Addis Ababa University, College of Business and Economics, Department of Accounting & Finance

PRINCIPLES OF ACCOUNTING II
Chapter 1
Accounting for Merchandising Inventories

Inventories are:
▪ Assets held for sale in the ordinary course of business,
▪ In the process of production for such sale or
▪ In the form of material or supplies to be consumed:
✓ In the production process, or
✓ In the rendering of services.

1.1 INVENTORIES
Merchandise Inventory is items or commodities held for resale to customers in the ordinary course of the
business.
In Merchandising Enterprise,
These items have two common characteristics:
1. They are owned or consigned by the company, and
2. They are in a form ready for sale to customers.
In Manufacturing Enterprise,
Are classified in to three:
1. Finished Goods Inventory: consists of completed products ready for sale. This inventory is
similar to merchandise inventory.
2. Work In Process (Goods in process): consists of products in the process of being
manufactured but not yet completed.
3. Raw Materials Inventory: refers to the goods a company acquires to use in making
products.
• In this course we will focus on the accounting principles and concepts of merchandise inventory.

1.2 INVENTORY SYSTEMS

There are two inventory accounting systems used to collect information about cost of goods sold and cost of
inventory on hand. The 2 systems are called Periodic & Perpetual.

1.2.1 Periodic Inventory System

A periodic inventory system requires updating the inventory account only at the end of a period to
reflect the quantity and cost of both goods on hand and goods sold. It does not require continual
updating of the inventory account. The company records the cost of new merchandise in a
temporary purchases account.

When merchandise is sold, revenue is recorded but the cost of the merchandise sold is not yet
recorded as a cost. When financial statements are prepared, the company takes a physical count of
inventory by counting the quantities of merchandise on hand, at the end of the period. Cost of
merchandise on hand is determined by relating the quantities on hand to records showing each
item’s original cost. The cost of merchandise on hand is then used to compute cost of goods sold.
The inventory account is adjusted to reflect the amount computed from the physical count of
inventory.

Periodic systems were historically used by companies such as hardware, drug, and department
stores that sold large quantities of low-value items. Without today’s computers and scanners, it was
not feasible for accounting systems to track such small items as pencils, toothpaste, paper clips,
socks, and Toothpicks through inventory and into customers’ hands.

1.2.2 Perpetual Inventory System

A perpetual inventory system keeps a continual record of the amount of inventory on hand. A
perpetual system accumulates the net cost of merchandise purchases in the inventory account and
subtracts the cost of each sale from the same inventory account. When an item is sold, its cost is
recorded in a Cost of Goods Sold account.

With a perpetual system we can find out the cost of merchandise on hand at any time by looking at
the balance of the inventory account. We can also find out the current balance of cost of goods sold
anytime during a period by looking in the Cost of Goods Sold account.

Under a perpetual system, the cost of each item is debited to the Merchandise Inventory account
when purchased. At the time of sale, the cost of each item is transferred from the Merchandise
inventory account to the Cost of Goods sold account. Thus, the Cost of Goods Sold account at all
times equals the cost of merchandise sold during the period, and the Merchandise inventory account
at all times equals the cost of merchandise on hand.
 1.3 MERCHANDIZE INVENTORY QUANTITIES AND COSTS

1.3.1 Determining Inventory Quantities

In order to prepare financial statement, it is necessary to determine the number of units of inventory
owned by the company at the statement date. For many companies, determining inventory
quantities consists of two steps; (1) taking a physical inventory of goods on hand, and (2)
determining the ownership of goods.
1.3.1.1 Taking a Physical Inventory
Taking a physical inventory involves actually counting, weighing, or measuring each kind of
inventory on hand.

To minimize errors in taking the inventory, a company should adhere to the following Internal
Control Principles by adopting certain procedures:
1. The counting should be done by employees who do not have custodial responsibility for the
inventory. (Segregation of Duties)
2. Each counter should establish the authenticity/accuracy of each inventory item, e.g., each box
does contain a 25-inch television set and each storage tank does contain gasoline.
(Establishment of Responsibility)
3. There should be a second count by another employee. (Independent Internal Verification)
4. Pre numbered inventory tags should be used, and all inventory tags should be accounted for.
(Documentation Procedures)

1.3.1.2 Determining Ownership of Goods

Before we can begin to calculate the cost of inventory, we need to consider the ownership of goods:
specifically, we need to be sure that we have not included in the inventory any goods that do not
belong to the company.

