Chapter Four

Inventories
Inventories: are asset items held for sale in the ordinary course of business or goods that will
be used or consumed in the production of goods to be sold. For any company that makes or
sales merchandise, inventory is an extremely important asset. Managing this asset is a
challenging task. It requires not only protecting the goods from theft or loss but also
ensuring that operations are highly efficient.
4.1 Nature and classification of inventory
They are mainly divided into two major categories:
Inventories of merchandising businesses; and
Inventories of manufacturing businesses
A. Inventories of merchandising businesses: are merchandise purchased for resale in the
normal course of business. These types of inventories are called merchandise inventories.
B. Inventories of manufacturing business: manufacturing businesses are businesses that
produce physical output. They normally have three types of inventories. These are:
Raw material inventory
Work in process inventory
Finished goods inventory
1. Raw material inventory: is the cost assigned to goods and materials on hand but not
placed into production. Raw materials include the wood to make a chair or other office
furniture’s, the steel to make a car etc.
2. Work in process inventory: is the cost of raw material on which production has
been started but not completed, and the direct labor cost applied specifically to this material
and allocated manufacturing overhead costs. In simple terms, work in process inventory
refers to the cost of those items that started in production but not yet completed.
3. Finished goods inventory: is the cost identified with the completed but unsold units
on hand at the end of each period.
The work in process and the finished goods inventories have three cost components
 Cost of the raw materials that go into the product
 Cost of the labor used to convert the raw materials to finished goods

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  Overhead costs that support the production process
 Overhead costs include the costs of indirect materials (such as packing materials), indirect
labor (such as the salaries of supervisors), factory rent, and depreciation of plant assets,
utilities, and insurance.
By observing the levels and changes in the levels of these three inventory types, financial
statement users can gain insight into management’s production plans. For example, low levels of
raw materials and high levels of finished goods suggest that management believes it has enough
inventory on hand and production will be slowing down perhaps in anticipation of a recession.
Conversely, high levels of raw materials and low levels of finished goods probably signal that
management is planning to step up production. Many companies have significantly lowered
inventory levels and costs using just-in-time (JIT) inventory methods. Under a just-in-time
method, companies manufacture or purchase goods only when needed for use.
Inventory is classified as a current asset since it usually converted in to cash within a year or
operating cycle of the business whichever is longer.
Importance of inventories
- It is the principal source of revenue for wholesale and retail businesses.
- Cost of merchandise sold is the largest deduction from sells to determine net income.
- A substantial part of merchandising firm’s resources is invested in inventory
- It is the largest of the current assets on merchandisers businesses.

4.2 Physical goods and 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.
Period Costs: Costs that are indirectly related to the acquisition or production of goods.
Period costs such as
 selling expenses and,

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  general and administrative expenses
Treatment of Purchase Discounts: Purchase or trade discounts are reductions in the selling
prices granted to customers.
IASB requires these discounts to be recorded as a reduction from the cost of inventories.
4.2 Valuation of inventories: A cost-basis approach

There are two principal system of inventory accounting.

1. Periodic
2. Perpetual.
Periodic inventory system
- In this system, only the revenue from sales is recorded each time a sale is made.
- No entry will be made to record the cost of merchandise sold at the time of sale.
- Physical inventory will be taken to determine the cost of the ending inventory at the end
of an accounting period.
Perpetual inventory system
- Uses according records that continuously disclose the amount of the inventory.
- The cost of merchandise sold will be recorded each time a sale is made.
- Physical inventory is taken to compare the records with the actual quantities on hand.
Determining actual quantities in the inventory
The first stage in the process of ―taking ―an inventory is to determine the quantity of each kind of
is merchandise owned by the enterprise.
All of the merchandise owned by the business on the inventory date and only such merchandise
should be included in the inventory.
Determine who has legal title to merchandise in transit on the inventory date by examining
purchase and sales invoices.
Shipping terms:
- FOB shipping point – title usually passes to the buyer when goods are shipped.
- FOB destination – title doesn’t pass to the buyer until the good are sold.
Consignments terms:
- Consignee – acts as an agent of the consignor to sell the goods.
- Consignor – retains title until the goods are sold.

