Fundamentals of Accounting II

Chapter One
Inventories
 Definition and importance of internal control over inventories

 During the financial scandals of the early 2000s, stockholders,

creditors, and other investors lost billions of dollars.
 As a result, the United States Congress passed the Sarbanes-Oxley
Act of 2002.
 This act, often referred to as Sarbanes-Oxley, is one of the most
important laws affecting U.S. companies in recent history.
 The purpose of Sarbanes-Oxley is to restore public confidence and
trust in the financial reporting of companies.
 Sarbanes-Oxley applies only to companies whose stock is traded
on public exchanges, referred to as publicly held companies.
 However, Sarbanes-Oxley highlighted the importance of assessing
the financial controls and reporting of all companies.
 As a result, companies of all sizes have been influenced by
Sarbanes-Oxley.
 Sarbanes-Oxley emphasizes the importance of
effective internal control.
 Internal control is defined as the procedures and
processes used by a company to:
1. Safeguard its assets.
2. Process information accurately.
3. Ensure compliance with laws and regulations.
 Sarbanes-Oxley requires companies to
maintain effective internal controls over the
recording of transactions and the preparing of
financial statements.
 Such controls are important because they deter
fraud and prevent misleading financial
statements.
 Sarbanes-Oxley also requires companies and
their independent accountants to report on the
effectiveness of the company’s internal
controls.
 Inventory Definition

Inventories are assets:

 items held for sale in the ordinary course of business, or
 goods to be used in the production of goods to be sold.

Businesses with Inventory

Merchandising or Manufacturing
Company Company

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 Inventory Classification
i. Inventories of merchandising businesses are merchandise
purchased for resale in the normal course of business. These types of
inventories are called merchandise inventories.

ii. Inventories of manufacturing businesses are businesses that

produce physical output. They normally have three types of
inventories. These are:
 Raw material inventory:-Items purchased for use in
production.
 Work in process inventory:-Items on the production process.
 Finished goods inventory:-Items completed and waiting for
sale.
 Inventory Control

All companies need periodic verification of the inventory

records
 by actual count, weight, or measurement, with
 counts compared with detailed inventory records.

Companies should take the physical inventory

 near the end of their fiscal year,
 to properly report inventory quantities in their annual
accounting reports.

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Effect of Inventory Errors
Ending Inventory Misstated
 Ending inventory is the cost of merchandise on hand at the
end of the accounting period. Let us see its effect on current
period’s financial statements.
The effect of inventory misstatement on Income statement
 Cost of goods (merchandise) sold =Beginning inventory
+ Net purchase – Ending inventory
 As you can see from the above, if ending inventory is
understated, the cost of merchandise sold will be
overstated and then Gross profit and operating income will
be understated and the inverse is also true.
Contd.
The effect of inventory misstatement on Balance sheet
• 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, the total current assets will be
understated and then total assets will be understated
and the inverse is also true.
• Inventory misstatement has no effect on liabilities.
• Owners’ equity: The net income will be transferred to
the owners’ equity at the end of accounting period. So,
net income has direct relationship with owners’ equity. If
ending inventory is understated, the owners’ equity will
be understated and the inverse is also true.
What would be the effects of beginning
inventory on the current period’s financial
statements
 Beginning inventory is inventory balance that was left on hand in
the previous period and transferred to the current period. Its effect
on Income Statement is summarized below:
 Cost of merchandise sold= Beginning inventory + Net Purchases –
Ending inventory
 As you can see, beginning inventory is an addition in determining
cost of goods sold. It has direct effect on cost of merchandise sold.
If the beginning inventory is understated, the cost of merchandise
sold will be understated and gross profit and operation income will
be overstated.
 What would be the effects of beginning inventory on the current period’s financial
statements

 Generally, It has no effect on Balance sheet.

