Fundamental of Accounting II (ACFn-2012) Handout

Department of Accounting and finance, Rift valley university 2022

UNIT 1: ACCOUNTING FOR INVENTORIES

1.1 Nature and definition of 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 example, in a grocery store, canned
goods, dairy products and meats, are just a few of the inventory items on hand. A
merchandising concern, ordinarily purchases its merchandise in a form ready for resale. It reports the
cost assigned to unsold units left on hand as merchandise inventory. Only one inventory account is
maintained in merchandising firms, Merchandise Inventory, appears in the financial statements in
the current portion of balance sheet.
Merchandise inventories are items or commodities held for resale to customers in the
ordinary course of the business. These items have two common characteristics: a) They
are owned by the company, and b) they are in a form ready for resale to customers
In a manufacturing enterprise, are also owned by the company, but some goods may not
yet be ready for sale. As a result, inventory is usually classified in to three categories:
a) Finished Goods, b) Work In Process, and Raw Materials.
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.
Since the accounting for inventories in manufacturing enterprise will be discussed in
another courses let’s focus on the accounting principles and concepts of merchandise
inventory in merchandised enterprises.
Inventories held in a business during the period may be consists of two categories at the end of the
accounting period. These include: a) Finished goods held for sale in the ordinary course of business
b) Goods held or consumed in the production of finished goods.

1.2 Inventory Cost Flow Assumptions

During any given fiscal period it is very likely that merchandise will be purchased at several different
prices. If inventories are to be priced at cost and numerous purchases have been made at different unit

Instructor: Simegn Z.
 Fundamental of Accounting II (ACFn-2012) Handout
Department of Accounting and finance, Rift valley university 2022

costs, which of the various cost should be used? Consequently, one of several systematic inventory
cost flow assumptions is used. The most common assumptions of determining the cost of the
merchandise sold are as follows:-
1. Specific Identification
2. Cost flow is in the order in which the expenditure were made - first-in, first out.
3. Cost flow is an average of the expenditure.
1.3 Inventory Costing Methods under Periodic and Perpetual Systems
1. Specific Identification: Specific identification calls for identifying each item sold and each
item in inventory. The costs of the specific items sold are included in the cost of goods sold,
and the costs of the specific items on hand are included in the inventory. It can be successfully
applied in situations where a relatively small number of costly, easily distinguishable items
are handled.
 The specific identification method tracks the actual physical flow of the goods.
 Each item of inventory is marked, tagged, or coded with its specific unit cost.
 It is most frequently used when the company sells a limited variety of high unit-cost items
2. First-in, first out method (FIFO): The FIFO method assumes that goods are used in the
order in which they are purchased. In other words, it assumes that the first goods purchased
are the first used (in a manufacturing concern) or sold (in a merchandising concern). The
inventory remaining must therefore represent the most recent purchases.
 The FIFO method assumes that the earliest goods purchased are the first to be sold.
 Often reflects the actual physical flow of merchandise.
 Under FIFO, the costs of the earliest goods purchased are the first to be recognized as CGS.
 The costs of the most recent goods purchased are recognized as the ending inventory.
3. Average Cost Method
 The average cost method assumes that the goods available for sale are homogeneous.
 The allocation of the cost of goods available for sale is made on the basis of the weighted
average unit cost incurred.
 The weighted average unit cost is then applied to the units sold to determine the cost of goods
sold and to the units on hand to determine the ending inventory.
 The average cost method, sometimes called the weighted average method.