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The cost of merchandise inventory is made up of the purchase price and all expenditures incurred
in acquiring such merchandise, including transportation, customs duties, and insurance against
losses in transit.
Those cost that are difficult to associate with specific inventory items may be prorated on some
equitable basis. On the other hand, if it is minor cost it can be treated as operating expense of the
period.
One of the most significant problems in determining inventory cost comes about when identical
units of a certain commodity have been acquired at different unit cost prices during the period.
In such a case it is necessary to determine the unit price of the items till on hand. At this time
there are three methods commonly used in assigning costs to inventory and of goods sold.
They are
i. Use of specific identification method
ii. First-in-first-out;
iii. Weighted average.
Specific Identification Method

Sometimes inventory are purchased to be utilized in a particular job or issues can be identified
with particular receipt. In these cases, the actual purchase price can be charged. This method can
be adopted when prices are stable or when the materials are covered by price control orders. This
method has limited application only. 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. Although such a technique might be possible for a business enterprise handling
a small number of items, for example, an automobile dealer, it becomes completely inoperable in
a complex manufacturing enterprise when the identity of the individual item is lost. Practical
considerations thus make specific identification inappropriate in most cases. Even when specific
identification is a feasible means of valuation, it may be undesirable form a theoretical point of
view.

Inventory costing methods under a periodic system

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When the periodic inventory system is used, only revenue is recorded each time a sale is made.
No entry is made at the time of the sale to record the cost of the merchandise sold. At the end of
the accounting period, a physical inventory is taken to determine the cost of the inventory and
the cost of merchandise sold.
First- in – first- out method (FIFO)
This method of costing inventory is based on the assumption that costs should be changed
against revenue in the order in which they were incurred. Hence, the inventory remain is
assumed to be made up of the most recent costs and the cost of inventory sold is made up of the
earliest costs.
Example: - The units of an item available for sale during the year were as follows (Assume
selling price of $ 50)
Jan.1 inventor 35 units at $ 23 $805
Mar.4 purchase 10 units at $ 25 $250
Aug.20 purchase 30 units at $28 840
Nov.30 purchase 25 units at $ 30 750
100 2,645
The physical count on December 31 shows that 45 units of the particular commodity are on
hand. In accordance with the assumption that the inventory is composed of the most recent costs,
the cost of the 45 units is determined as follows:
FIFO method: (45 units were on hand).
Most recent cost, Nov. 30………..25 units at $30………. $750
Next most recent costs, Aug. 20…20 units at $28………. $560
Inventory, Dec. 31…………………………………… 1,310
Deduction of the inventory of 1,310 from the 2,645 of merchandise available for sale yields
1,335 as the cost of merchandise sold, which represents the earliest costs incurred for this
commodity. Or
Earliest cost jan1. 35 units at $ 23 $ 805
Next earliest cost Mar 4, 10 units at $ 25 250
Next earliest cost Aug 20 10 units at $ 28 280
Cost of merchandise sold 55 1335
The cost of inventory at Dec 31= $ 2,645-1,335 = $ 1,310