✓ Goods In Transit
Goods are considered to be in transit when they are in the hands of a public carrier, such as a
railroad, trucking, or airline company at the statement date. Goods in transit should be included in
the inventory of the party that has legal title to the goods.

Legal title is determined by the terms of sale, as shown below:

1. 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.
2. When the terms are FOB Destination, legal title to the goods remains with the seller until the
goods reach the buyer.

Significant errors may occur in determining inventory quantities if goods in transit at the statement
date are ignored.
Assume, for example, that Hargrove Company has 20,000 units of inventory on hand on
December 31 and the following goods in transit:
(1) Sales of 1,500 units shipped December 31 FOB destination, and
(2) Purchases of 2,500 units shipped FOB shipping point by the seller on December 31.
Hargrove has legal title to both the units sold and the units purchased.
Consequently, inventory quantities would be understated by 4,000 units (1,500 +
2,500) if units in transit are ignored.

✓ Consigned Goods
In some lines of business, it is customary to acquire merchandise on consignment. Under a
consignment arrangement, the holder of the goods (called the consignee) does not own the goods.
Ownership remains with the shipper of the goods (called the consignor) until the goods are actually
sold to a customer. Because consigned goods are not owned by the consignee, they should not be
included in the consignee’s physical inventory count. Conversely, the consignor should include
merchandise held by the consignee as part of its inventory.

Why are inventories and their valuation important?

• Inventories are the largest deduction for merchandizing business: In merchandising business
merchandise will be continuously purchased and soled; this is the case for most whole sale and
retail business.
While determining the income for the period, the cost of merchandises sold will constitute the highest
deduction form revenue. In most cases the cost merchandizing is the largest amount from all other expenses.
• Inventories provide the principal (largest) revenue or profit for whole or retail business.
 • Substantial part of merchandising business resource is invested in inventories.
Determination of inventory cost plays an important role in matching expired costs with the corresponding
revenue of the period. Further more the determination of the cost of inventory will also affect the amount that
is reported in the asset as inventory in the balance sheet.
• An error in identifying the value of inventory at the end of a period will cause an equal
misstatement in gross profit and also in the net income.
• Furthermore the amount reported as inventory in the asset of the balance sheet and also the
owners’ equity in the capital section of the balance sheet will also be misstated by the same
magnitude assuming no other error.
Example: Assume that the correct ending inventory is Br 20,000.00 but let us assume that in assumption
number 01 we have misstated the ending inventory as 25,000.00 while in assumption number 02 we have
misstated the ending inventory as 15,000.00. And let us see now the effect of the misstatement in the balance
sheet and income statement items,
The correct ending inventory
Beginning inventory Br 18,000.00 Beginning owner’s equity
44,000.00
Add Purchase 190,000.00 Add Additional investment
0.00
Available for sale 208,000.00 Net income
6,000.00
Less Ending inventory 20,000.00 Less Withdrawal 0.00
Cost of goods sold 188,000.00 Ending owner’s equity 50,000.00
Income statement Balance sheet
Net sales Br 200,000.00 Merchandise inventory 20,000.00
Less Cost of goods sold 188,000.00 other asset
60,000.00
Gross Profit 12,000.00 Total Assets
80,000.00
Expenses 6,000.00
Net Income 6,000.00 Liabilities
30,000.00
Owners equity 50,000.00
Total Liability + Capital 80,000.00
The ending inventory incorrectly determined as 25,000.00
Beginning inventory Br 18,000.00 Beginning owner’s equity
44,000.00
Add Purchase 190,000.00 Add Additional investment
0.00
Available for sale 208,000.00 Net income 11,000.00
Less Ending inventory 25,000.00 Less Withdrawal 0.00
Cost of goods sold 183,000.00 Ending owner’s equity 55,000.00
Income statement Balance sheet
Net sales Br 200,000.00 Merchandise inventory 25,000.00
Less Cost of goods sold 183,000.00 other asset
60,000.00
Gross Profit 17,000.00 Total Assets
85,000.00
Expenses (6,000.00)
Net Income 11,000.00 Liabilities 30,000.00
Owners equity 55,000.00
Total Liability + Capital 85,000.00
The ending inventory incorrectly determined as 15,000.00
Beginning inventory Br 18,000.00 Beginning owner’s equity
44,000.00
Add Purchase 190,000.00 Add Additional investment
0.00
Available for sale 208,000.00 Net income
1,000.00
 Less Ending inventory 15,000.00 Less Withdrawal 0.00
Cost of goods sold 193,000.00 Ending owner’s equity
45,000.00
Income statement Balance sheet
Net sales Br 200,000.00 Merchandise inventory 15,000.00
Less Cost of goods sold 193,000.00 other asset
60,000.00
Gross Profit 7,000.00 Total Assets
75,000.00
Expenses (6,000.00)
Net Income 1,000.00 Liabilities
30,000.00
Owners equity 45,000.00
Total Liability + Capital 75,000.00
The misstatement in identifying the ending inventory will have the following effect:
• Understatement in identifying the ending inventory will result in overstatement of the cost of
good sold, in turn the overstatement of cost of good sold will understate the gross profit, as a
result the net income of the period will be understated by the same amount.
• The understatement of the period net income will result in understatement of the owner’s equity
for the period.
• The understated ending inventory for these period will the beginning inventory for the next period
which still are understated. The understatement of beginning inventory in the subsequent period
will understate the cost of good sold for the period.
• The understated cost of goods in the subsequent period will overstate the period’s net income.
• The overstated net income will in turn over state the period’s owner’s equity which was
understated in the previous period; thus the understated owner’s equity in the previous period
will be compensated by the overstated owner’s equity of this period.
Thus the amount of misstatement will be equal in two subsequent periods but of opposite direction, therefore,
these two misstatements will cancel each other, these means if the effect in the net income of an incorrectly
stated inventory is not corrected, it is limited only to the period of the error and the following period.

