CHAPTER ONE

INVENTORIES
1.0 AIMS AND OBJECTIVES

This unit aims at discussing the meaning, importance and effects of inventories. It also discusses the
inventory systems and determining actual quantities in inventories. After studying this unit, you will be
able to:
 Explain the meaning of inventories
 Describe effect of inventory on financial statements of the current period and the following
period
 Identify and describe the two principal inventory systems
 Identify the procedures for determining the actual quantities in inventory.
 Discussed inventory cost determination and inventory costing methods.
 aware of the most common inventory costing methods under a periodic system
 compare the effect of the methods on operating results
 Describe the accounting for inventory under the perpetual
 Explain the valuation of inventory at other than cost, including valuation at the lower of cost or market.
 Acquaint yourself with various methods of estimating cost of an inventory, including retail
method and gross profit method.
1.1 INTRODUCTION
In the last section of Principles of Accounting I, you have learned about the principles and practices of
accounting for receivables – one of the current asset items in the balance sheet of a retail business. In
this unit you will learn and discuss the concepts in accounting for 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. They are mainly divided into two major:
 Inventories of merchandising businesses
 Inventories of manufacturing businesses
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
 Work in process inventory
 Finished goods inventory
1. Raw material inventory -is the cost assigned to goods and materials on hand but not yet placed into
production. Raw materials include the wood to make a chair or other office furniture’s, the steel to make a car
etc.

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2. Work in process inventory-
inventory- is the cost of raw material on which production has been started but not
completed, plus the direct labor cost applied specifically to this material and allocated manufacturing
overhead costs.
3. Finished goods inventory- is the cost identified with the completed but unsold units on hand at the
end of each period.
In this unit only the determination of the inventory of merchandise purchased for resale commonly
called merchandise inventory will be discussed.
1.2 IMPORTANCE OF INVENTORIES
Merchandise purchased and sold is the most active elements in merchandising business, i.e. in
wholesale and retail type of businesses. This is due to the following reasons:
1. The sale of merchandise is the principal source of revenue for them.
2. The cost of merchandise sold is the largest deductions from sales.
3. Inventories (ending inventories) are the largest of the current assets or those firms.
Because of the above reasons inventories, have effects on the current and the following period’s
financial statements. If inventories are misstated (understated of overstated), the financial statements will be
distorted.
1.3 INVENTORY SYSTEMS: PERIODIC VS PERPETUAL

There are two principal systems of inventory accounting periodic and perpetual.
1.4.1 Periodic inventory system
Under this system there is no continuous record of merchandise inventory account. The inventory
balance remains the same through out the accounting period, i.e. the beginning inventory balance.
This is because when goods are purchased,
purchased, they are debited to the purchases account rather than
merchandise inventory account. When goods are bought, a temporary purchases account is debited
instead of the inventory account itself. Likewise, when goods are sold revenue is recorded, but the fact
that there is a reduction in merchandise inventory is not recognized means entry is made for the cost
of goods sold. This is because the Merchandise Inventory account is not credited every time goods are
sold. Therefore, if one wants to know the cost of goods on hand, it is a must that a physical inventory
be conducted first.
Physical inventory means counting the quantity of goods on hand. Once the quantity of goods on hand
has been determined, it is multiplied by the unit price of those goods to determine the cost of goods on
hand. The revenue from sales is recorded each time a sale is made. No entry is made for the cost of
goods sold. So, physical inventory must be taken periodically to determine the cost of inventory on