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In most businesses, there is a tendency to dispose of goods in the order of their acquisition. This
would be particularly true of perishable merchandise and goods in which style or model changes
are frequent. Thus, the FIFO, methods is generally in harmony with the physical movement of
merchandise is an enterprise.
Average cost method
The average cost method is sometimes called the weighted average method. When this meted is
used, cost is matched against revenue according to the weighted average unit costs of the goods
sold. The same weighted average unit cost are used in determine the cost of the merchandise
remaining in the inventory.
The weighted average unit cost is determined by dividing the total cost of the identical units of
each commodity available for sale during the period by the related number of units of that
commodity.
Average unit cost = total cost of the available units
Number of units
= $ 2,645 = $26.45
100 units
The cost of ending inventory at Dec 31= 45* $26.45 = 1190.25
Cost of merchandise sold =55 units at 26.45 = $ 1,454.75
Or 2,645-1,190.25=1,454.75
Accounting for and reporting Inventory under a perpetual system
In a perpetual inventory system, all merchandise increases and decreases are recorded in a
manner similar to the recording of increases and decreases in cash. The merchandise inventory
account at the beginning of an accounting period indicated the merchandise in stock on that date.
Purchases are recorded by debiting merchandise inventory and crediting cash or accounts
payable, on the data of each sale the cost of merchandise sold is recorded by debiting cost of
merchandise sold and crediting merchandise Inventory.
Example: - the following units of item X are available for sale.
Item –X units cost
Jan 1 inventory 20 $ 20
4 sale 14
10 purchase 18 21

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 22 sale 8
28 sale 6
30 purchase 20 22
The firm used a perpetual inventor system, and there are 30 units of one item on hand at end of
the year. What is the total cost of goods sold and ending inventory according to:
A. FIFO B. Average Cost Method
First- in, first – out (FIFO) method
Using cost, costs are included in the merchandise sold in the order in which they were incurred.
Purchases Cost of merchandise Inventory
sold
Quantity Unit Total Quantity Unit Total Quantity Unit Total
Date cost cost cost cost cost cost
1 20 400
20
4 14 20 280 6 20 120
10 18 21 378 6 20 120
18 21 378
22 6 20 120
2 21 42 16 21 336
28 6 21 126 10 21 210
30 10 21 210
20 22 440 20 22 440
Balance $568 $650
Thus cost of merchandise sold = $ 568, cost of ending inventory = $ 650.
Average cost method
When the average cost method is used in a perpetual inventory system an average unit cost for
each type of item is computed each time a purchase is made. This unit cost is then used to
determine the cost of each sale until another purchase is made and a new average is computed.
This averaging technique is called a moving average.

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 Average cost method:-
Purchases Cost of merchandise Inventory
sold
Quantity Unit Total Quantity Unit Total Quantity Unit cost Total cost
Date cost cost cost cost
Jan 1 20 20 400
4 14 20 280 6 20 120
10 18 21 378 24 20.75 498

22 8 20.75 166 16 20.75 332

28 6 20.75 124.5 10 20.75 207.5

30 20 22 440 30 21.57 647.5

Balance $570.5 $647.5
Cost of merchandise sold = 570.5, Cost of ending inventory =647
Uses of FIFO
- Corresponds to the actual physical flow of goods.
- Less subject to manipulation than other recent costs
- Ending inventory is shown at the most recent costs
Disadvantages of FIFO
- Older cost is matched against revenues.
- In periods of rising prices, can result in higher income taxes.

4.4 Special inventory valuation methods

4.4.1. Lower-of-cost-or-net realizable value (LCNRV) method
If the cost of replacing inventory is lower than its recorded purchase cost, the lower of- cost-or-
market (LCM) method is used to value the inventory. Market, as used in lower of cost or market,

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is the cost to replace the inventory. The market value is based on normal quantities that would be
purchased from suppliers.
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.
The amount of any price decline is included in the cost of merchandise sold. This, in turn,
reduces gross profit and net income in the period in which the price declines occur. This
matching of price declines to the period in which they occur is the primary advantage of using
the lower-of-cost-or-market method.
Example: - On the basis of the following data, determine the value of inventory at the lower of
cost or market.
Commodity Inventory Quantity Unit Cost Price Unit Market Price
A 10 $ 325 $320
B 17 110 115
C 12 275 260
D 15 51 45
E 30 95 100
Answer
______Total_____
Commodity Inventory Unit cost Unit market Cost Market LCM
Quantity Price Price
A 10 $ 325 $320 3,250 3,200 3,200
B 17 110 115 1,870 1,955 1,870
C 12 275 260 3,300 3,120 3,120
D 15 51 45 765 675 675
E 30 95 100 2,850 3,000 2,850
Total ………………………………………………. $12035 $11,950 $11,715