1.4 INVENTORY COSTING

With a reliable physical count of the inventory (considering both goods in transit and consigned
goods), we are now ready to assign costs to the inventory.

1.4.1 Determining Inventoriable Cost

All expenditures necessary to acquire the goods and to make them ready for sale are included as
inventoriable costs. Inventoriable costs may be regarded as a pool of costs that consists of two
elements:
(1) The cost of the beginning inventory, and
(2) The cost of goods purchased during the year.

The sum of these two elements equals the cost of goods available for sale. The individual items
included in cost of goods purchased are shown below

Item Account Title Effect on Inventoriable Cost

Invoice Price Purchases Increase

Freight Charges Paid by Purchaser Freight-in Increase
Purchase Discounts Taken by Purchaser Purchase Discounts Decrease
Purchase Returns and Allowances Purchase Returns &
Allowance Granted Decrease
by the Seller
 1.4.2 Allocating Inventoriable Costs
➢ To illustrate, assume that General Suppliers Inc. has a cost of goods available for sale of
Br120,000, based on a beginning inventory of Br20,000 and cost of goods purchased of
Br100,000. The physical inventory indicates that 5,000 units are on hand. The costs
applicable to the units are Br3.00 per unit. The allocation of the pool of costs is shown
below. As shown, the Br120,000 of goods available for sale is allocated Br15,000 to ending
inventory and Br105,000 to cost of goods sold.
Pool of costs
Cost of Goods Available For Sale
Beginning Inventory Br 20,000
Cost of Goods Purchased 100,000
Cost of Goods Available For SaleBr120,000

Step 1 Step 2
Ending
Inventory Cost of Goods sold
Unit Total Cost of Goods available for
Units Cost Cost sale Br120,000
Less: Ending Inventory 15,000
5,000 Br3.00 Br15, 000 Cost of Goods sold Br105,000

1.5 ASSIGNING COSTS OF INVENTORY

1.5.1 Inventory Costing Methods under a Periodic inventory System

1.5.1.1 Using Actual Physical Flow Costing – Specific Identification

This method tracks the actual physical flow of the goods. Each item of inventory is marked,
tagged, or coded with its “specific’ unit cost. Items still in inventory at the end of the year are
specifically costed to arrive at the total cost of the ending inventory.
• Assume, for example, that Southland Music Company purchases three 46-inch television sets
at costs of Br700, Br750, and Br800, respectively. During the year, two sets are sold at Br1,
200 each. At December 31, the company determines that the Br750 set is still on hand.
Accordingly, the ending inventory is Br750 and the cost of goods sold is Br1, 500 (Br700 +
Br800).