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hand and goods sold. The periodic inventory system is less costly to maintain than the perpetual
inventory system, but it gives management less information about the current status of merchandise.
This system is often used by retail enterprises that sell many kinds of low unit cost merchandise
such as groceries, drugstores, hardware etc.
The journal entries to be prepared are:
1. At the time of purchase of merchandise:
Purchases XX at cost
Accounts payable or cash XX
2. At the time of sale of merchandise:
Accounts receivable or cash XX at retail price
Sales XX
3. To record purchase returns and allowance:
Accounts payable or cash XX
Purchase returns and allowance XX
4. To record adjusting entry or closing entry for merchandise inventory:
Income Summary XX
Merchandise inventory (beginning) XX
To close beginning inventory
Merchandise inventory (ending) XX
Income summary XX
To record ending inventory
1.4.2 Perpetual inventory system
Under this system the accounting record continuously disclose the amount of inventory. So, the
inventory balance will not remain the same in the accounting period. All increases are debited to
merchandise inventory account
account and all decreases are credited to the same account.
There are no purchases and purchase returns and allowances accounts in this system. At the time of
sale, the cost of goods sold is recorded in addition to Journal entry for the sale. So, we can determine
the cost of inventory as well as goods sold from the accounting record. No need of physical
counting to determine their costs.
costs. Companies that sell items of high unit value,
value, such as appliances
or automobiles, tended to use the perpetual inventory system. Given the number and diversity of items
contained in the merchandise inventory of most businesses, the perpetual inventory system is
usually more effective for keeping track of quantities
quantities and ensuring optimal customer service.
Management must choose the system or combination of systems that is best for achieving the
company's goal. Journal entries to be prepared are:
1. At the time of purchase of merchandise
Merchandise inventory XX at cost
Accounts payable/cash XX
To record cost of goods sold
2. At the time of sale of merchandise
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 Accounts receivable or cash XX at retail price
Sales XX
To record cost of goods sold
To record the sales
Cost of goods sold XX
Merchandise inventory XX at cost
To record the cost of merchandise sold
3. To record purchase returns and allowances
Accounts payable or cash XX
Merchandise inventory XX
4. No adjusting entry or closing entry for merchandise inventory is needed at the end of each
accounting period.
Illustration – 2
In its beginning inventory on Jan 1, 2002, NINI Company had 120 units of merchandise that cost Br. 8
Per unit. The following transactions were completed during 2002.
February 5 Purchased on credit 150 units of merchandise at Br. 10 per unit.
9 Returned 20 detective units from February 5 purchases to the supplier.
June 15 Purchased for cash 230 units of merchandise at Br 9 per unit.
September 6 Sold 220 units of merchandise for cash at a price of Br. 15 per unit. These goods are: 120
units from the beginning inventory and 100 units for February Purchases.
December 31 260 units are left on hand, 30 units from February 5 purchases.
Required: Prepare general journal entries for NINI Company to record the above transactions and
adjusting or closing entry for merchandise inventory on December 31,
a) Periodic inventory system
b) Perpetual inventory system
Solution
a) February 5 Purchases (150 x Br.10) 1,500
Account payable 1,500
9 Accounts payable (20 x Br. 10) 200
Purchase returns and allowances 200
June 15 Purchases (230 x Br. 9) 2,070
Cash 2,070
September 6 Cash (220 x Br. 15) 3,300
Sales 3,300
December 31 To record or close the merchandise inventory account
Income summary (120 x Br. 8) 960
Merchandise inventory (beginning) 960
To close the beginning inventory
Merchandise inventor (ending) 2,370
Income summary [(30 x Br. 10) + (230 x Br. 9)] 2,370
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 To record the ending merchandise inventory
b) February 5 Merchandise inventory 1,500
Accounts payable 1,500
9 Accounts payable 200
Merchandise inventory 200
June 15 Merchandise inventory 2,070
Cash 2,070
September 6 i) to record the sales
Cash 3,300
Sales 3,300
ii) To record cost of merchandise sold
= (120 x Br. 8) + (100 x Br. 10)
= Br. 960 + Br. 1,000 = Br. 1,960
Cost of merchandise sold 1,960
Merchandise inventory 1,960
December 31 No entry is needed to record or close merchandise inventory account.

1.4 DETERMINING ACTUAL QUANTITIES IN THE INVENTORY

The physical count of inventory is needed under both inventory systems.

systems. The physical count (some
times called “taking
“taking an inventory”)
inventory”) is used to adjust the inventory account balance to the actual
inventory on hand. This means that nearly all companies take a physical count of inventory at least
once each year. Under the periodic inventory system, it is a must to take a physical count to know the
actual account balance of the merchandise inventory account and,, it is needed to determine the cost of
inventory and goods sold any time. This is because the merchandise inventory account is not up dated
every time purchases and sales are made.
The inventory account under perpetual inventory systems is always up to date. We determine a birr
(dollar) amount for physical count of inventory on hand at the end of a period by: We determine the
Birr amount for the physical count of inventory on hand at the end of the period by following steps
indicated below:
(1) Counting the units of each product on hand
(2) Multiplying the count for each product by its cost per unit
(3) Adding the cost for all products
Example: Assume that ABC Company had reported the physical count of the inventory on Sene
30, 1993 as follows:
Inventory item physical count unit cost
Sugar 1,000 kg Birr 4 per kg
Salt 2,000 kg Birr 1.40 per kg
Macaroni 3,000 kg Birr 3 per kg
Required: Compute the total inventory cost to be reported on the balance sheet on Sene 30, 1993.
I. PHYSICAL GOODS TO BE INCLUDED IN INVENTORY

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At the time of taking an inventory,
inventory, all the merchandise owned by the business on the inventory
date, and only such merchandise, should be included in the inventory.
inventory. The merchandise owned by
the business may not necessarily be in the warehouse,
warehouse, they may be in transit.
Technically, purchase should be recorded when legal title to the goods passes to the buyer. General
practice, however, is to record the acquisitions when the goods are received, because it is difficult for
the buyer to determine the exact time of legal passage of title for every purchase. In addition, no
material error is likely to resort from such a practice if it is consistently applied.