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Valuation at net realizable value
Merchandise that is out of date, spoiled, or damaged can often be sold only at a price below its
original cost. Such merchandise should be valued at its net realizable value.
Net realizable value is determined as follows:
Net Realizable Value = Estimated Selling Price - Direct Costs of Disposal
Direct costs of disposal include selling expenses such as special advertising or sales commissions
on sale. To illustrate, assume the following data about an item of damaged merchandise:
Original cost $1,000
Estimated selling price 800
Selling expenses 150
The merchandise should be valued at its net realizable value of $650 as shown below.
Net Realizable Value = $800 - $150 = $650
Recall that cost is the acquisition price of inventory computed using one of the historical cost-
based methods—specific identification, average-cost, or FIFO. The term net realizable value
(NRV) refers to the net amount that a company expects to realize from the sale of inventory.
Specifically, net realizable value is the estimated selling price in the normal course of business
less estimated costs to complete and estimated costs to make a sale

To illustrate, assume that Mander Corp. has unfinished inventory with a cost of $ 950, a sales
value of $ 1,000, estimated cost of completion of $ 50, and estimated selling costs of $ 200.
Mander’s net realizable value is computed as follows

Inventory value -----------------------$1000

Less estimated cost of completion ----$ 50
Estimated cost to sell ---------------------$ 200 250
Net realizable value ---------------------------------------$ 750

Mander reports inventory on its statement of financial position at $750. In its income statement,
Mander reports a Loss on Inventory Write-Down of -$ 200 ($ 950 -$ 750). A departure from cost
is justified because inventories should not be reported at amounts higher than their expected
realization from sale or use. In addition, a company like Mander should charge the loss of utility
against revenues in the period in which the loss occurs, not in the period of sale. Companies
therefore report their inventories at the lower-of-cost-or-net realizable value (LCNRV) at each
reporting date

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Illustration of LCNRV

As indicated, a company values inventory at LCNRV. A company estimates net realizable value
based on the most reliable evidence of the inventories’ realizable amounts (expected selling
price, expected costs of completion, and expected costs to sell)

Food cost net realizable value final inventory value

Spinach $ 80,000 $ 120,000 $ 80,000

Carrot $ 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

As indicated, the final inventory value of $ 384,000 equals the sum of the LCNRV for each of
the inventory items. That is, the company applies the LCNRV rule to each individual type of
food.

For the most part, companies record inventory at LCNRV. However, there are some situations in
which companies depart from the LCNRV rule. Such treatment may be justified in situations
when cost is difficult to determine, the items are readily marketable at quoted market prices, and
units of product are interchangeable. In this section, we discuss two common situations in which
net realizable value is the general rule for valuing inventory

• Agricultural assets (including biological assets and agricultural produce).

• Commodities held by broker-traders

Agricultural Inventory

Under IFRS, net realizable value measurement is used for inventory when the inventory is
related to agricultural activity. In general, agricultural activity results in two types of agricultural
assets:

(1) Biological assets or

(2) Agricultural produce at the point of harvest.

A biological asset (classified as a non-current asset) is a living animal or plant, such as sheep,
cows, fruit trees, or cotton plants. Agricultural produce is the harvested product of a biological

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asset, such as wool from a sheep, milk from a dairy cow, picked fruit from a fruit tree, or cotton
from a cotton plant. The accounting for these assets is as follows.

