CHAPTER FOUR

ACCOUNTING FOR
INVENTORY
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 Classifying and Determining Inventory

Classifying Inventory

Merchandising Manufacturing
Company Company

One Classification: Three Classifications:

 Inventory  Raw Materials
 Work in Process
Regardless of the classification,  Finished Goods
companies report all inventories
under Current Assets on the
statement of financial position.

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 Inventory System
A perpetual inventory system maintains a continuous record
of inventory changes in the Inventory account. That is, a
company records all purchases and sales (issues) of goods
directly in the Inventory account as they occur.

A periodic inventory system, companies determine the

quantity of inventory on hand only periodically. A company
debits a Purchases account, but the Inventory account remains
the same. It determines cost of goods sold at the end of the
period by subtracting ending inventory from cost of goods
available for sale. A company ascertains ending inventory by
physical count.

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 Determining Inventory Quantities

Physical Inventory taken for two reasons:

Perpetual System
1. Check accuracy of inventory records.
2. Determine amount of inventory lost due to wasted raw
materials, shoplifting, or employee theft.

Periodic System
3. Determine the inventory on hand.
4. Determine the cost of goods sold for the period.

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 Determining Inventory Quantities

TAKING A PHYSICAL INVENTORY

Involves counting, weighing, or measuring each kind of inventory

on hand.

Companies often “take inventory”

 when the business is closed or business is slow.
 at the end of the accounting period.

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 Determining Inventory Quantities

DETERMINING OWNERSHIP OF GOODS

1. GOODS IN TRANSIT
 Purchased goods not yet received.

 Sold goods not yet delivered.

Goods in transit should be included in the inventory

of the company that has legal title to the goods.
Legal title is determined by the terms of sale.

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 DETERMINING OWNERSHIP OF GOODS

GOODS IN TRANSIT Illustration 2

Terms of sale

Ownership of the goods

passes to the buyer when the
public carrier accepts the
goods from the seller.

Ownership of the goods

remains with the seller until the
goods reach the buyer.

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 Determining Ownership of Goods

2. CONSIGNED GOODS
Consignment; 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.
Sometimes a company arranges for another company to sell its
product under consignment. The goods are physically transferred to
the other company (the consignee), but the transferor (consignor)
retains legal title. If the consignee can’t find a buyer, the goods are
returned to the consignor. If a buyer is found, the consignee remits the
selling price (less commission and approved expenses) to the
consignor.

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 > Exercise DO IT!
Deng Yaping Company completed its inventory count. It arrived at a total inventory
value of 200,000. You have been given the information listed below. Discuss how this
information affects the reported cost of inventory.
1. Deng included inventory goods held on consignment for Falls Co.,costing 15,000.
2. The company did not include in the count purchased goods of 10,000, which
were in transit (terms: FOB shipping point).
3. The company did not include in the count inventory that had been sold with a
cost of 12,000, which was in transit (terms: FOB shipping point).

Solution
1. Goods of 15,000 held on consignment should be deducted from the inventory
count.
2. The goods of 10,000 purchased FOB shipping point should be added to the
inventory count.
3. Item 3 was treated correctly. Inventory should be 195,000
(200,000 - 15,000 + 10,000).
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 SALES RETURNS
Recall that when the right of return exists, a seller must be able
to estimate those returns before revenue can be recognized.

The adjusting entry for estimated sales returns includes a debit

to sales returns and a credit to refund liability. At the same time,
cost of goods sold is reduced and an estimate of inventory to be
returned is made.

As a result, a company includes in ending inventory the cost of

merchandise sold that it anticipates will be returned.
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 Costs of unloading, unpacking, and preparing merchandise inventory for sale or raw
materials inventory for use also part of costs.
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 Classifying and Determining Inventory

Inventory is accounted for at cost.

 Cost includes all expenditures necessary to acquire
goods and place them in a condition ready for sale.
 Unit costs are applied to quantities to compute the total
cost of the inventory and the cost of goods sold using the
following costing methods:
► Specific identification
► First-in, first-out (FIFO) Cost Flow
Assumptions
► Average-cost

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 Specific Identification

• At first thought one might argue that each item of inventory should
be identified with its actual cost and that the total of these amounts
should constitute the inventory value.

• For each unit sold during the period or each unit on hand at the
end of the period to be matched with its actual cost.