1. Goods in transit
These Are goods purchased but not yet received, at the end of a fiscal period. The accounting for these
shipped goods depends on who owns them on the unitary date and can be determined by application of
the “passage of legal title”. The legal title to the merchandise in transit on the inventory date is known
by examining purchase and sales invoices of the last few days of the current accounting period and
the first few days of the following accounting period. This legal title depends on shipping terms
(agreements). There are two main types of shipping terms. FOB shipping point and FOB destination
(1) FOB shipping point
point- the ownership title passes too the buyer when the goods are shipped (when
the goods are loaded on the means of transportation, i.e. at the seller’s point). The purchaser is
responsible for freight charges. It is must that the transaction should also be recorded as:
Purchase XXXXX
Account Payable XXXXX
The above transaction should be recorded in the current period rather than recording the transaction in
the following period.
(2) FOB destination – the title passes to the buyer when the goods arrive at their destination, i.e. at
the buyer’s point.
Generally, goods in transit purchased on FOB shipping point terms are included in the inventories
of the buyer and excluded from the inventories of the buyer and excluded from the inventories of the
seller, and goods in transit purchased on FOB destination terms are included in the inventories of
the seller and excluded from the inventories of the buyer. The accounting rule is that goods to which
legal title has passed should be recorded as purchase of the fiscal period. Otherwise a series of
misstatement may be included in the FS.
Example:
a. If NIKE sells goods to TARGET with terms FOB shipping point, which will report these goods in
its inventory while they are in transit?

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 b. An art gallery [painter] purchases a painting for Birr 11,400 on terms FOB shipping point.
Additional costs in obtaining and offering the art work for sale includes Birr 130 for
transportation-in, Birr 150 for import duties, Birr 100 for insurance during shipment, Birr 180 for
advertising and Birr 800 for sales salaries. For computing inventory, what cost is assigned to the
painting?
2. Consigned Goods
There are also a problem with goods on consignment at the time of taking and inventory.
inventory Under this
arrangement, the consignor ships merchandise to the consignee, who acts as the consigner’s agent in
selling the goods.
The consignee agrees to accept the goods without any liability, except to exercise due care and
reasonable protection from loss or damage, until the goods are said to a third party. When the
consignee sells the goods, the revenue less a selling commission and expenses incurred in
accomplishing the rate is remitted to the consigner. Goods out on consignment remain the property of
the consignor and must be included in the consigner’s inventory at purchase price or production
cost. The consignee must no entry to the inventory account to goods received because they are the
property of the consignor.
3. Sales on Installment

“Goods sold on installment” describes any types of sale in which payment is required in periodic
installments over an extended period of time. Because the risk of loss from Uncollectible is higher in
installment sale situations than in other sales transactions, the seller often withholds legal title to the
merchandise until all the payments have been made. The question is whether the inventory should
be considered sold, even though legal title has not passed. The answer is that the goods should be
excluded from the seller’s inventory if the percentage of bad debts can be reasonably estimated.
Installment sales are discussed here to show that in some cases, the goods should be removed from
inventory, although legal title may not have period.
4. Damaged or obsolete goods
It is possible that some goods could be damaged or obsolete on the date of physical count. Damage
refers to physical destruction on goods. Obsolescence refers to the deterioration of importance
[acceptability of a product] for the users [purchasers]. Such goods are not salable at the usual selling
price. Therefore, care must be taken not to include the cost of such goods at their purchase price. If
such items do not have a sales value, they should be excluded from the physical counting. If they are
salable at reduced price, their cost is determined by taking the net realizable value. The net realizable
value is sales price minus the cost of making the sales.

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5. Avoiding errors during Physical Count,
When taking a physical count, care must be taken not to count items more than once or omit an item
in the counting process. There are different methods to avoid such errors. One of the methods is to use
pre-numbered inventory tickets.
This ticket may have the following format.

Inventory ticket No. 10001

Quantity counted _______ _ Purchase date _______

Sales price per unit Birr_______
Cost price per unit Birr _______
Counted by ___________________ Signature ____
Checked by ___________________ Signature ____

6. Procedures of inventory taking

The process of physical count is fairly standard. It means all companies use the same procedure or steps
in the physical count process. The following procedures are usually followed by most merchandising
companies:
(1) Decide the date and period of inventory counting [for example, inventory count will start on Sene
25 and shall end in one-week time].
(2) Assign individuals who will conduct the physical count [for example, Abebe, Tesema, and Alemu
are assigned to take the count with specific responsibility, i.e., Abebe will count, Alemu will
measure, and Tesema will check the count].
(3) Prepare at least one inventory ticket for each product on hand.
(4) Issue the pre-numbered tickets to the assigned employees who will conduct the count.
(5) An employee will count the quantity of the product and obtain information on its purchase date,
selling price, and cost. [This information is sometimes included with the product but must often be
obtained from accounting records or invoices].
(6) Once the necessary information is collected, the employee records it on the ticket, signs the ticket
and attach it to the counted inventory so that it will be checked and avoid double counting and
omitting it from the count.
(7) Another employee often recounts and rechecks information on the ticket, signs the ticket, and
returns it to the inventory manager.
(8) To insure no ticket is lost or missed, internal control procedures verify that all pre-numbered
tickets are returned.
(9) The quantity and cost data on the inventory tickets are aggregated by multiplying the number of
units for each product by its unit cost.