1. Current assets: The inventory included in current assets is

the ending inventory. So, beginning inventory has no effect
on current assets.
2. 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.
The effect of an error on net income in one year will be counterbalanced in the
next, however the income statement will be misstated for both years.
 Inventory systems: Two types of systems for maintaining
inventory records are perpetual system or periodic system.
Perpetual System
1. Purchases of merchandise are debited to Inventory.
2. Freight-in is debited to Inventory. Purchase returns and
allowances and purchase discounts are credited to
Inventory.
3. Cost of goods sold is debited and Inventory is credited for
each sale.
4. Subsidiary records show quantity and cost of each type of
inventory on hand.
5. Companies that sell items of high unit value, such as
appliances or automobiles use this method.
The perpetual inventory system provides a continuous record of
the balance in both the Inventory and Cost of Goods Sold accounts.

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 Inventory Cost Flow
Periodic System
1. Purchases of merchandise are debited to Purchases.

2. Ending Inventory determined by physical count.

3. Companies that sell high volumes of low value items used

this method.

4. Calculation of Cost of Goods Sold:

Beginning inventory $ 100,000

Purchases, net + 800,000
Goods available for sale 900,000
Ending inventory - 125,000
Cost of goods sold $ 775,000

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 Basic Issues in Inventory Valuation
Valuing inventories requires determining the
followings:
1. The physical goods to include in inventory:
Who owns the goods?
a. Goods in the company’s store.
b. Goods in transit under f.o.b. shipping point.
These items should be reported in the buyer’s
accounting book.
c. Consigned goods:- Goods that are given to a
business to sell, but for which title to the goods
remains with Consignor.
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Cont.
d. Special sales agreements a) Sales with
Repurchase Agreements (The transferor should report
the inventory and related liability on its books) b) Sales
with Rights of Return. If the seller is unable to
estimate the level of returns, it should not report any
revenue until the returns become predictive).
2. The costs to include in inventory (product vs.
period costs).
3. The cost flow assumption to adopt (specific
identification, average-cost, FIFO etc.).
 COSTS INCLUDED IN INVENTORY

Product Costs
Costs directly connected with bringing the goods to the buyer’s
place of business and converting such goods to a salable
condition.

Cost of purchase includes all of:

1. The purchase price.

2. Import duties and other taxes.

3. Transportation costs.

4. Handling costs directly related to the acquisition of the goods.

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 COSTS INCLUDED IN INVENTORY

Period Costs
Costs that are indirectly related to the acquisition or production
of goods.

Period costs such as

 selling expenses and distribution expenses and,
 general and administrative expenses are not included as
part of inventory cost.

Treatment of Purchase Discounts

IASB requires these discounts to be recorded as a reduction
from the cost of inventories.
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 WHICH COST FLOW ASSUMPTIONS TO
ADOPT?

Cost Flow Methods

 Specific Identification
 First-in, First-out (FIFO) or
 Last- in, First-out (LIFO): It is abandoned by IFRS
 Average (WAC) Cost

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 Cost Flow Methods Under periodic inventory
system
1. Specific Identification
 IASB requires in cases where inventories are not ordinarily
interchangeable or for goods and services produced or
segregated for specific projects.
Cost of ending inventory includes costs of the specific items
left on hand.
 Cost of goods sold includes costs of the specific items sold.
 Used when handling a relatively small number of costly,
easily distinguishable items.
 Matches actual costs against actual revenue.

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• To illustrate, assume that Beza’s 300 units of ending inventory
consists of 100 units from the Sep 2 purchase, 100 from the
Nov 26 purchase, and 100 from the Dec 4 purchase.
Illustration 1.1 shows how Beza computes the cost of ending
merchandise inventory and cost of goods sold under periodic
inventory systems.

illustration
Illustration:
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 1200 units Br.59, 520
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
300units Br. 13,600
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. Average-Cost
 Prices items in the inventory on the basis of the average
cost of all similar goods available during the period.
 This method is appropriate when the variety of
merchandise carried in stock is small and the volume of
sales is relatively small.
 To calculate the cost of ending inventory, we should
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

8-22
 To apply this method consider the previous illustration
1.1 except that the items left on hand (300 units) at the
end of the year are not specifically known from which
. purchase they are.