• It is used frequently by companies selling unique, expensive

products with low sales volume which makes it relatively easy and
economically feasible to associate each item with its actual cost.

• It may be undesirable from a theoretical point of view.

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 Specific Identification

Actual physical flow costing method in which items still in

inventory are specifically costed to arrive at the total cost of the
ending inventory.

Specific identification the cost flow matches the physical flow of the goods.

Some argue that specific identification allows a company to manipulate net

income.

 Practice is relatively rare.

 Most companies make assumptions (cost flow assumptions)

about which units were sold.
 IFRS indicates specific identification is the preferred inventory
16 method, unless it is impracticable to use.
 Specific Identification

If Carik sold the TVs it purchased on February 3 and May 22,

then its cost of goods sold is £1,500 (£700 + £800), and its
ending inventory is £750.

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 Cost Flow Assumptions

There are two assumed cost flow methods:

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

2. Average-cost

3. Last in First Out (LIFO)

Cost flow does not need be consistent with the physical

movement of the goods.

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 Cost Flow Assumptions

1. FIRST-IN, FIRST-OUT (FIFO)

 Costs of the earliest goods purchased are the first to be
recognized in determining cost of goods sold.

 Often parallels actual physical flow of merchandise.

 Companies obtain the cost of the ending inventory by taking the

unit cost of the most recent purchase and working backward until
all units of inventory have been costed.
 In all cases where FIFO is used, the inventory and cost of goods
sold would be the same at the end of the month whether a perpetual
or periodic system is used.

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 Example

Data for Lin Electronics’ Astro condensers.

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

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 FIRST-IN, FIRST-OUT (FIFO)

• HELPFUL HINT
Another way of thinking about
the calculation of FIFO ending
inventory is the LISH
assumption—last in still here.

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 Cost Flow Assumptions

2. AVERAGE-COST
 Allocates cost of goods available for sale (CGAFS) on the
basis of weighted-average unit cost incurred.

 Applies weighted-average unit cost to the units on hand to

determine cost of the ending inventory.

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 AVERAGE-COST

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 AVERAGE-COST

Illustration 11

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 > DO IT!
The accounting records of Shumway Ag Implement show the following.
Beginning inventory 4,000 units at £ 3
Purchases 6,000 units at £ 4
Sales 7,000 units at £12
Determine the cost of goods sold during the period under a periodic
inventory system using (a) the FIFO method and (b) the average-cost
method.
Solution
Cost of goods available for sale = (4,000 × £3) + (6,000 × £4) = £36,000
Ending inventory = 10,000 − 7,000 = 3,000 units
(a) FIFO: £36,000 − (3,000 × £4) = £24,000
(b) Average cost per unit: [(4,000 × £3) + (6,000 × £4)] ÷ 10,000 = £3.60
Average-cost: £36,000 − (3,000 × £3.60) = £25,200
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 Financial Statement and Tax Effects of
Cost Flow Methods

Either of the two cost flow assumptions is acceptable for use.

For example,
 adidas (DEU) and Lenovo (CHN) use the average-cost
method, whereas
 Syngenta Group (CHE) and Nokia (FIN) use FIFO.

A recent survey of IFRS companies, approximately

► 60% use the average-cost method,
► 40% use FIFO, and
► 23% use both for different parts of their inventory.
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 INCOME STATEMENT EFFECTS

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 STATEMENT OF FINANCIAL POSITION
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.

 A major shortcoming of the average-cost method is

that in a period of inflation, the costs allocated to
ending inventory may be understated in terms of
current cost.

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 TAX EFFECTS

 Both inventory and net income are higher when

companies use FIFO in a period of inflation.

 Average-cost results in the lower income taxes

(because of lower net income) during times of
rising prices.

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 Using Cost Flow Methods Consistently

 Method should be used consistently,

enhances comparability.

 Although consistency is preferred, a

company may change its inventory costing
method.

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 Lower-of-Cost-or-Net Realizable Value

Cost is usually the most appropriate basis for valuation of

inventory. Nevertheless, the inventory may be valued at
Lower-of-Cost-or-Net Realizable Value When the value of
inventory is lower than its cost
 companies must “write down” the inventory to its net
realizable value.

Net realizable value: Amount that a company expects to

realize (receive from the sale of inventory).

