances and purchase discounts are credited to Inventory rather
than to separate accounts.
 Cost of goods sold is recorded at the time of each sale by debiting Cost of Goods
Sold and crediting Inventory.
 A subsidiary ledger of individual inventory records is maintained as a control measure.
The subsidiary records show the quantity and cost of each type of inventory on hand.
 Companies that sell items of high unit value, such as appliances or automobiles, tended to
use the perpetual inventory system.

Journal entries to be prepared are (Perpetual Inventory System):

1. At the time of purchase of merchandise

Merchandise inventory XX at cost

Accounts payable/cash XX

To record cost of goods sold

2. At the time of sale of merchandise

Accounts receivable or cash XX at retail price

Sales XX

To record cost of goods sold

To record the sales

Cost of goods sold XX

Merchandise inventory XX at cost

To record the cost of merchandise sold

3. To record purchase returns and allowances

Accounts payable or cash XX

Merchandise inventory XX

4. No adjusting entry or closing entry for merchandise inventory is needed at the end of
each accounting period.
 Illustration – 2

In its beginning inventory on Jan 1, 2020, Nile Company had 100 units of merchandise that cost
Br. 6 Per unit. The following transactions were completed during 2020.

February 5 Purchased on credit 500 units of merchandise at Br. 6 per unit.

9 Returned 50 detective units from February 5 purchases to the supplier.

June 15 Purchased for cash 400 units of merchandise at Br 8 per unit.

September 6 Sold 600 units of merchandise for cash at a price of Br. 12 per unit. These

goods are: 100 units from the beginning inventory, 450 units for February

Purchases, and 50 units from June purchase.

December 31 There was no sales or purchase transaction after the September 6 sales.

Required: Prepare general journal entries for Nile Company to record the above transactions and
adjusting or closing entry for merchandise inventory on December 31,

a) Periodic inventory system

b) Perpetual inventory system

Periodic inventory system Perpetual inventory system

Feb. 5 Feb. 5
Purchase……………………..…….3000 Merchandise Inventory……………….3000
Accounts payable …………….……3000 Accounts payable …...…………..……3000

Feb. 9 Feb. 9
Accounts payable……….300 Accounts payable……………………..300
Purchase return & allowance………300 Merchandise Inventory ………………300
June 15 June 15
Purchase……………………..…….3200 Merchandise Inventory …………….3200
Cash ……………..………….……3200 Cash ……………..……………..……3200
Sept. 6 Sept. 6
Cash……………………..…….7200 Cash……………………..………...7200
Sales ……………..………….……7200 Sales ……………..…………….……7200
Cost of goods sold……………….....3700
Merchandise Inventory ………………3700
Dec. 31 Dec. 31
Income summary…………………………600
Merchandise inventory (beginning)…..…600 No entry is needed

Merchandise inventor (ending)…….....2800

Income summary………………………2800

Assume that at the end of the reporting period, the perpetual inventory account reported an
inventory balance of $4,000. However, a physical count indicates inventory of $3,800 is actually
on hand. This time there should be an adjusting entry. The entry to record the necessary write-
down is as follows:

Inventory Over and Short……………………..…200

Inventory………………………………………200

The physical count of inventory is needed under both inventory systems. Under periodic
inventory system, it is needed to determine the cost of inventory and goods sold.
The inventory account under perpetual inventory systems is always up to date. Yet events
can occur where the inventory account balance is different from inventory on hand. Such
events include theft, loss, damage, and errors. The physical count is used to adjust the inventory
account balance to the actual inventory on hand. We determine a birr (dollar) amount for
physical count of inventory on hand at the end of a period by:

1. Counting the units of each product on hand

2. Multiplying the count for each product by its cost per unit
3. Adding the cost for all products.

At the time of taking an inventory, all the merchandise owned by the business on the
inventory date, and only such merchandise, should be included in the inventory.

1.5 DETERMINING OWNERSHIP OF GOODS

Goods in Transit

A complication in determining ownership is goods in transit (on board a truck, train, ship, or
plane) at the end of the period. The company may have purchased goods that have not yet been
received, or it may have sold goods that have not yet been delivered. To arrive at an accurate
count, the company must determine ownership of these goods.
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 the sale.