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

 Assumes goods are sold in the order in which they are

purchased.
 Used when identical units of an item are purchased at
different unit costs. This is true regardless of whether
the perpetual or periodic inventory system is used.
 Approximates the physical flow of goods.
 Ending inventory is close to current cost.
 Using FIFO, costs are included in the merchandise sold
in the order in which they were incurred.
 Fails to match current costs against current revenues
on the income statement.

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 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.

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
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 INVENTORY COSTING METHODS UNDER PERPETUAL
INVENTORY SYSTEM
Under perpetual inventory systems we will apply the inventory costing methods each time
sale of merchandise is made. We calculate the cost of goods (merchandise) sold and
inventory on hand at the time of each sale. This means the merchandise inventory account is
continually updated to reflect purchase and sales.
Illustration:
The beginning inventory, purchases and sales of Nesru Company for the month of January is
as follows: Units Cost
Jan. 1 Inventory 15 Br. 10.00
6 Sale 5
10 purchase 10 Br. 12.00
20 Sale 8
25 purchase 8 Br. 12.50
27 Sale 10
30 purchase 15 Br. 14.00
First-in-First-out Method-Perpetual
 The assignment of costs to goods sold and inventory using
FIFO is the same for both the perpetual and periodic
inventory systems, because each withdrawal of goods is
from the oldest stock on hand.
 The oldest is the same whether we use periodic inventory
system or perpetual inventory system.
 The cost of goods sold and cost of ending inventory under
perpetual inventory system from the above illustration is
determined as follows:
 Perpetual - FIFO
Date Purchase Cost of merchandise sold Inventory
Qty. Unit cost Total cost Qty Unit Total cost Qty Unit cost Total cost
cost
an. 1 15 Br. 10.00 Br. 150.00
6 5 Br.10.00 Br. 50.00 10 10.00 100.00
10 10.00 100.00
0
10 10 Br. 12.00 Br.120.00 10 12.00 120.00

20 8 10.00 80.00 2 10.00 20.00

10 12.00 120.00
2 10.00 20.00
25 8 12.50 100.00 10 12.00 120.00
8 12.50 100.00
27 2 10.00 20.00 2 12.00 24.00
8 12.00 96.00 8 12.50 100.00
2 12.00 24.00
0
30 15 14.00 210.00 8 12.50 100.00
15 14.00 210.00
23 Br. 246.00 25 Br. 334.00
 Cont.
So, the cost of merchandise sold and ending inventory under perpetual- FIFO method are Br.
246 and Br. 334 respectively.
Let us see them under periodic - FIFO method:
Units on hand = units available for sale – units sold
= (15 + 10 + 8 + 15) – (5+ 8 + 10)
= 48 - 23 = 25
Cost of ending inventory = Br. 14 x 15 = Br. 210
Br. 12.50 x 8 = 100
Br. 12 x 2 = 24
Br. 334
Cost of goods available for sale = Br. 150 +120 + Br. 100 + Br. 210 = Br. 580
Cost of goods sold = Br. 580 – Br. 334
Br 246
Weighted average inventory cost method-Perpetual

• Under this method, the average unit cost is calculated

each time purchase is made to be applied on the
sales made after the purchases. The results may be
different under periodic and perpetual inventory system.
 The cost of goods sold and cost of ending inventory
under perpetual inventory system from the above
illustration is determined as follows:
 Average Cost Method (Moving Average)
Purchase Cost of merchandise sold Inventory
Qty Unit cost Total cost Qty Unit cost Total cost Qty Unit cost Total cost

15 Br. 10.00 Br. 150.00

5 Br. 10.00 Br. 50.00 10 10.00 100.00

20 11.00 220.00
10 12.00 Br. 120.00 =
100+120
10+10
8 11.00 88.00 12 11.00 132.00
20 11.60 + 232.00
8 12.00 100.00 132+100
12+8