Instructor: Simegn Z.
 Fundamental of Accounting II (ACFn-2012) Handout
Department of Accounting and finance, Rift valley university 2022

 Average unit cost has to be determined and applied both to ending inventory and cost of
goods sold.
Illustration 2: Consider the following data for YERON COMPANY for the month
ended March 31, 2020
Inventory, March 1 200 units at Br. 4
Purchases:
March 10 500 units at Br.4.50
March 20 400 units at Br 4.75
March 30 300units at Br5.00
Sales: March 15 500 units
March 25 400 units
Assume that the March specific sales of inventory consisted of 25 from the beginning inventory, 100
units from the March 10 purchase, 175 units from the March 20 purchase, and 200 units from the
March 30 purchase. Required: Determine:
I. Cost of ending inventory and Cost of goods sold assuming:
1) Specific identification method-periodic
2) Periodic FIFO and perpetual FIFO
3) Periodic Weighted average and perpetual weighted average
Determining cost of goods available for sale:
March 1 Inventory 200 units at Br 4.00 Br 800
March 10 purchase 500 units at Br 4.50 Br 2,250
March 20 purchase 400 units at Br 4.75 Br 1,900
March 30 purchase 300 units at Br 5.00 Br 1,500
Available for sale 1400 units Br6, 450
1. Specific identification method:
25 units @ Br.4 = Br.100
100 units @ Br.4.50= 450
175 units @Br.4.75 = 831.25
200 units @Br.5 = 1,000
500 units Br.2, 381.25
2. (a) Periodic FIFO

Instructor: Simegn Z.
 Fundamental of Accounting II (ACFn-2012) Handout
Department of Accounting and finance, Rift valley university 2022

Cost of ending inventory:

Most recent costs, March 30 300units at Br 5.00 Br 1,500
Next most recent costs, March 20 200unit at Br 4.75 950
Inventory for sales 500 units Br 2450
Cost of goods sold:
Cost of goods available for sales Br 6,450
Less- cost of ending inventory 2,450
Cost of goods sold 4,000
b) Perpetual FIFO
Purchase Inventory
Cost of goods sold
Date Qty Unit Total Qty Unit Total Qty Unit cost Total cost
cost cost cost cost
Mar 1 - - - - - 200 4.00 800
10 500 4.50 2,250 - - - 200 4.00 800
500 4.50 2,250
15 - - - 200 4.00 800 200 4.50 900
300 4.50 1350
20 400 4.75 1,900 - - - 200 4.50 900
400 4.75 1900
25 - - - 200 4.50 900 200 4.75 950
200 4.75 950
30 300 5.00 1,500 - - - 200 4.75 950*
300 5.00 1500*
4,000
Cost of ending inventory:
200 units at 4.75 ------950 *
300 units at 5.75-------1500*
500 units Br2, 450
Cost of goods sold: From cost of goods sold column Br 4,000
3. (a) Weighted average- periodic

Instructor: Simegn Z.
 Fundamental of Accounting II (ACFn-2012) Handout
Department of Accounting and finance, Rift valley university 2022

Average cost= Cost of goods available for sale = 6450=Br 4.61

Total units available for sales 1400
Cost of ending inventory:
500 units at Br 4.61 =Br 2,305
Cost of goods sold
Cost of goods available for sale Br 6450
Less: Cost of ending inventory 2305
Cost of goods sold 4,145
(b) Weight average- perpetual
Purchases Sales Balance
Date
March 1 200 units at Br 4 = 800
March 10 500 units at Br 4.5=2250 700 units at Br 4.36=3052
March 15 500 units at Br 4.36= 2180* 200 units at Br 4.36=872
March 20 400 units at Br 4.75=1900 600 units at Br 4.62=2772
March 25 400 units at Br 4.62= 1848* 200 units at Br 4.62=924
March 30 300 units at Br 5.00= 1500 500 units at Br 4.85=2425
Cost of ending inventory: 500 units at Br 4.85 =Br2, 425

Cost of goods sold: Br 2180* +Br 1848* =Br4, 028

Key points
 The requirements for accounting for and reporting inventories are more principles-based
under IFRS. That is GAAP provides more detailed guidelines in inventory accounting.
 A major difference between IFRS and GAAP relates to the LIFO cost flow assumption. IFRS
prohibits its use LIFO. The reason why it did not use is since LIFO produce high Cost of
goods sold, less net income, less tax and not recent ending inventory
1.4Valuation of Inventory at other than cost
Special circumstances sometimes call for inventory valuation methods other than cost. This departure
(or circumstances) arises:

Instructor: Simegn Z.
 Fundamental of Accounting II (ACFn-2012) Handout
Department of Accounting and finance, Rift valley university 2022

a. When the cost of replacing items in Inventory is below recorded cost (When a continuous
decline in the market value of merchandise), and
b. When the inventory (merchandise) is not salable at normal sells prices due to physical
deterioration, obsolescence, imperfections, shop wear, style changes or introduction of new
brands to the market or other causes.
A) Valuation of inventory at Lower of cost or Market (LCM)
 When the value of inventory is lower than the cost, the inventory is written down to its market
value. This is known as the lower of cost and market (LCM) method.
 Market is defined as replacement cost or net realizable value.
The benefits attributed to this method of inventory valuation are:
1. The loss, if any, is identified with the accounting period in which it occurred, and
2. Goods are valued at an amount that measures the expected contribution to revenue of future
periods. The common practice is to use total inventory rather than individual items or major
categories in determining the LCM valuation. The LCM method can be applied to each inventory
item, to major classes of inventory, and to inventory as a whole
From the following data, apply the rule of LCM: (a) item by item, and (b) to the entire inventory
Item Cost Market LCM
A. Br50 Br55 Br50
B. 60 70 60
C. 65 60 60
Total Br175 Br185 Br170
 Applied to each item, the inventory will be valued at Br170.
 Applied in total, Br175 will be compared with Br185, the inventory will be valued at Br175
B) Estimating Inventory cost
Under cases where taking a physical inventory or maintaining a perpetual inventory become
impossible for example, taking a physical inventory each month may be too costly, when a fire has
destroyed the inventory (Catastrophe), estimation of inventory can be made. Two commonly used
methods of estimating inventory costs are:
1) Retail method and
2) The gross profit method

Instructor: Simegn Z.
 Fundamental of Accounting II (ACFn-2012) Handout
Department of Accounting and finance, Rift valley university 2022

1. Retail Method of Inventory Costing:

The retail inventory method of inventory costing is widely used by retail businesses, particularly
department stores. Steps to be followed:
1. Find goods available for sale at cost and at retail price.
2. Calculate ratio of cost to retail price.
3. Find ending inventory at retail price.
4. Multiply ending inventory at retail by the ratio of retail price.
Example:
Cost Retail
Beginning inventory, Jan.1 Br.25, 650 Br.35, 000
Net purchase for the month 210,600 340,000
Net Sales 280,000
1. Merchandise available for sale =25,650+210.600 35,000+340,000
= Br.236, 250 =Br.375, 000
2. Ratio of cost to retail price:
236,250
375,000 =63%
3. Merchandising inventory, Jan31, at retail------ 375,000-280,000= Br.95, 000
4. Merchandising inventory, Jan31 at estimated cost (Br.95, 000*63%) -- Br59, 850
Advantage of Retail method:
 When only the selling price is available it permits valuation of inventory.
 Used to estimate the cost of inventory for interim accounting periods.
 Avoid the time- consuming and expensive process of taking a physical inventory each
month or quarter.
2. Gross profit Method of Estimating Inventories
Most companies would like to prepare interim financial statements such as monthly, quarterly or
semiannually. Physical count inventory is made at the end of year. For this reason the companies use
some methods to calculate its ending inventory, one of these methods called "The Gross Profit
Method".
The gross profit method is used:

Instructor: Simegn Z.
 Fundamental of Accounting II (ACFn-2012) Handout
Department of Accounting and finance, Rift valley university 2022

a) To control and verify the validity of inventory.

