Infolink University college Wolayita

Sodo campus department of Economics

CHAPTER 1
PRINCIPLES OF ACCOUNTING II
Accounting for Inventories

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After studying this chapter you should be able to meet these
learning objectives:
 Explain the meaning of inventories;
 Describe the effect of inventory on the financial statements of
the current period and the following period;
 Identify and describe the two principal inventory systems 
Describe how to determine the cost of inventory;
 Identify the most common inventory costing methods under a
periodic system and perpetual system.
 value inventories at the lower of cost or market price;
 Understand the need for estimating inventories using retail
and gross profit method.

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 1.1. Nature and effect of Inventories on financial statements
1.1.1. Meaning 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 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.

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• They are mainly divided into two major categories:
 Inventories of merchandising businesses; and
 Inventories of manufacturing businesses

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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 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

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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
furniture9s, 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.

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 1.1.2. Internal Control of Inventories

Management is vitally interested in inventory planning and

control. Whether a company manufactures or merchandises goods,
it needs an accurate accounting system with up-to-date records. It
may lose sales and customers if it does not stock products in the
desired style, quality, and quantity. Further, companies must
monitor inventory levels carefully to limit the financing costs of
carrying large amounts of inventory. In a perfect world, companies
would like a continuous record of both their inventory levels and
their cost of goods sold. The popularity and affordability of
computerized accounting software makes the perpetual system
cost-effective for many kinds of businesses. Companies now
started to incorporate the recording of sales with optical scanners at
the cash register into perpetual inventory systems.

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• However, many companies cannot afford a complete
perpetual system. But, most companies need current
information regarding their inventory levels, to protect
against stock-outs or over- purchasing and to aid in
preparation of monthly or quarterly financial data. As a
result, these companies use a modified perpetual
inventory system. This system provides detailed
inventory records of increases and decreases in quantities
only not dollar amounts. It is merely a memorandum
device outside the double-entry system, which helps in
determining the level of inventory at any point in time.

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• Whether a company maintains a complete perpetual inventory
in quantities and dollars or a modified perpetual inventory
system, it probably takes a physical inventory once a year. No
matter what type of inventory records companies use, they all
face the danger of loss and error. Waste, breakage, theft,
improper entry, failure to prepare or record requisitions, and
other similar possibilities may cause the inventory records to
differ from the actual inventory on hand. Thus, all companies
need periodic verification of the inventory records by actual
count, weight, or measurement, with the counts compared with
the detailed inventory records. Finally, a company corrects the
records to agree with the quantities actually on hand.

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• Insofar as possible, companies should take the physical
inventory near the end of their fiscal year, to properly report
inventory quantities in their annual accounting reports.
Because this is not always possible, however, physical
inventories taken within two or three months of the year's end
are satisfactory, if a company maintains detailed inventory
records with a fair degree of accuracy.
• Two primary objectives of control over inventory are as
follows:
 Safeguarding the inventory from damage or theft.
 Reporting inventory in the financial statements.

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• Safeguarding Inventory - Controls for
safeguarding inventory begin as soon as the
inventory is ordered.
• The following documents are often used for
inventory control:
Purchase order
Receiving report
Vendor9s invoice

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• The purchase order authorizes the purchase of the inventory
from an approved vendor. As soon as the inventory is received,
a receiving report is completed.
• The receiving report establishes an initial record of the
receipt of the inventory. To make sure the inventory received
is what was ordered, the receiving report is compared with the
company9s purchase order.
• The price, quantity, and description of the item on the
purchase order and receiving report are then compared to the
vendor’s invoice.
• If the receiving report, purchase order, and vendor9s invoice
agree, the inventory is recorded in the accounting records.

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• Recording inventory using a perpetual inventory system is also an
effective means of control.
 This helps keep inventory quantities at proper levels. For
example, comparing inventory quantities with maximum and
minimum levels allows for the timely re-ordering of inventory
and prevents ordering excess inventory.
 Finally, controls for safeguarding inventory should include
security measures to prevent damage and customer or employee
theft.
Some examples of security measures include the following:
 Storing inventory in areas that are restricted to only authorized
employees.
 Locking high-priced inventory in cabinets.
 Using two-way mirrors, cameras, security tags, and guards.
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• Reporting Inventory - A physical inventory or count of
inventory should be taken near year-end to make sure that the
quantity of inventory reported in the financial statements is
accurate. After the quantity of inventory on hand is
determined, the cost of the inventory is assigned for reporting
in the financial statements.

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• 1.1.3. Importance of Inventories
Merchandise purchased and sold is the most active elements in a
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 following periods financial statements. If inventories
are misstated(overstated or understated), the financial statements of
the business will be distorted.
 1.2. The Effect of Inventory on the Financial Statements
1.2.1. The effect of inventory on the current period’s financial statements

 Ending inventory is the cost of merchandise on hand at the end of

the accounting period.
 The effect of ending inventory is reflected in both income
statements and balance sheets.
Income Statement
a. Ending inventory is used in calculating cost of goods sold in the
income statement.
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,
Note: the
there exists an costorof
inverse merchandise
negative relationship sold will
between be inventory
ending understated.
and cost of
merchandise sold.
b. The cost of the merchandises sold will then subsequently be
used in calculating the gross profit of the enterprise.
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 opposites 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 to overstated, the gross profit
will be overstated.

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c. Operating income = Gross Profit -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. Note: there exists positive or direct
relationship between ending inventory and gross profit as well as
operating income (net income).

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• Balance Sheet
• A balance sheet is a financial statement that lists all assets, liabilities and capitals
of an organization on a specific date. The ending inventory of an organization
affects the two major components of a balance sheet:
• 1. Current Assets - Ending inventory is part of current assets, even the largest.
Therefore, it has a direct (positive) relationship to current assets. If ending
inventory balance is understated (overstated), 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: 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. Therefore,
net income has direct relationship with owners9 equity at the end of accounting
period. The effect-ending inventory on owners9 equity is the same as its effect on
net income, i.e. if ending inventory is understated (Overstated), the owners9 equity
will be understated (Overstated).

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• Illustration:

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The end of Chapter One
Thanks !!

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