This gives us the Birr amount for each product in inventory. The total of all products is the Birr amount
reported for inventory on the balance sheet. The above procedures are commonly used. However, do
not conclude that all companies must follow all the steps. A company can devise its own way of taking
physical count procedures.
The Functions of Inventory Taking

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Inventory taking is an activity which is used to determine cost and quantity of unsold or unused items.
A firm needs inventories as a protection against uncertainty and to have a smooth and continuous
operation.
It is known that no business can operate without inventories and company’s basic need of inventories
can better be understood by examining the prime functions of inventories. These functions of
inventories are the following:
1. To meet anticipated customer demand: Inventories are on hand to ensure good customer service.
It is only when inventories get out of hand that they become unnecessary burden. If they are
managed properly, they permit quick and economical customer service.
2. To smooth production requirements: Firms that experience seasonal patterns in demand often
build up inventories during off-season periods in order to meet overly high requirements that exist
during certain seasonal periods. Therefore, inventories are used to smoothen out seasonal demands
by leveling out production.
3. To Protect against stock outs: Delayed deliveries and unexpected increases in demand increase
the risk of shortages. Delays can be due to weather conditions, suppliers’ stock outs, and deliveries
of wrong materials, quality problems, and so on. Holding safety stocks.
4. To take advantage of stock order cycles: In order to minimize purchasing and inventory costs, it
is often necessary to buy quantities that exceed immediate usage requirements. This necessitates
storing some or the entire purchasing amount for later use. Similarly, it is usually economical to
produce in large, rather than small quantities.
5. To hedge against price increases: Occasionally a firm may suspect that a substantial price increase
is about to be made and purchases larger than normal amounts to achieve some saving.
6. To permit operations: The fact that production or operations take a certain amount of time, that is
they are not instantaneous/ immediate, means that there will generally be some work in process
inventory. In addition, intermediate stocking of goods at production sites as well as goods stored in
warehouses leads to pipe production sites as well as goods stored in warehouses leads to pipe line
inventories throughout a production distribution system.
While determining or taking physical inventory, first the Quantity of each kind of Merchandise owned
by an enterprise is identified, when periodic system is adopted, counting, weighting or measuring is
made at the end of the period. Only merchandise owned by the business at the inventory date is
included in inventory. This is to say it is necessary to examine purchase and sales invoice of the last
few days to determine the legal ownership title of merchandise in transit. In general inventory should
include all (but only) those goods which the business has legal ownership at the date of the balance
sheet.
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1.5 The Effects of Inventories error on Current and Following Period’s Financial Statements.

The misstatement in identifying the ending inventory will have the following effect:
o Understatement in identifying the ending inventory will result in overstatement of the cost of good
sold, in turn the overstatement of cost of good sold will understate the gross profit, the as a result
the net income of the period will be understated by the same amount.
o The understatement of the period net income will result in understatement of the owner’s equity for
the period.
o The understated ending inventory for this period will be the beginning inventory for the next period
which still is understated. The understatement of beginning inventory in the subsequent period will
understate the cost of good sold for the period.
o The understated cost of goods in the subsequent period will overstate the period’s net income. The
overstated net income will in turn over state the period’s owner’s equity which was understated in
the previous period; thus the understated owner’s equity in the previous period will be compensated
by the overstated owner’s equity of this period.
o Thus the amount of misstatement will be equal in two subsequent periods but of opposite direction,
therefore, these two misstatements will cancel each other, these means if the effect in the net
income of an incorrectly stated inventory is not corrected, it is limited only to the period of the error
and the following period.
1.5.1 Effect of ending inventory on current period’s financial statements
Ending inventory is the cost of merchandise on hand at the end of accounting period. Let us see its
effect on current period’s financial statements. Income statement
a. Cost of goods (merchandise) sold =Beginning inventory + Net purchase – Ending inventory
As you see, ending inventory is a deduction in calculation cost of merchandise sold. So, it has an
indirect (negative) relationship to cost of merchandise sold, i.e. if ending inventory is understated, the
cost of merchandise sold will be overstated, and if ending inventory is overstated, the cost of
merchandise sold will be understated.
b. Gross Profit = Net sales – Cost of merchandise sold
Here, the cost of merchandise sold had indirect relationship to gross profit. So, the effect of ending
inventory on gross profit is the opposite of the effect on cost of merchandise sold. That is, if ending
inventory is understated, the gross profit will be understated and if ending inventory is overstated, the
gross profit will be overstated. This is a direct (positive) relationship.
c. Operating income = Gross Profit – Operating Expenses
Gross profit and operating income have direct relationships. Thus, the effect of ending inventory on net
income is the same as its effect on gross profit, i.e. direct (positive) effect (relationship).
Balance Sheet
1. Current 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 (overstated),
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 the total current assets will be understated (overstated). Since current assets are part of total
assets, ending inventory has direct relationship to total assets.
2. Liabilities-
Liabilities- No effect on liabilities. Inventory misstatement has no effect on liabilities.
3. Owners’ equity – The net income will be transferred to the owners’ equity at the end of
accounting period. Closing income summary account does this. So, net income has direct
relationship with owners’ equity at the end of accounting period. The effect-ending inventory on
owners’ equity is the same as its effect on net income, i.e. if ending inventory is understated
(Overstated), the owners’ equity will be understated (Overstated).
1.5.2 Effects of beginning inventory on 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 is summarized below:
Income Statement
1. Cost of merchandise sold= Beginning inventory + Net Purchases – Ending inventory
As you see, beginning inventory is an addition in determining cost of goods sold. It has direct
effect on cost of merchandise sold. That is, if the beginning inventory is understated
(Overstated), the cost of merchandise sold will be understated (Overstated)
2. Gross Profit= Net Sales – Cost of merchandise sold
The effect of beginning inventory on gross profit is the opposite of the effect on cost of
merchandise sold, i.e. indirect (negative) relationship. If the beginning inventory is understated,
the gross profit will be overstated and if it is overstated, the gross profit will be understated.
3. Net income = Gross Profit – Operating expenses
The effect of beginning inventory on net income is the same as its effect on gross profit.
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-
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. But if the error is
made in the current period, it will have indirect effect on ending owners’ equity.
1.5.3 Effect of ending inventory on the following period’s financial statements
The ending inventory of the current period will become the beginning inventory for the following
period. So, it will have the same effect as beginning inventory of the current period. Let us summarize it.
Income statement of the following period