• Biological assets are measured on initial recognition and at the end of each reporting period at
fair value less costs to sell (net realizable value). Companies record a gain or loss due to changes
in the net realizable value of biological assets in income when it arises

Agricultural produce (which are harvested from biological assets) are measured at fair value less
costs to sell (net realizable value) at the point of harvest. Once harvested, the net realizable value
of the agricultural produce becomes its cost, and this asset is accounted for similar to other
inventories held for sale in the normal course of business

Illustration of Agricultural Accounting at Net Realizable Value

To illustrate the accounting at net realizable value for agricultural assets, assume that Bancroft
Dairy produces milk for sale to local cheese-makers. Bancroft began operations on January 1,
2015, by purchasing 420 milking cows for €460,000. Bancroft provides the following
information related to the milking cows.

As indicated, the carrying value of the milking cows increased during the month. Part of the
change is due to changes in market prices (less costs to sell) for milking cows. The change in
market price may also be affected by growth— the increase in value as the cows mature and
develop increased milking capacity. At the same time, as mature cows are milked, their milking
capacity declines (fair value decrease due to harvest)

Bancroft makes the following entry to record the change in carrying value of the milking
cows.

Biological Asset (milking cows) (€493,800 - €460,000)------------- 33,800

Unrealized Holding Gain or Loss—Income --------------------------------------------33,800

In addition to recording the change in the biological asset, Bancroft makes the following
summary entry to record the milk harvested for the month of January.

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Inventory (milk) ------------------------------------------36,000

Unrealized Holding Gain or Loss—Income ------------------------------------36,000

Assuming the milk harvested in January was sold to a local cheese-maker for €38,500,

Bancroft records the sale as follows.

Cash -------------------------------------------38,500

Cost of Goods Sold --------------------------36,000

Inventory (milk) -----------------------------------------------------36,000

Sales Revenue --------------------------------------------------------38,500

Thus, once harvested, the net realizable value of the harvested milk becomes its cost, and the
milk is accounted for similar to other inventories held for sale in the normal course of business.
A final note: Some animals or plants may not be considered biological assets but would be
classified and accounted for as other types of assets (not at net realizable value). For example, a
pet shop may hold an inventory of dogs purchased from breeders that it then sells. Because the
pet shop is not breeding the dogs, these dogs are not considered biological assets. As a result, the
dogs are accounted for as inventory held for sale (at LCNRV)

Commodity Broker-Traders

Commodity broker-traders also generally measure their inventories at fair value less costs to sell
(net realizable value), with changes in net realizable value recognized in income in the period of
the change. Broker-traders buy or sell commodities (such as harvested corn, wheat, precious
metals, heating oil) for others or on their own account. The primary purpose for holding these
inventories is to sell the commodities in the near term and generate a profit from fluctuations in
price. Thus, net realizable value is the most relevant measure in this industry because it indicates
the amount that the broker trader will receive from this inventory in the future.

Assessing whether a company is acting in the role of a broker-trader requires judgment.

Companies should consider the length of time they are likely to hold the inventory and the extent
of additional services related to the commodity. If there are significant additional services, such
as distribution, storage, or repackaging, the company is likely not acting as a broker-dealer.
Thus, measurement of the commodity inventory at net realizable value is not appropriate. For

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example, Columbia Coffee Wholesalers buys coffee beans and resells the commodity in the same
condition after a short period of time. Accounting for the coffee inventory at net realizable value
appears appropriate. However, if Columbia expands the business to roast the beans and
repackage them for resale to local coffee shops, the coffee inventory should be accounted for at
LCNRV, similar to other inventory held for sale