Specific identification is possible when a company sells a limited variety of high-unit cost items
that can be clearly identified from the time of purchase through the time of sale. Examples of such
companies are automobile dealerships (cars, trucks, and vans), music stores (pianos and organs),
and antique shops (tables and cabinets). Under this method, the ending inventory is reported at
actual cost and the actual cost of goods sold is matched against sales revenue.
1.5.1.2 Using Assumed Cost Flow Methods
Because specific identification is often impractical, other cost flow methods are allowed. These
differ from specific identification in that they assume flows of costs that may be unrelated to the
physical flow of goods. For this reason we call them assumed cost flow methods or cost flow
assumptions. They are:
1. First-in, first-out (FIFO).
2. Average cost.
• To illustrate these inventory cost flow methods, we will assume that RIFT Valley Electronics
uses a periodic inventory system and has the information shown below for its Z202 Astor
condenser.
RIFT VALLEY ELECTRONICS
Z202 Astro Condensers

Date Explanation Units Unit Cost Total Cost

1/1 Beginning inventory 100 Br10 Br 1,000
4/15 Purchase 200 11
2,200
8/24 Purchase 300 12
3,600
11/27 Purchase 400 13
5,200
Total 1,000 Br12, 000
During the year, 550 units were sold and 450 units are on hand at December 31.
A. First-In, First-Out (FIFO)
The FIFO Method assumes that the earliest goods purchased are the first to be sold. FIFO often
parallels the actual physical flow of merchandise because it generally is good business practice to
sell the oldest units first. Under the FIFO method, therefore, the costs of the earliest good purchased
are the first to be recognized cost of goods sold. The allocation of the cost of goods available for
sale at RIFT Valley Electronics under FIFO is shown below:
Pool of costs
Cost of Goods
Available for
Sale
Unit Total
Date Explanation Units Cost Cost
Beginning
1/1 Inventory 100 Br 10 Br 1,000
4/15 Purchase 200 11 2,200
8/24 Purchase 300 12 3,600
11/27 Purchase 400 13 5,200
Total 1,000 Br 12,000
Step 1 Step 2
Ending
Inventory Cost of Goods sold
Unit Total
Unit
Date s Cost Cost
Cost of Goods Available
11/27400 Br13 Br 5,200 For Sale Br12,000
8/24 50 12 600 Less: Ending Inventory 5,800
Total 450 Br 5,800 Cost of Goods Sold Br 6,200
Note that the ending inventory is based on the latest units purchased. That is, the cost of the ending
inventory is obtained by taking the unit cost of the most recent purchase and working backward
until all units of inventory have been costed.
We can verify the accuracy of the cost of goods sold by recognizing that the first units acquired are
the first units sold. The computations for the 550 units sold are shown below:
Date Units Unit Cost
Total Cost
1/1 100 x Br10
= Br1,000
4/15 200 x 11
= 2,200
8/24 250 x 12 =
3,000
Total 550 =
Br 6,200
❖ Note that ending inventory of Br5,800 and the cost of goods sold of Br6,200 equals cost of
goods available for sale Br.12, 000

B. Average Cost
The average cost method assumes that the goods available for sale are homogeneous. Under this
method, the allocation of the cost of goods available for sale is made on the basis of the weighted
average unit cost incurred. The formula and sample computation of the weighted average unit cost
is:

÷ =

The weighted average unit cost is then applied to the units on hand to determine the cost of the
ending inventory. The allocation of the cost of goods available for sale at RIFT Valley Electronics
using average cost is shown below.