A. When the terms are FOB (free on board) shipping point, ownership of the goods
passes to the buyer when the public carrier accepts the goods from the seller.
B. When the terms are FOB destination, ownership of the goods remains with
the seller until the goods reach the buyer.

If goods in transit at the statement date are ignored, inventory quantities may be seriously
miscounted. Assume, for example, that H Company has 20,000 units of inventory on hand on
December 31. It also has the following goods in transit:

I. Sales of 1,500 units shipped December 31 FOB destination.

II. Purchases of 2,500 units shipped FOB shipping point by the seller on December 31.

H Company has legal title to both the 1,500 units sold and the 2,500 units purchased. If the
company ignores the units in transit, it would understate inventory quantities by 4,000 units
(1,500 1 2,500).

Consigned goods

In some lines of business, it is common to hold the goods of other parties and try to sell the
goods for them for a fee, but without taking ownership of the goods. These are called consigned
goods.

For example, you might have a used car that you would like to sell. If you take the item to a
dealer, the dealer might be willing to put the car on its lot and charge you a commission if it is
sold. Under this agreement, the dealer would not take ownership of the car, which would still
belong to you. Therefore, if an inventory count were taken, the car would not be included in the
dealer’s inventory.

Special Sales Agreements

As we indicated earlier, transfer of legal title is the general guideline used to determine
whether a company should include an item in inventory. Unfortunately, transfer of legal title and
the underlying substance of the transaction often do not match. For example, legal title may have
passed to the purchaser, but the seller of the goods retains the risks of ownership. Conversely,
transfer of legal title may not occur, but the economic substance of the transaction is such that
the seller no longer retains the risks of ownership.

Two special sales situations are illustrated here to indicate the types of problems companies
encounter in practice:

I. Sales with buyback agreement.

II. Sales with high rates of return
 I. Sales with Buyback Agreement

Sometimes an enterprise finances its inventory without reporting either the liability or
the inventory on its balance sheet. This approach, often referred to as a product financing
arrangement, usually involves a “sale” with either an implicit or explicit “buyback”
agreement.

II. Sales with High Rates of Return

In industries such as publishing, music, toys, and sporting goods, formal or informal agreements
often exist that permit purchasers to return inventory for a full or partial refund.

1.6 DETERMINING THE COST OF INVENTORY

Inventory Costing Methods under Periodic Inventory System

There are three methods commonly used in assigning costs to inventory and cost of
merchandise sold. These are:

 Specific identification
 First-in first-out (FIFO)
 Weighted average

Illustration: 3
Beza Company began the year and purchased merchandise as follows:
Jan-1 Beginning inventory 80 units@ Br. 60 = Br. 4,800
Feb. 16 Purchase 400 units@ 56 = 22,400
Sep.2 Purchase 160 units @ 50 = 8,000
Nov. 26 Purchase 320 units@ 46 = 14,720
Dec. 4 Purchase 240 units@ 40 = 9,600
Total

The ending inventory consists of 300 units, 100 from each of the last three purchases.

2.2.1 Specific Identification Method

When each item in inventory can be directly identified with a specific purchase and its invoice, we can
use specific identification (also called specific invoice pricing) to assign costs. This method is appropriate
when the variety of merchandise carried in stock is small and the volume of sales is relatively small. We
can specifically identify the items sold and the items on hand.
Example
From the above illustration, the ending inventory consists of 300 units, 100 from each of the last
purchases. So, the items on hand are specifically known from which purchases they are:

Cost of ending inventories under specific identification method

Br. 40 x 100= Br. 4,000
Br. 46 x 100= 4,600
Br. 50 x 100= 5,000

 Cost of Ending inventory cost = Br. 13,600

 The cost of merchandise sold = Cost of goods available for sale - Ending inventory
= Br. 59,520 – Br. 13,600
= Br. 45,920

2.2.2 First-in, First-out (FIFO)

This method of assigning cost to inventory and the goods sold assumes inventory items are sold in the
order acquired. This means the cost flow is in the order in which the expenditures were made. So, to
determine the cost of ending inventory, we have to start from the most recent purchase and continue to
the next recent. Because the first purchased items (old purchases) are the first to be sold they are used
(included) in the computation of cost of goods sold.