10 11.60 116.00 10 11.60 116.00

15 14.00 210.00 15 13.04 326.00
116+210
10+15
23 Br. 254.00 25 Br. 13.04 Br 326.00
 Cont.
So, the cost of goods sold and ending inventory under perpetual inventory system are Br.
254.00 and Br. 326.00, respectively.
The results under periodic inventory system are:
Weighted average unit cost = Br. 580 = Br. 12.08
48
Ending inventory cost = Br. 12.08 x 25
= Br. 302
Cost of merchandise sold = Br. 580 – Br. 302
= Br. 278
So, the result is different under periodic and perpetual inventory systems.
Reporting Merchandise Inventory in the
Financial Statements (Special inventory
costing methods)
 Cost is the primary basis for valuing and reporting
inventories in the financial statements.
 However, inventory may be valued at other than cost
in the following cases:
1. A company abandons the historical cost principle when
the future utility (revenue-producing ability) of the
asset drops below its original cost.
OR
2. The inventory cannot be sold at normal prices due to
imperfections, style changes, or other causes. In this case
the appropriate valuation method is LOWER-OF-COST-
OR-NET REALIZABLE VALUE (LCNRV)
 LCNRV

Net Realizable Value

Estimated selling price in the normal course of business less
 estimated costs to complete and
 estimated costs to make a sale. ILLUSTRATION 9-1
Computation of Net
Realizable Value

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 LCNRV ILLUSTRATION 9-3
Determining Final
Inventory Value

Illustration of LCNRV: Jinn-Feng Foods computes its

inventory at LCNRV (amounts in thousands).

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 LCNRV

Methods of Applying LCNRV ILLUSTRATION 9-4

Alternative Applications
of LCNRV

9-36
 LCNRV

Methods of Applying LCNRV

 In most situations, companies price inventory on an item-
by-item basis.
 Tax rules in some countries require that companies use an
individual-item basis.
 Method should be applied consistently from one period to
another.

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 Recording Net Realizable Value

Illustration: Data for Ricardo Company

Cost of goods sold (before adj. to NRV) Br. 108,000
Ending inventory (cost) 82,000
Ending inventory (at NRV) 70,000

Loss
Loss Loss Due to Decline to NRV 12,000
Method
Method Inventory (Br. 82,000 – Br. 70,000) 12,000

COGS
COGS Cost of Goods Sold 12,000
Method
Method Inventory 12,000

9-38
 LCNRV

Use of an Allowance account

Instead of crediting the Inventory account for net realizable
value adjustments, companies generally use an allowance
account.

Loss
Loss Method
Method

Loss Due to Decline to NRV 12,000

Allowance to Reduce Inventory to NRV
12,000

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 LCNRV

Recovery of Inventory Loss

 Amount of write-down is reversed.
 Reversal limited to amount of original write-down.

Continuing the Ricardo example, assume the net realizable

value increases to Br. 74,000 (an increase of Br. 4,000).
Ricardo makes the following entry, using the loss method.

Allowance to Reduce Inventory to NRV 4,000

Recovery of Inventory Loss 4,000

9-40
Estimating Inventory Cost (Additional
inventory valuation issues)
 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.

3. Monthly or quarterly financial statements are needed, but a

physical inventory is taken only once a year. To estimate the cost

of inventory, two methods can be used. These are retail method

and gross profit method.
Retail method of Estimating inventory
costs
This method is mostly used by retail business. 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
 Assume that the following data are given for ABC
merchandise company for the month of September

Example
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 to estimate cost of inventory 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) Estimate Cost of merchandise sold.
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
E x am pl e
. 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
 Presentation of Inventories
Accounting standards require disclosure of:

1) Accounting policies adopted in measuring inventories,

including the cost formula used (weighted-average, FIFO).

2) Total carrying amount of inventories and the carrying

amount in classifications (merchandise, production supplies,
raw materials, work in progress, and finished goods).

3) Carrying amount of inventories carried at fair value less

costs to sell.

4) Amount of inventories recognized as an expense during the

period.

9-46
 Cont.

Presentation of Inventories
Accounting standards require disclosure of:
5) Amount of any write-down of inventories recognized as
an expense in the period and the amount of any reversal
of write-downs recognized as a reduction of expense in
the period.

6) Circumstances or events that led to the reversal of a

write-down of inventories.

7) Carrying amount of inventories pledged as security for

liabilities, if any.

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