Pool of
 Costs
Cost of Goods Available For Sale
Unit Total
Date Explanation Units Cost Cost
Beginning
1/1 Inventory 100 Br 10 Br 1,000
4/15 Purchase 200 11 2,200
8/24 Purchase 300 12 3,600
11/27 Purchase 400 13 5,200
Total 1,000 Br 12,000
Step 1 Step 2
Ending
Inventory Cost of Goods sold
Cost of Goods Available For
Br12,000 ÷ 1,000 = Br12.00 Sale Br12,000
Unit- Total- Less: Ending Inventory 5,400
Units Cost Cost Cost of Goods Sold Br 6,600
Br5,40
450 XBr12.00 = 0
We can verify the cost of goods sold under this method by multiplying the units sold by the weighted average unit cost
(550 x Br12 = Br 6,600).
1.5.2 Inventory Costing Methods Under Perpetual
• To illustrate the application of the assumed cost flow method (FIFO) & Average Cost, we will use
the data shown below for module X 268l4 Econo Radios in the Glorious Company

Date Purchases Sale Balance in units

April 3 4,000@$8.00 4,000
April 10 12,000@$8.80 1 6,000
April 26 8,000 units 8,000
April 29 4,000@$8.30 12,000

1.5.2.1 Specification Identification Method:

The amount of costs assigned to inventory and cost of good sold is the same under perpetual and
periodic system when using specific identification. This is because specification identification
precisely defines which units are in inventory and which are sold.

1.5.2.2 Using Cost Flow Assumption:

A. First-In, First-Out (FIFO)

Under FIFO, the cost of earliest goods on hand prior to each sale is changed to cost of good sold.
Therefore, the cost of good sold on April 26 consists of the items purchased on April 3 and April
10. The inventory on a FIFO method Perpetual System is shown below:

Date Purchases Sales Balance

April 3 (4,000 @ $8.00) $32,000 (4,000 @8.00) $ 32,000

April 10 (12,000@ $8.80) $105,600 (4,000 @ 8.00)

(12,000@$8.80) $137,600
April 26 (4,000 @ $8.00)

(4,000 @ $8.80) = 67,200 (8,000 @ $ 8.80) $70,400

April 29 (4,000 @ $8.30) $ 33,200 (8,000 @ $ 8.80)
(4,000 @ $8.30) $103,600

▪ The ending inventory in this situation is $ 103,600 and the cost of good sold is $67,200
[(4,000 @$8.80)+( 4,000 @$8.00)].

For this particular example, the results under FIFO in a perpetual system are the same as in a
periodic system. Regardless of the system, the first cost in are the first assigned to cost of goods
sold.

B. Average Cost
The average cost method in perpetual inventory system is called the moving average method. Under
this method a new average is computed after each purchase. The average cost is computed by
dividing the cost of goods available for sale by the units on hand. The average cost is then applied
to:
(1) The units sold, to determine the cost of goods sold, and
(2) The remaining units on hand, to determine the ending inventory amount. The application of the
average cost method for Glorious Company is shown below:

Date Purchases Sales Balance

April 3 (4,000 @ $8.00) $ 32,000 (4,000 @ $ 8.00) $32,000
April; 10 (12,000 @ $ 8.80) $105,600 (16,000 @ $8.60) $137,600
April 26 (8,000 @ $ 8.60) (8,000 @ 8.60) $ 68,800
($68,800)
April 29 (4,000 @ $8.30) $ 33,200 (12,000 @ $8.50) $102,000

As indicated above, a new average is computed each time a purchase is made. On April 10, after
12,000 units are purchased for $105,600, a total unit of 16,000 for $ 137,600 is on hand. The
average unit cost is $137,600 divided by 16,000, or $8.60. Accordingly, the unit cost of the 8,000
units sold on April 26 is shown at $ 8.60, and the total cost of goods sold is $68,800. On April 29,
following the purchase of 4,000 units for $33,200, there are 12,000 unites in hand costing $102,000
($68,800+$33,200). The new average cost is $8.50 ($102,000 ÷12,000)

1.5.3 Other Methods of Valuing Inventory

Special circumstances sometimes call for inventory valuation methods other than those presented in
this section. For example, consider to following situations:

1.5.3.1 Valuing Inventory at the Lower of Cost or Market (LCM) – Generally Accepted
Accounting Principles (GAAP)
When the value of inventory is lower than its cost, the inventory is written down to its market
value. This is accomplished by valuing the inventory at the lower of cost or market (LCM) in the
period in which the price decline occurs. LCM is an example of the accounting concept of
conservatism. Conservatism means that when choosing among accounting alternatives, the best
choice is to select the method that is least likely to overstate assets and net income.