For example, easily spoiled goods such as fruits, vegetables etc., must be sold near the time of their
acquisition. So, the inventory on hand will be from the recent purchases. As an example, consider the
previous illustration on page 21.

The cost of ending inventory under FIFO method

= Br. 40 x 240 Br. 9,600
= Br. 46 x 60 2,760
300 units Br. 12,360
 Cost of Ending inventory Br. 12,360
 Cost of merchandise sold = Br. 59,520 – Br. 12,360
Br. 47,160
Weighted Average Method

This method of assigning cost requires computing the average cost per unit of merchandise
available for sale. That means the cost flow is an average of the expenditures. To calculate the
cost of ending inventory, we will calculate first the cost per unit of goods available for sale
Average cost per unit = Cost of goods available for sale

Total units available for sale

Weighted average unit cost = Br. 59,520 = Br. 49.60

1,200

Ending inventory cost = Br. 49.60x 300

= Br. 14,880

Cost of merchandise sold = Br. 59,520-Br. 14,880

= Br. 44,640

Inventory Costing Methods under Perpetual Inventory System

Illustration: 4

Item Units Cost

Jan. 1 inventory 1,000 $20.00
4 sale at $30 per unit 700
10 Purchase 500 22.40
22 sale at $30 per unit 360
28 sale at $30 per unit 240
30 Purchase 600 23.30

First-in, First-out (FIFO)

1. The beginning balance on January 1 is $20,000 (1,000 units at a unit cost of $20).
2. On January 4, 700 units were sold at a price of $30 each for sales of $21,000 (700 units
×$30). The cost of merchandise sold is $14,000 (700 units at a unit cost of $20). After the
sale, there remains $6,000 of inventory (300 units at a unit cost of $20).
3. On January 10, $11,200 is purchased (500 units at a unit cost of $22.40). After the
purchase, the inventory is reported on two lines, $6,000 (300 units at a unit cost of
$20.00) from the beginning inventory and $11,200 (500 units at a unit cost of $22.40)
from the January 10 purchase.
4. On January 22, 360 units are sold at a price of $30 each for sales of $10,800 (360 units
× $30). Using FIFO, the cost of merchandise sold of $7,344 consists of $6,000 (300 units
at a unit cost of $20.00) from the beginning inventory plus $1,344 (60 units at a unit cost
 of $22.40) from the January 10 purchase. After the the sale, there remains $9,856 of
inventory (440 units at a unit cost of $22.40) from the January 10 purchase.
5. The January 28 salee and January 30 purchase are recorded in a similar manner.
6. The ending balance on January 31 is $18,460. This balance is made up of two layers
of inventory as follows:

Weighted Average Method (moving

moving average)
average

When the weighted average cost method is used in a perpetual inventory system, a
weighted average unit cost for each item is computed each time a purchase is made.
This unit cost is used to determine the cost of each sale until another another purchase is
made and a new average is computed. This technique is called a moving average.

1. The beginning balance on January 1 is $20,000 (1,000 units at a unit cost of $20).
2. On January 4, 700 units were sold at a price of $30
$30 each for sales of $21,000 (700 units ×
$30). The cost of merchandise sold is $14,000 (700 units at a unit cost of $20.00). After
the sale, there remains $6,000 of inventory (300 units at a unit cost of $20.00).
3. On January 10, $11,200 is purchased (500 units at a unit cost of $22.40). After the
purchase, the weighted average unit cost of $21.50 is determined by dividing the total
cost of the inventory on hand of $17,200 ($6,000 + $11,200) by the total quantity of
inventory on hand of 800 (300 + 500) units. Thus, after the purchase, the inventory
consists of 800 units at $21.50 per unit for a total cost of $17,200.
 4. On January 22, 360 units are sold at a price of $30 each for sales of $10,800 (360 units ×
$30). Using weighted average, the cost of merchandise sold is $7,740 (360 units × $21.50
per unit). After the sale, there remains $9,460 of inventory (440 units × $21.50 per unit).
5. The January 28 sale and January 30 purchase are recorded in a similar manner.
6. The ending balance on January 31 is $18,280 (800 units × $22.85 per unit).