NRV is the estimated selling price in the normal course of

business, less estimated costs to complete and sell.
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 Lower-of-Cost-or-Net Realizable Value

Illustration: Assume that Gao TV has the following lines of

merchandise with costs and market values as indicated.

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 Illustration; assume that ABC Corporation has unfinished
inventory with a sales value of Br. 1,000, estimated cost of
completion of Br. 300. NRV can be determined as follows.
Inventory—sales value………………………… Br. 1,000
Less: Estimated cost of completion …….…… 300
Net realizable value……………………...……… 700

A company estimates NRV based on the most reliable

evidence of the inventories’ realizable amounts
(expected selling price, expected costs of completion,
and expected costs to sell).
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 To illustrate, ABC Restaurant computes its inventory at LCNRV.
Food Cost NRV 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.
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LCNRV can be applied for:
1. Each individual items
2. Major groups
3. Total items

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
37 canned 185,000 164,000 164,000
Recording Net Realizable Value Instead of Cost

• Two methods may be used to record the income effect of valuing

inventory at NRV.

• First method, referred to as the CGS method, debits CGS for the
write-down of the inventory to NRV. As a result, the company does
not report a loss in the POLS because the CGS 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 NRV.

Assume that the following data is for XYZ Company.

Cost of goods sold (before adjustment to NRV) 108,000

Ending inventory (@ Cost) 82,000
Ending inventory (@ NRV) 70,000
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 The following illustration shows the NRV evaluation for ABC Company and the
effect of NRV adjustments on income.

Inventory at Inventory at Amount Required in Adjustment of Effect on

Date Cost NRV Allowance Account Allowance Account Net Income
Balance
Dec. 31, 2017 188,000 176,000 12,000 12,000 Increase. Decrease
Dec. 31, 2018 194,000 187,000 7,000 5,000 Decrease. Increase
Dec. 31, 2019 173,000 174,000 0 7,000 Decrease. Increase
Dec. 31, 2020 182,000 180,000 2,000 2,000 Increase. Decrease

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 Inventory Errors

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

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 Income Statement Effects

Inventory errors affect the computation of cost of goods

sold and net income in two periods.

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 Income Statement Effects

 Inventory errors affect the computation of CGS and NI in

two periods.
 An error in ending inventory of the current period will have
a reverse effect on NI of the next accounting period.
 Over the two years, the total NI is correct because the
errors offset each other.
 Ending inventory depends entirely on the accuracy of
taking and costing the inventory.

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 Example; Income Statement Effects
2016 2017
Incorrect Correct Incorrect Correct
Sales € 80,000 € 80,000 € 90,000 € 90,000
Beginning inventory 20,000 20,000 12,000 15,000
Cost of goods purchased 40,000 40,000 68,000 68,000
Cost of goods available 60,000 60,000 80,000 83,000
Ending inventory 12,000 15,000 23,000 23,000
Cost of good sold 48,000 45,000 57,000 60,000
Gross profit 32,000 35,000 33,000 30,000
Operating expenses 10,000 10,000 20,000 20,000
Net income € 22,000 € 25,000 € 13,000 € 10,000

Combined income for (€3,000) €3,000

2-year period is correct Net income Net income
understated overstated
(Offset each other).
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 Statement of Financial Position Effects

Effect of inventory errors on the statement of financial position

is determined by using the basic accounting equation:
Assets = Liabilities + Equity.
Errors in the ending inventory have the following effects.

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 Statement Presentation

Presentation
Statement of Financial Position - Inventory classified as
current asset.

Income Statement - Cost of goods sold is subtracted from

sales.

There also should be disclosure of the

1) major inventory classifications,

2) basis of accounting (cost or LCNRV), and

3) costing method (specific identification, FIFO, or average-

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cost).
 Estimating Inventories

Gross Profit Method

Estimates the cost of ending inventory by applying a gross profit rate

to net sales.

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 Gross Profit Method
Illustration: Kishwaukee Company’s records for January show net sales of
$200,000, beginning inventory $40,000, and cost of goods purchased $120,000.
The company expects to earn a 30% gross profit rate. Compute the estimated
cost of the ending inventory at January 31 under the gross profit method.

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 Retail Inventory Method

Company applies the cost-to-retail percentage to ending inventory at

retail prices to determine inventory at cost.