Under the LCM basis, market is defined as current replacement cost, not selling price. For a
merchandising company, market is the cost of purchasing the same goods at the present time from
the usual suppliers in the usual quantities. Current replacement cost is used because a decline in the
replacement cost of an item usually leads to a decline in the selling price of the item. The lower of
market basis may be applied to:
(1) Individual Items of Inventory,
(2) Major Categories of Inventory,
(3) Total Inventory.

For example, assume that Len’s TV has the following lines of merchandise with costs and market
values as indicated. LCM produces the following three results:

Lower of Cost or Market by:

Individual Major Total
Cost Market Items Categories Inventory
Television set
Consoles Br 60,000 Br 55,000 Br 55,000
Portables 45,000 52,000 45,000
Total 105,000 107,000 Br 105,000
Video Equipment
Recorders 48,000 45,000 45,000
Movies 15,000 14,000 14,000
Total 63,000 59,000 59,000
Total Inventory Br 168,000 Br166,000 Br159,000 Br 164,000 Br 166,000

The amount (Br. 159,000) entered in the individual items column is the lower of the cost or market
amount for each item. For the major categories column, the amount (Br. 164,000) is the lower of
 total cost or total market for each category. Finally, the amount (Br, 166,000) for the total inventory
column is the lower of the cost or marker for the entire inventory.

1.5.3.2 Valuation at Net Realizable Value (NRV) – International Financial Reporting

Standard (IFRS)
Obsolete, spoiled, or damaged merchandise and other merchandise that can be sold only at prices
below cost should be valued at net realizable value. For this purpose, net realizable value is the
estimated selling price less any direct cost of disposition, such as sales commissions.
To illustrate, assume that damaged merchandise that had a cost of Br1,000 can be sold for only
Br800, and direct selling expenses are estimated at Br150.
This inventory would be valued at Br 650 (Br800 - Br150), which is its net realizable value.

1.6 ESTIMATING INVENTORIES

We have assumed throughout the unit that a company would be able to do a physical count of its
inventory. But what if it cannot, as in the example of the lumber inventory destroyed by fire? In that
case, we would use an estimate.
Two circumstances explain the reasons for estimating rather than counting
inventories:
i. First, management may want monthly or quarterly financial statements (Interim F/S)
but a physical inventory is taken only annually.
ii. Second, a casualty such as fire, flood, or earthquake may make it impossible to take
a physical inventory. The need for estimating inventories is associated primarily with
a periodic inventory system because of the absence of detailed inventory records.

There are two widely used methods of estimating inventories:

(1) The Gross Profit Method and
(2) The Retail Inventory Method.
1.6.1 Gross Profit Method
The gross profit method estimates the cost of ending inventory by applying a gross profit rate to net
sales. It is used in preparing monthly financial statements when physical inventories are not taken.
This method is a relatively simple but effective estimation technique.
To use this method, a company needs to know:
o Its Net Sales,
o Cost of Goods Available for Sale, and
o Gross Profit Rate.
The company then uses the gross profit rate to estimate its gross profit for the accounting
period.
The formulas for using the gross profit method are given below:

Step - 1

Step - 2

➢ To illustrate, assume that Wesen Company wishes to prepare an income statement for the month of January,
when its records show net sales Br200,000; beginning inventory Br40,000; and cost of goods purchased
Br120,000. In the preceding year, the company realized a 30% gross profit rate, and it expects to earn the
same rate this year. Given these facts and assumptions, the estimated cost of the ending inventory at January
31, under the gross profit method is Br 20,000, computed as follows:
Step 1:
Net Sales Br200, 000
Less: Estimated gross profit (30% X Br 200,000) 60,000
Estimated cost of goods sold Br140, 000
 Step 2:
Beginning Inventory Br 40,000
Cost of Goods Purchased 120,000
Cost of Goods Available for Sale 160,000
Less: Estimated Cost of Goods Sold 140,000
Estimated Cost of Ending Inventory Br 20,000
1.6.2 Retail Inventory Method
A retail store has thousands of different types of inventory at low unit costs. In such cases the application of
units cost to inventory quantities is difficult and time-consuming. An alternative is to use the retail inventory
method to estimate the cost of inventory. In most retail concerns, a relationship between cost and sales price
can be established.
Under the retail inventory method, the cost to retail percentage is then applied to the ending inventory at
retail prices to determine inventory at cost.