1.7 ADDITIONAL VALUATION PROBLEMS FOR INVENTORIES

Valuation at Lower of Cost or Net Realizable Value (LC-NRV)

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 market 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.
Companies therefore report inventories at the lower-of-cost-or-market at each reporting
period.

The lower-of-cost-or-market method can be applied in one of three ways. The

cost, market price, and any declines could be determined for the following:

1. Each item in the inventory.

2. Each major class or category of inventory.
3. Total inventory as a whole.
Illustration: 5

The following are the inventory of ABC motor sports, retailer.

Inventory units per unit

Items on hand cost market

Cycles:

Roadster 50 Br. 15,000 Br. 14,000

Sprint 20 9,000 9,500

Off Road:

Trax-4 10 10,000 11,200

Blaz’m 6 16,000 14,500

Solution

Inventory items Total cost Total market LCM

Roadster Br. 750,000 Br. 700,000 Br. 700,000

Sprint 180,000 190,000 180,000

Categories sub total Br. 930,000 Br. 890,000

Trax-4 100,000 112,000 100,000

Blaz‟m 96,000 87,000 87,000

Categories sub total Br. 196,000 Br. 199,000

Totals Br.1,126,000 Br. 1,089,000 Br. 1,1,067,000

(Separately to each

individual item)

Totals Br. 1,126,000 Br. 1089,000 Br. 1,086,000

(Major categories

of items)

Totals (whole of inventory) Br. 1,089,000

 1.8 ESTIMATING INVENTORY COST

In practice, an inventory amount is estimated for some purposes, especially when it is impossible
to take a physical inventory or to maintain perpetual inventory records.

Retail Method of Inventory Costing

The estimate is made based on the relationship between the cost and the retail price of
merchandise available for sale.

The steps to be followed are:

1. Calculate the cost to retail ratio = Cost of merchandise available for sale

Retail Price of merchandise available for sale

2. Calculate the ending inventory at retail price

Ending inventory at retail price = retail price of merchandise available for sale – Sales
3. Calculate the estimated cost of ending inventory
Estimated cost of ending inventory = Cost to retail ration X Ending inventory at retail

Illustration: 6

Cost Retail

Sep. 1, beginning inventory Br. 25,000 Br. 40,000

Purchases in September (net) 125,000 160,000

Sales in September (net) 140,000

(1) Cost retail ration = Br. 25,000 + Br. 125,000 = 0.75

Br. 40,000 + Br. 160,000

(2) Ending inventory at retail = (Br. 40,000 + Br. 160,000) – Br. 140,000 = Br. 60,000

(3) Estimated ending inventory at cost = 0.75 X Br. 60,000

= Br. 45,000
Gross profit method

This method uses an estimate of the gross profit realized during the period to estimate the cost of
inventory. The gross profit rate may be estimated based on the average of previous period’s gross
profit rates.

The steps are as follows:

1. The gross profit rate is estimated and then estimated gross profit is calculated.

Estimated gross profit = Gross profit rate X Sales

2. Cost of merchandise sold is estimated

Estimated cost of merchandise sold = Sales - Estimated gross profit

3. Calculate the estimated cost of ending inventory

Estimated cost of ending inventory =

Cost of merchandise available for sale – Estimated cost of merchandise sold.

Illustration: 7

Oct. 1, beginning inventory (cost) – Br. 36,000

Net purchases during October (cost) 204,000

Net sales during October 220,000

Estimated gross profit rate is 40%

The ending inventory is estimated as follows:

(1) Estimated gross profit = 0.4 X 220,000

= Br. 88,000

(2) Estimated cost of merchandise sold= Br. 220,000 – Br. 88,000

= Br. 132,000

(3) Estimated cost of ending inventory= (Br. 36,000 + 204,000) – Br. 132,000

= Br. 240,000 – Br. 132,000

= Br. 108,000