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 Retail Inventory Method
Illustration:

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

cost of goods on hand at any given time.

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 Retail Inventory Method with Markups and Markdowns

 Original selling price: The price at which goods originally are offered for sale.

 Markup: The original or initial margin between the selling price and cost. It is also referred
to as gross margin or mark-on.

 Additional Markup: An increase above the original selling price

 Markup cancellation: a reduction in the selling price after there has been an additional
markup. The reduction dose not reduces the selling price below the original selling price.
Additional markups less markup cancellation are referred to as net markups.

 Mark down: a reduction in selling price bellow original selling price.

 Markdown cancellation: an increase in the selling price, following the new selling price
above the original selling price. Mark down less markdown cancellation is referred to as

net markdowns. Neither a markup cancellation nor a markdown cancellation can exceed
the original markup or markdown.

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Retail Inventory Method with Markups and Markdowns
 Retailers use markup and markdown concepts in developing the proper
inventory valuation at the end of the accounting period.
 To obtain the appropriate inventory figures, companies must give proper
treatment to markups, markup cancellations, markdowns, and markdown
cancellations.
There are two approaches to calculate cost ratio
a. A cost ratio can be computed after markups and markup cancellations but before
markdowns.
b. A cost ratio after both markups and markdowns (and cancellations).
Consider the following example for Sunshine company
Cost Retail
Beginning inventory € 500 € 1,000
Purchases (net) 20,000 35,000
Markups 3,000
Markup cancellations 1,000
Markdowns 2,500
Markdown cancellations 2,000
Sales (net) 25,000
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 Cost Retail
Beginning inventory € 500 € 1,000
Purchases (net) 20,000 35,000
Merchandise available for sale 20,500 36,000
Add: Markups €3,000
Less: Markup cancellations 1,000
Net markups 2,000
20,500 38,000
€20,500
(A) Cost-to-retail ratio = = 53.9%
€38,000

Deduct:
Markdowns 2,500
Less: Markdown cancellations (2,000)
Net markdowns 500
€20,500 37,500
€20,500
(B) Cost-to-retail ratio = = 54.7%
€37,500

Deduct: Sales (net) 25,000

Ending inventory, at retail €12,500

Ending inventory at cost = (Ending inventory at retail)*(Cost to retail ratio)

Approach A: 12,500*0.539= 6,737.5

53 Approach B: 12,500*0.547= 6,837.5

Cont’d…
The retail inventory method becomes more complicated when we
consider such items as freight-in, purchase returns and allowances,
and purchase discounts. In the retail method, we treat such items as
follows.
 Freight costs are part of the purchase cost.
 Purchase returns are ordinarily considered as a reduction of the
price at both cost and retail.
 Purchase discounts and allowances usually are considered as a
reduction of the cost of purchases.
 Transfers-in from another department are reported in the same way
as purchases from an outside enterprise.
 Normal shortages (breakage, damage, theft, shrinkage) should
reduce the retail column because these goods are no longer
available for sale.
 Abnormal shortages, are deducted from both the cost and retail
columns and reported as a special inventory amount or as a loss.
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 Example

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Exercise -1:
Corporation has the following four items in its ending inventory.

Item Cost NRV

Jokers €2,000 €2,100
Penguins 5,000 4,950
Riddlers 4,400 4,625
Scarecrows 3,200 3,830

Determine;
A. the LCNRV for each item, and
B. the amount of write-down, if any, using
I. an item-by item LCNRV evaluation and
II. a total-group LCNRV evaluation.
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 Exercise -2:
Assume that KMK Corp. has a beginning inventory of €60,000 and
purchases of €200,000, both at cost. Sales at selling price amount to
€280,000. The gross profit on selling price is 30 percent. KMK
applies the gross profit method to estimate ending inventory at cost.

Required: how much is the estimated ending inventory?

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Exercise -3: The information related to Luzon Company.
Cost Retail
Beginning inventory $ 58,000 $100,000
Purchases (net) 122,000 200,000
Net markups 20,000
Net markdowns 30,000
Sales 186,000

Instructions
A. Compute the ending inventory at retail.
B. Compute a cost-to-retail percentage (round to two
decimals) under the following conditions.
C. Excluding both markups and markdowns.
D. Excluding markups but including markdowns.
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 End of chapter-4

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