To use the retail inventory method, a company must maintain records that show both the cost and retail
value of the goods available for sale. Under the retail inventory method, the estimated cost of the ending
inventory is derived from the formulas presented below:

Step - 1

Step - 2

Step- 3

-
3
♥ The logic of the retail method can be demonstrated by using unit cost data.

Illustration, the accounting recodes of Lucy company disclosed the following information’s:
Beginning inventory at cost Br.14,000, at retail Br.21,500; Cost of goods purchased at cost
Br.61,000, at retail Br.78,500; and Net sales Br.70,000.
At Cost At Retail
Beginning inventory Br14, 000 Br 21, 500
Goods purchased 61,000 78, 500
Goods available for sale Br 75, 000 100,000
Net sales 70,000
(1) Ending inventory at retail -------- Br 30,000

(2) Cost to retail ratio = (Br75, 000 ÷ Br100, 000) = 75%

(3) Estimated cost of ending inventory = (Br30, 000 x 75%) Br22, 500

1.7 COMPARISON OF INVENTORY COSTING METHOD

1.7.1 Financial Statement Effects of Cost Flow Methods

 1.7.1.1 Income Statement Effects
To understand why companies might choose a particular cost flow method, let’s examine the effects
of the different flow assumptions on the financial statements of RIFT Valley Electronics. The
condensed income statements in illustration bellow assume that RIFT Valley sold its 550 units for
Br11,500, its operating expenses were Br2,000, and its income tax rate is 30%.
FIFO Average cost
Sales Br 11,500 Br 11,500
Beginning Inventory 1,000 1,000
Purchases 11,000 11,000
Cost of Goods Available for Sale 12,000 12,000
Ending Inventory 5,800 5,400
Cost of Goods Sold 6,200 6,600
Gross Profit 5,300 4,900
Operating Expenses 2,000 2,000
Income Before Income Taxes 3,300 2,900
Income Tax Expense (30%) 990 870
Net Income Br 2,310 Br 2,030
♦ In a period of rising prices (inflation), FIFO reports the highest net income
♦ If prices are falling, FIFO will report the lowest net income
1.7.1.2 Balance Sheet Effects
A major advantage of the FIFO method is that in a period of inflation, the costs allocated to ending
inventory will approximate their current cost. The understatement becomes greater over prolonged
periods of inflation if the inventory includes goods purchased in one or more prior accounting
periods.
1.7.2 Tax Effects
We have seen that both inventory on the balance sheet and net income on the income statement are
higher when FIFO is used in a period of inflation.
1.7.3 Effect of the Misstatements/Error of Inventory on the Financial Statement
It is true that the inventory at the end of one period becomes the beginning inventory for the
succeeding period.
Thus, if the inventory is incorrectly stated at the end of a period;
1.7.3.1 Income Statement
i) Net income of the same period will be misstated by an equal amount in the same direction, (For
example in the above illustration, Ending Inventory is 5,800/more than the others and NI is 2,310
still more than the others)
ii) Net income of the next period will be misstated by an equal amount but in an opposite direction.
(Because, if for example the Ending Inventory is overstated in the first year, it understate the next
year NI)
1.7.3.2 Balance Sheet
Asset (Inventory) Accounts are misstated only in the period of the misstatement if there are no
other errors.(Since the misstatement is corrected in the next year by physical count)

ILLUSTRATION
Effect of the Misstatements/Error of Inventory on the F/S
CORRECT Year 1 Year 2
Beginning Inventory 10,000 40,000
Purchases 100,000 100,000
Cost of Goods Available for Sale110,000 140,000
Ending Inventory 40,000 55,000
Cost of Goods Sold 70,000 85,000
Sales 90,000 110,000
Gross Profit 20,000 25,000

OVERSTATED
Year 1 Year 2
Beginning Inventory 10,000 50,000
Purchases 100,000 100,000
Cost of Goods Available for Sale110,000 150,000
Ending Inventory 50,000 55,000
Cost of Goods Sold 60,000 95,000
Sales 90,000 110,000
Gross Profit 30,000 15,000
 UNDERSTATED
Year 1 Year 2
Beginning Inventory 10,000 35,000
Purchases 100,000 100,000
Cost of Goods Available for Sale110,000 135,000
Ending Inventory 35,000 55,000
Cost of Goods Sold 75,000 80,000
Sales 90,000 110,000
Gross Profit 15,000 30,000