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 Cost of merchandise sold direct relationship
Gross profit indirect relationship
Net income indirect relationship
Balance sheet of the following period
The ending inventory of the current period will not have an effect on the following period’s balance
sheet items.
Illustration – 1 The following amounts were reported in Belay Company’s financial statements for
three consecutive fiscal year ended December 31.
2000 2001 2002
a) Cost of merchandise sold Br. 130,000 Br. 154,000 Br. 140,000
b) Net income 40,000 50,000 42,000
c) Total Current assets 210,000 230,000 200,000
d) Owner’s equity 234,000 260,000 224,000
In making the physical counts of inventory, the following errors were made:
 Inventory on December 31, 2000, under stated by Br. 12,000
 Inventory on December 31, 2001, overstated by Br. 6000
Required: Determine the correct amount of the items listed above.
Solution
2000 2001 2002
a) Cost of merchandise sold:
sold:
Reported Br. 130,000 Br. 154,000 Br. 140,000
Adjustment of
2000 error (12,000) 12,000 _
2001 error _ 6,000 (6,000)
Corrected Br. 118,000 Br. 172,000 Br. 136,000
b) Net income:
Reported Br. 40,000 Br. 50,000 Br. 42,000
Adjustment of
2000 error 12,000 (12,000) _
2001 error _ (6,000)
(6,000) 6,000
Corrected Br. 52,000 Br. 32,000 Br. 48,000
c) Total current assets:
Reported Br. 210,000 Br. 230,000 Br. 200,000
Adjustment of
2000 error 12,000 _ _
2001 error _ (6,000)
(6,000) _
Corrected Br. 222,000 Br. 224,000 Br. 200,000
d) Owner’s equity:
Reported Br. 234,000 Br. 260,000 Br. 224,000
Adjustment of
2000 error 12,000 _ _
2001 error _ (6,000) _
Corrected Br. 246,000 Br. 254,000 Br. 224,000

1.6 DETERMINING THE COST OF INVENTORY

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One of the most important decisions in accounting for inventory is determining per unit costs assigned
to inventory items. When all units are purchased at the same unit cost, this process is simple since the
same unit cost is applied to determine the cost of goods sold and ending inventory. But when identical
items are purchased at different costs, a question arises as to what amounts are included in the cost of
merchandise sold and what amounts remain in inventory.
I. INVENTORY COSTING METHODS UNDER PERIODIC INVENTORY SYSTEM