b) To estimate the ending inventory for interim financial reports or internal reports prepared
during the year when it is impractical to count the inventory physically and perpetual
inventory system is not used.
c) To estimate the cost of inventory destroyed by an accident, such as fire or storm. Valuation of
inventory lost is necessary to account for the accident and to establish basis for insurance
claims and income taxes.
To compute the ending inventory by the Gross Profit Method, there are five steps:
1. Compute the Total cost of goods available for sale. The cost of goods available for sales
consist of Beginning Inventory + Net Purchases + Fright in ; (Net Purchases = Purchases
–Discount , Returns & Allowances Purchases)
2. Compute the estimated Gross profit by multiplying Sales ×Gross Profit percentage.
3. Compute the cost of goods sold by subtracting the Computed Gross Profit from Sales.
4. Compute ending inventory by subtracting the computed cost of goods sold from cost of goods
available for sale.
To illustrate that, assume the following information:-
Beginning Inventory Br 30,000; Net Purchases 120,000; Net Sales 185,000;
Fright in 25,000; Gross Profit 30% of sales:
Compute ending inventory
Solution:
1) Cost of Goods available for sales =Br30,000+120,000+25,000=Br175,000
2) The estimated Gross Profit =Br185,000*30%=Br55,500
3) Cost of Goods Sold = Br185,000-55,500=Br129,500 ,or Br185,000*70%=Br129,500
4) Ending Inventory =Br175,000-129,500= Br45,500
Net realizable value (NRV) is defined as the estimated selling price in the ordinary course of
business less reasonably predictable costs of completion and disposal. A normal profit margin is
subtracted from that amount to arrive at net realizable value less a normal profit margin.
To illustrate, assume that Robenus Company has unfinished inventory with a sales value of Br1, 000,
estimated cost of completion of Br300, and a normal profit margin of 10 percent of sales.
The following net realizable value can be determined.

Instructor: Simegn Z.
 Fundamental of Accounting II (ACFn-2012) Handout
Department of Accounting and finance, Rift valley university 2022

Inventory—sales value Br1, 000

Less: Estimated cost of completion and disposal 300
Net realizable value 700
Less: Allowance for normal profit margin (10% of sales) 100
Net realizable value less a normal profit margin Br 600
1.5 Internal Control of inventories
Inventory control plays an important role in matching expired cost with revenue of the
period. When merchandises are sold, the portion of sold merchandise reduces the asset
account and transfers it to cost of goods sold account .As a result the total cost of goods
available for sale has two elements at the end of the period. These are; cost of ending
inventory –cost of unsold merchandise (unexpired cost) –which are to be reported on the balance
sheet and cost of goods sold expired cost-which is to be reported on income statement. Therefore,
determining the exact number and amounts of inventories and controlling the reliability and
reasonableness of inventories are important for: a) Ensuring availability of inventory items and b)
Preventing excessive accumulation of inventory items.
From the above, you can understand that if there is an error in the determination of the inventory
figure at the end of the period will cause an equal misstatement of gross profit and mislead the users
of financial statements. This misstatement has its own effect on current period and on the following
period statements.
1.6 Financial Statement Effects of Cost Flow Methods
Each of the three cost flow methods is acceptable. The reasons why companies adopt
different inventory cost flow methods are varied but they usually involve one of the
following factors: A) Income statement effect, B) Balance sheet effect and C) Tax
effects
A. 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
Yeron Company. Assume that Yeron Company sold its 900 units for Br10, 000, its
operating expenses were Br2, 000, and its income tax rate is 20%.
FIFO Average cost LIFO

Instructor: Simegn Z.
 Fundamental of Accounting II (ACFn-2012) Handout
Department of Accounting and finance, Rift valley university 2022