4.4.2. Gross profit method inventory costing

The gross profit method uses the estimated gross profit for the period to estimate the inventory at
the end of the period. The gross profit is estimated from the preceding year, adjusted for any
current-period changes in the cost and sales prices.
The gross profit method is applied as follows:
Step 1. Determine the merchandise available for sale at cost.
Step 2. Determine the estimated gross profit by multiplying the net sales by the gross profit
percentage.
Step 3. Determine the estimated cost of merchandise sold by deducting the estimated gross profit
from the net sales.
Step 4. Estimate the ending inventory cost by deducting the estimated cost of merchandise sold
from the merchandise available for sale.
Example: The merchandise inventory was destroyed by fire on October 20. The following data
were obtained from the accounting records.
Jan 1. Merchandise inventory $ 160,000
Jan 1. Oct purchases (net) 850,000
Sales (net) 1,080,000
Estimated gross profit rate 36%
Required: Estimate the cost of merchandise destroyed:
Solution:
Merchandise inventory, January $160.000
Purchase (net) 850,000
Merchandise available for sales $1,010,000
Sales (net) $1,080,000
Less estimated gross profit

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 (1,080,000*36%) (388,800)
Estimated cost of merchandise sold ($691,200)
Estimated merchandise inventory, Oct 20 $318,800
The gross profit method is useful for estimating inventories for monthly or quarterly financial
statements. It is also useful in estimating the cost of merchandise destroyed by fire or other
disasters.
4.4.3 Retail method of inventory costing
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.
The retail inventory method of estimating inventory cost requires costs and retail prices to be
maintained for the merchandise available for sale. A ratio of cost to retail price is then used to
convert ending inventory at retail to estimate the ending inventory cost.
The retail inventory method is applied as follows:
Step 1. Determine the total merchandise available for sale at cost and retail.
Step 2. Determine the ratio of the cost to retail of the merchandise available for sale.
Step 3. Determine the ending inventory at retail by deducting the net sales from the
merchandise available for sale at retail.
Step 4. Estimate the ending inventory cost by multiplying the ending inventory at retail by
the cost to retail ratio.
Example: on the basis of the following data, estimate the cost of the merchandise inventory
at June 30 by the retail method
Cost Retail
June 1. Merchandise inventory $ 428,300 $ 670,500
1-30 purchasers (net) 608,500 949,000
1-30 sales (net) 1,140.000

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Solution:
Cost Retail
Merchandise inventory June 1 $ 428,300 $ 670,500
Purchases in June (net) 608,500 949,500
Merchandise available for sale $1,036,800 1,620,000
Ratio of cost to retail price: 1,036,800 = 64%
1,620,000
Sales for June (net) 1,140,000
Merchandise inventory, June 30, at retail 480,000
Merchandise inventory, June 30, at estimated cost
(480.000*64%)…………………................................................................................307,200

When estimating the cost to retail ratio, the mix of items in the ending inventory is assumed to be
the same as the merchandise available for sale. If the ending inventory is made up of different
classes of merchandise, cost to retail ratios may be developed for each class of inventory.
An advantage of the retail method is that it provides inventory figures for preparing monthly
statements. Department stores and similar retailers often determine gross profit and operating
income each month, but may take a physical inventory only once or twice a year. Thus, the retail
method allows management to monitor operations more closely.
Special Items Relating to Retail Method

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.

In short, the treatment for the items affecting the cost column of the retail inventory approach
follows the computation for cost of goods available for sale. Note also that sales returns and

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allowances are considered as proper adjustments to gross sales. However, when sales are
recorded gross, companies do not recognize sales discounts. To adjust for the sales discount
account in such a situation would provide an ending inventory figure at retail that would be
overvalued.

In addition, a number of special items require careful analysis:

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. Such costs are reflected in the selling price
because a certain amount of shortage is considered normal in a retail enterprise. As a result,
companies do not consider this amount in computing the cost-to-retail percentage. Rather, to
arrive at ending inventory at retail, they show normal shortages as a deduction similar to sales.

• Abnormal shortages, on the other hand, are deducted from both the cost and retail columns
and reported as a special inventory amount or as a loss. To do otherwise distorts the cost-to-retail
ratio and overstates ending inventory.

• Employee discounts (given to employees to encourage loyalty, better performance, and so on)
are deducted from the retail column in the same way as sales. These discounts should not be
considered in the cost-to-retail percentage because they do not reflect an overall change in the
selling price

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