A periodic inventory system determines cost of merchandise sold and inventory at the end of the
period. We must record cost of merchandise sold and reductions in inventory as sales occur using a
perpetual inventory system. How we assign these costs to inventory and cost of merchandise sold
affects the reported amounts for both systems. There are four methods commonly used in assigning
costs to inventory and cost of merchandise sold. These are:
I. Specific identification III. Last-in first-out (LIFO)
II. First-in first-out (FIFO) IV. Weighted average
Let us see these costing methods under periodic inventory system based on the following 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,
Br.59, 520
The ending inventory consists of 300 units, 100 from each of the last three purchases.
1.6.1 Specific Identification Method
When each item in inventory can be directly identified with a specific purchase and its invoice, we can
use specific identification (also called specific invoice pricing) to assign costs. This method is
appropriate when the variety of merchandise carried in stock is small and the volume of sales is
relatively small. We can specifically identify the items sold and the items on hand.
Example: 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.
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
1.6.2 First-in, First-out (FIFO)
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This method of assigning cost to inventory and the goods sold assumes inventory items are sold in the
order acquired.
acquired. This means the cost flow is in the order in which the expenditures were made. 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.
For example, easily spoiled goods such as fruits, vegetables etc., must be sold near the time of their
acquisition. So, the inventory on hand will be from the recent purchases. As an example, consider
the previous illustration on page 21.
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
1.6.3 Last-in first-out (LIFO)
This method of assigning cost assumes that the most recent purchases are sold first. Their costs are
charged to cost of goods sold, and the costs of the earliest purchases are assigned to inventory.
inventory. The
cost flow is in the reverse order in which expenditures were made. In calculating the cost of goods
sold, we will start from the earliest purchases. As an example, take the previous illustration
The cost-ending inventory under FIFO method
=Br.60 x 80 = Br. 4,800
=Br. 56 x 220 = 12,320
300 units
Ending inventory cost = Br. 17,120
Cost of merchandise sold = Br. 59,520 – Br. 17,120
= Br. 42,400
1.6.4 Weighted Average Method
This method of assigning cost requires computing the average cost per unit of merchandise
available for sale. That means the cost flow is an average of the expenditures.
expenditures. To calculate the cost
of ending inventory, we will 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
Then the weighted average unit cost is multiplied by units on hand at the end of the period to
calculate the cost of ending inventory. Also, the same average unit cost is applied in the
computation of cost of goods sold.
sold. As an example, take the previous illustration
Weighted average unit cost = Br. 59,520 = Br. 49.60
1,200
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  Ending inventory cost = Br. 49.60x 300
= Br.
Br. 14,880
 Cost of merchandise sold = Br. 59,520-Br. 14,880
= Br.
Br. 44,640
1.7 COMPARISON OF INVENTORY COSTING METHODS
If the cost of units and prices at which they are sold remains stable, all the four methods yield the
same results. But if prices change, the three methods usually yield different amounts for:
- Ending inventory - Gross profit or net
- Cost of merchandise sold income
In periods of rising (increasing) prices: (or if there is inflationary trend):
trend):
FIFO yields – higher ending inventory
_ Lower cost of merchandise sold and higher gross profit (net income)
LIFO yields _ Lower ending inventory
_ Higher cost of merchandise sold and Lower gross profit (net income)
W.A yields _ The results between the two.
In periods of declining (decreasing) prices:
FIFO yields _ Lower ending inventory
_ Higher cost of merchandise sold and Lower gross profit or net income
LIFO yields _ higher ending inventory
_ Lower cost of merchandise sold and higher gross profit or net income
W.A yields _ Between the two
The uses of three cost flow assumptions are revised under the inflation and deflation period as follows:
Cost follow assumption Inflation Period Defilation Period
Ending inventory High Low
FIFO Cost of goods sole Low High
Gross profit High Low
Ending inventory Average Average
Average Cost of goods sole Average Average
Gross profit Average Average
Ending inventory Low High
LIFO Cost of goods sole High Low
Gross profit Low High

At a time of inflation, most portions of the gross profits is from sale of the inventory is attributed to
inflation effects, and are referred as inventory profits or illusory profits.
o The major criticism in FIFO method is that it has a tendency to maximize the effect of inflation
and defilation trends on amounts reported as gross profit.
o But the advantage of FIFO method is that the merchandise reported in inventory on the balance
sheet is usually at about the same as the current replacement cost.
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 o The major criticism on LIFO is that the birr amount reported for merchandise inventory in
balance sheet may be quit far from the current replacement cost.
o But those organizations which use LIFO usually disclose or attach a note to the financial
statement stating the difference between LIFO inventory amount and the inventory amount if
FIFO had been used.
LIFO provides tax advantage in the inflationary periods because most recent costs will be included in
the cost of good sold, and as a result the revenues are in effect matched against current costs and the
gross profit is low in relation to FIFO.
Average cost method compromises between FIFO and LIFO. The effect of price trend is averaged, both
in cost of good sold or cost of inventory. Weather in deflation or inflation period, average costing
method provides the same cost.
II. 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 fare as follows:
Units Cost
Jan. 1 Inventory 12 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
1.4.1 First-in first-out Method
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. Let us
calculate the cost of goods sold and ending inventory under perpetual inventory system from the above
illustration.

Perpetual - FIFO
Date Purchase Cost of merchandise sold Inventory
Qty. Unit cost Total cost Qty Unit cost Total cost Qty Unit cost Total cost
Jan. 1 15 Br. 10.00 Br. 150.00
6 5 Br. 10.00 Br. 50.00 10 10.00 100.00
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 10 10.00 100.00
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
30 15 14.00 210.00 8 12.50 100.00
15 14.00 210.00

23 Br. 246.00 25 Br. 334.00

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. 12.5 x 8 = 100
Br. 12 x 2 = 24
Br. 334
Cost of goods available for sale = Br. 120 + Br. 100 + Br. 210 = Br. 580
Cost of goods sold = Br. 580 – Br. 334
Br 246
So, the same results of cost of gods sold and ending inventory under both periodic inventory systems.
2.4.2 Lasting, First-Out method
Unlike FIFO method, different results may occur under periodic and perpetual inventory system. The
most recent purchases change when new purchase occurs. Let us calculate first the cost of goods sold
and ending inventory for the above illustration under perpetual inventory system. Then, we will see the
results under periodic inventory system.