Sales Br10,000 Br10,000 Br10,000

Beginning Inventory 800 800 800
Purchases 5,650 5,650 5,650
Cost of Goods Available for Sale 6,450 6,450 6,450
Ending Inventory 2,450 2,305 2,150
Cost of Goods Sold 4,000 4,145 4,300
Gross Profit 6,000 5,955 5,700
Operating Expenses 2,000 2,000 2,000
Income Before Income Taxes 4,000 3,955 3,700
Income Tax Expense (20%) 800 791 740
Net Income 3,200 3,164 2,960
 In periods of rising prices, FIFO reports the highest net income, LIFO the lowest
and average cost falls in the middle.
 The reverse is true when prices are falling.
 When prices are constant, all cost flow methods will yield the same results.
 LIFO reports higher cost of goods sold and lowers gross profit –which results in lower net
income before taxes.
 The report of Weighted Average falls in between FIFO and LIFO
B) Balance Sheet Effects
 FIFO produces the best balance sheet valuation since the inventory costs are closer to their
current, or replacement, costs.
 FIFO reports higher ending inventory as compared to LIFO
 LIFO reports lower ending inventory as compared to FIFO
 The report of Weighted Average ending inventory falls in between FIFO and LIFO
C) Tax Effects
 FIFO cost flow assumption results with higher income tax liability in the period
of raising price as the above comparison than LIFO cost flow assumption. But in
the period of falling price, the report will be reversed.
 The Weighted Average’s report of tax liability falls between FIFO and LIFO.
Inventory Errors - Income Statement Effects

Instructor: Simegn Z.
 Fundamental of Accounting II (ACFn-2012) Handout
Department of Accounting and finance, Rift valley university 2022

 Both beginning and ending inventories appear on the income statement.

 The ending inventory of one period automatically becomes the beginning
inventory of the next period.
 Inventory errors affect the determination of cost of goods sold and net income.
 The effects on cost of goods sold can be determined by entering the incorrect
data in the following formula and then substituting the correct data.
BI+ Cost of purchase– Ending inventory = Cost of Goods Sold
If beginning inventory is understated, cost of goods sold will be understated. On the
other hand, an understatement of ending inventory will overstate cost of goods sold. The
effects of inventory errors on the current year’s income statement are shown in bellow:
Effects of Inventory Errors on Current Year’s Income Statement

Understate beginning inventory Understated Overstated

Overstate beginning inventory Overstated Understated
Understate ending inventory Overstated Understated
Overstate ending inventory Understated Overstated
An error in ending inventory of the current period will have a reverse effect on net
income of the next accounting period. This is shown below. In the table Note that the
understatement of ending inventory in 2020 results in an understatement of beginning
inventory in 2018 and an overstatement of net income in 2021.
Condensed Income Statement
2020 2021
Particulars Incorrect Correct Incorrect Correct
Sales Br 80,000 Br 80,000 Br 90,000 Br 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 for
sale 60,000 60,000 80,000 83,000
Ending Inventory 12,000 15,000 23,000 23,000
Cost of Goods Sold 48,000 45,000 57,000 60,000

Instructor: Simegn Z.
 Fundamental of Accounting II (ACFn-2012) Handout
Department of Accounting and finance, Rift valley university 2022

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
 In 2010 Net income Understated Br3, 000 (22,000-25,000)
 In 2011 Net income Overstated Br3, 000(10,000-13,000)
Ending Inventory Error – Balance Sheet Effects
The effect of ending inventory errors on the balance sheet can be determined by using the basic
accounting equation:
Assets = Owner’s Equity + Liabilities
Ending inventory error Assets Liabilities owner’s equity
Overstated overstated none over stated
Understated understated none understated

1.7 Presentation of merchandise inventory on the balance sheet

Merchandise inventory is usually presented in the current asset section of the balance sheet, following
receivables. Both the method of determining the cost of inventory (fifo or average) and the method of
valuing the inventory (cost or the lower of cost or market) should be shown. The details may be
disclosed in parentheses on the balance sheet or in a foot note to the financial statements. The
company may change its inventory costing methods for valid reason. In such cases, the effect of the
change and the reason for the change should be disclosed in the financial statements for period in
which the change occurred.

Instructor: Simegn Z.