Perpetual - LIFO
Date Purchase Cost of merch. Sold Inventory
Qty Unit cost Total cost Qty Unit cost Total cost Qty Unit cost Total cost
Jan1 15 Br. 10.00 Br. 150.00
6 5 Br. 10.00 Br. 50.00 10 10.00 100.00
17
10 10 Br. 12.00 Br. 120.00 10 10.00 100.00
10 12.00 120.00
20 8 Br. 12.00 Br. 96.00 10 10.00 100.00
2 12.00 24.00
25 8 12.50 100.00 10 10.00 100.00
2 12.00 24.00
8 12.50 100.00

27 8 12.50 100.00 10 10.00 100.00

2 12.00 24.00
30 15 14.00 210.00 10 10.00 100.00
15 24.00 210.00
23 Br. 270.00 25 Br.310.00
Br.310.00

So, the cost of merchandise sold and ending inventory under perpetual inventory system are Br. 270
and Br. 310 respectively. The results under periodic inventory system are:
Cost of ending inventory = Br. 10 x 15 = Br. 150
Br. 12 x 10 = 120
25
Br. 270
Cost of merchandise sold = Br. 580 - 270
= Br. 310
As you see, the results are different under periodic & perpetual inventory systems.
2.4.3 Weighted average cost method.
Under this method, the average unit cost is calculated each time purchased is made to be applied on the
sales made after the purchases. The results may be different under periodic and perpetual inventory
system. Let us calculate the cost of merchandise sold and ending inventory comes out from the previous
illustration under perpetual inventory system

Average Cost Method (Moving Average)

Purchase Cost of merchandise sold Inventory
Date Qty Unit Total cost Qty Unit Total cost Qty Unit cost Total cost
cost cost
Jan.1 15 Br. 10.00 Br. 150.00
6 5 Br. 10.00 Br. 50.00 10* 10.00 100.00*
20 11.00 220.00
10 10* 12.00 Br. 120.00* * = 100+120

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 10+10
20 8 11.00 88.00 12** 11.00 132.00*
*
20 11.60 232.00
25 12.00 ** = 132+100
8** 100.00** 12+8
27 10 11.60 116.00 10’’ 11.60 116.00’’
30 15’’ 14.00 210.00’’ 15 13.04 326.00
“ =116+210
=116+210
10+15
23 Br.
Br. 254.00 25 Br. 13.04 Br 326.00
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
8. Additional valuation problems for inventories by other methods than cost

An attempt has been made in this unit to explain how costs are assigned to ending inventory and cost of
goods sold using one of four costing methods (FIFO, LIFO, Weighted average, or specific
identification). So far inventories have been valued at cost which is the purchase price of merchandise.
Yet, the cost of inventory is not necessarily the amount always reported on a balance sheet.
sheet. Under
certain circumstance, however, inventory is valued at other than cost. Two commonly identified
circumstances arise when: For example:
1. When the cost of replacing the item is below recorded cost.
cost.
2. When the inventory is not salable at normal price because of imperfection, style change,
shops wear …etc.
Accounting principles require that inventory be reported at the market value of replacing inventory
when market is lower than cost. Merchandise inventory is then said to be reported on the balance sheet
at the lower of cost or market (LCM).
8.1 VALUATION AT LOWER OF COST OR MARKET (LCM)
In applying LCM, cost is the acquisition price of inventory computed using one of the historical cost
methods - specific identification, FIFO, LIFO, and Weighted average; but market cost is defined as
the current market value (cost) of replacing inventory. It is the current cost of purchasing the same
inventory items in the usual manner. It is important to know that market is not defined as the sales
prices.
prices.

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 If the replacement price of an item in the inventory is lower than its cost,
cost, the use of the lower of cost
or market method provides two advantages:
a. The gross profit (and net income) are reduced for the period in which decline occurred and,
b. An approximately normal gross profit is realized during the period in which the item sold.
A decline in market cost reflects a loss of value in inventory. This is because the recorded cost of
inventory is higher than the current market cost. When this occurs, a loss is recognized. This is done
by recognizing the decline in merchandise inventory from recorded cost to market cost at the end of
the period.
Example:
Assume The sales price is Br 100.00
The cost of inventory is 70.00
Gross profit 30.00 30% of sales price
Assume the market price has declined to Br 60.00, if the costs of inventory declines, the sales price
will also declines.
Assume the sales price has become Br 90.00:

Thus Sales Price Br 90.00

Cost 63.00
Gross profit 27.00 which is also 30% of sales price.
Therefore, according to the lower of cost or market, if the cost of merchandise is not reduced to
Br. 63.00, the cost of merchandise as they are sold in subsequent period will be:
Sales Price Br 90.00
Cost 70.00
Gross profit 20.00
Which is less by Br 7.00 because of market price decrease in the previous period? But matching
states all cost or expense of the period must be matched against the period’s revenue.
Thus it is important to identify a decrease in inventory if market is less than cost and adjust the
inventory to the market value in the period the decline occurred.
LCM is applied in one of three ways:
(1)
(2) Separately to individual
item
(3) To major categories of
items
(4) To the whole of inventory

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The less similar the items are that make up inventory, the more likely it is that companies apply LCM
to individual items. Advances in technology further encourage the individual item application.
Illustration The following are the inventory of ABC motor sports, retailer.

Inventory units per unit

Items on hand cost market
Cycles:
Roadster 50 Br. 15,000 Br. 14,000
Sprint 20 9,000 9,500
Off Road:
Road:
Trax-4 10 10,000 11,200
Blaz’m 6 16,000 14,500

Let us see LCM computation under the three ways:

(1) Separately to each individual item

Inventory items Total cost Total market LCM
Roadster Br. 750,000 Br. 700,000 Br. 700,000
Sprint 180,000 190,000 180,000
Categories sub total Br.
Br. 930,000 Br. 890,000 880,000
Trax-4 100,000 112,000 100,000
Blaz’m 96,000 87,000 87,000
Categories sub total Br. 196,000 Br. 199,000 187.000
(3) Totals Br.
Br.1, 126,000 Br. 1,089,000 Br. 1, 067,000

(2) Major categories of items

Inventory Categories Categories LCM
Categories total cost total market
Cycles Br. 930,000 Br. 890,000 Br. 890,000
Off. Road 196,000 199,000 196,000
Totals Br. 1,126,000 Br. 1089,000 Br. 1,086,000
1. When LCM is applied to the whole of inventory,
inventory, the market cost is Br. 1,089,000.
1,089,000. Since this
market cost is Br.
Br. 37,000 lower than Br. 1,126,000 recorded cost, it is the amount reported for
inventory on the balance sheet.
2. When LCM is applied to individual items of inventory,
inventory, the market cost is Br. 1,067,000.
1,067,000. Since
market is again less than Br. 1,126,000 costs,
costs, it is the amount reported for inventory.
3. When LCM is applied to the major categories of inventories, the market is Br. 1,086,000 which is
also lower than cost.Thus
cost. the decline in the cost that is Br 37,000 (1,126,000 -1,089,000) will either
be included in cost of good sold, to reduce the gross profit, or it could be reported as administration
expenses reported separately.
1. Cost of Good Sold Br 37,000
Inventory Br 37,000
2. Unrealized Loss Br 37,000
Inventory Br 37,000
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8.2 Valuation at Net Realizable Value
Obsolete, damaged, spoiled Merchandises and other merchandise that can be sold only at a price
below cost should be valued at net realizable value. For this purpose, net realizable value is the
estimated selling price less any direct cost of disposition, such as sales commissions.
Net Realizable Value = Estimated sales value – Any direct cost to sell this merchandises
Example: Assume that damaged merchandises, which have a selling value of Br 1,500.00, could be
sold at Br 800.00 and to sell these proud we have direct expense (transportation, brokerage fee, and the
likes) of Br 150.00. Thus the inventory should be valued at Net Realizable value (NRV).
NRV= Br 800.00- 150.00 =Br 650.00
9. ESTIMATING INVENTORY COST
In practice, an inventory amount is estimated for some purposes, when it is impossible to take physical
inventory, or to maintain perpetual inventory records. Yet events can occur where the inventory
account balance is different from inventory on hand.
hand. Such events include theft, loss, damage,
damage, and
errors
Example
1) Monthly income statements are needed. It may be too costly, to take physical inventory. This is
especially the case when periodic inventory system is used.
2) When a catastrophe such as a fire has destroyed the inventory. In such case, to ask claims from
insurance companies, there is a need of estimated inventory. To estimate the cost of inventory, two
methods are used. These are retail method and gross profit method.
9.1 Retail method of inventory costing
This method is mostly used by retail business.
business. The estimate is made based on the relation ship 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
Example
Cost Retail
Sep. 1, beginning inventory Br. 25,000 Br. 40,000
Purchases in September (net) 125,000 160,000
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 Sales in September (net) 140,000
(1) Cost to retail ratio = 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
9.2 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 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) Cost of merchandise sold is estimated
Estimated cost of merchandise sold = Sales - Estimated gross profit
(3) Calculate the estimated cost of ending inventory

Estimated cost of = Cost of merchandise – Estimated cost of

Ending inventory Available for sale merchandise sold.

Example
Oct. 1, beginning inventory (cost) – Br. 36,000
Net purchases during October (cost) 204,000
Net sales during October 220,000
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

23