ACCOUNTS AND BUDGET SERVICE LEVEL IV

Learning Guide
Unit of Competence Maintain Inventory Records
Module Title Maintaining Inventory Records

LG Code: BUF ACB4 12 0812

TTLM Code: BUF ACB4M 12 0812

Summary of Learning Outcomes

After completing this learning guide, you should be able to:

.
Lo1:- .Process inventory purchase
Lo2:- .Record inventory flows
Lo3:- Reconcile inventory records to general ledgers
Lo4:- Prepare inventory schedules and ad hoc reports
Learning objectives
After studying this lesson you must understand.
 How inventory quantities are determined.
 How to compute ending inventory and costs of goods sold under FIFO, LIFO and
average cost.
 The alternative inventory cost flow assumption.
Definition of inventory
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 materials used as input for producing
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.
2. Work in process 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.

THE EFFECT OF INVENTORIES ON CURRENT AND FOLLOWING PERIOD’S FINANCIAL

STATEMENTS.
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 that, 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. Net- income = Gross Profit – Operating Expenses

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. So, it has a direct 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. So, net income has direct relationship with owners’ equity at the end
of acc ounting period. If ending inventory is understated (Overstated), the owners’ equity
will be understated (Overstated).
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.
The effects of ending inventory on Income statement of the following period:
Cost of merchandise sold direct relationship
Gross profit indirect relationship
Net income indirect relationship

INVENTORY SYSTEMS
There are two principal systems of inventory accounting periodic and perpetual.

Periodic inventory system

Under this system there is no continuous record of merchandise inventory account. The
inventory balance remains the same throughout the accounting period, i.e. the beginning
inventory balance. This is because when goods are purchased, they are debited to the purchases
account rather than merchandise inventory account.
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 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 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.

Companies that sell items of high unit 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 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

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
_ 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.

Cost flow assumptions

A company typically starts an accounting period with units in the beginning
inventory and then purchases or process additional units during the period.
Together these constitute the goods available for sale, which are then either sold or
remain in the ending inventory.
We will discuss each cost flow assumption in the following sections and apply it to
both the perpetual and the periodic inventory systems using the information for
ABC Company.

A. Specific Identification Method

Under the specific identification inventory cost flow assumption, a company
identifies each unit sold and each unit remaining in the ending inventory and
includes the actual costs of those units in cost of goods sold and ending inventory,
respectively.
The specific identification method can be applied in either a perpetual or a periodic
inventory system but it is more reasonable to use it with a perpetual system in
which: - each unit is identifies as it is sold and the appropriate cost attached.

B. First in first out (FIFO)

Under the FIFO cost flow assumption, a company includes the earliest cost
incurred in the cost of goods sold, and includes the most recent cost in the ending
inventory.
Earliest Costs cost of goods sold Income statement
FIFO
Latest costs ending inventory Balance sheet
In other words the first costs incurred are the first transferred to cost of goods sold
(in a merchandising company) or goods in process and then to finished goods and
costs of goods sold (in a manufacturers company).
Consequently the ending inventory consists of the most recent costs incurred.
Therefore in periods of rising costs, FIFO produces a lower costs of goods sold
figure in dollar (Birr), whereas ending inventory is based on the most recent and
higher costs.
Illustration 7-4 Inventory inflows and out flows for ABC Company
Inventory, April 1 --------------------- 100 units at $10 per unit -------------- $ 1,000
Purchases, April 10 ------------------- 80 units at $11 per unit ------------------ $ 880
Purchases, April 20 ------------------- 70 units at $12 per unit ------------------ $ 840
Goods available for sale --------------250 units --------------------------------- $ 2,720
Sales, April 18 ---------------------------- (90) units
140 units
Sales, April 27 ---------------------------- (50) units
Inventory, April 30 --------------------110 units

FIFO cost flow assumption

(Periodic inventory system)
Ending inventory (110 units)
40 units at $ 11 --------------------------------------------------$440
70 units at $ 12 --------------------------------------------------$840
Total ------------------------------------------------------------$1,280
Cost of goods sold (140 units)
 Beginning inventory +Purchases - ending inventory = Cost of goods sold
$ 1000 +$1,720 - $1,280 =$1440
If ABC Company uses perpetual inventory system (for cost as well as physical
quantities) it calculates the cost of goods sold of $1,440 and the end inventory of
$1,280 as shown below:
FIFO cost flow assumption
 (Periodic inventory system)
Cost of goods sold (140 units):
April 18:90 units at $10 -------------------------------------------- $900
April 27: 50 units: 10 units at $10 --------------------------------- 100
: 40 units at $ 11 ------------------------------- 440
Total ---------------------------------------------------------$1,440
Ending inventory (110 units)
40 units at $11=$440
70 units at $12= 840
Total-------------------- $1,280
Note that the ending inventory and the cost of goods sold under both the perpetual
and the periodic systems are equal this always is true for the FIFO cost flow
assumption because the most recent costs incurred are included in the ending
inventory.
C. Last-in first-out method (LIFO)
In this method of costing is based on the assumption that the most recent
cost incurred should be charged against revenue. Hence the inventory
remaining is assumed to be composed of the earliest costs.
LIFO cost flow assumption
(Periodic inventory system)
Cost of goods sold (140 units):
April 20:70 units at $12 -------------------------------------------- $ 840
20 units at $ 11 ----------------------------------------------- 220
April 27: 50 units at $11 --------------------------------------------- 550
Total --------------------------------------------------------- $ 1,610
Ending inventory (110 units)
100 units at $10=$1000
10 units at $11 = 110
Total------------------- $1,110

D. Average cost Flow Assumption

Under the average cost flow assumption, a company considers all the costs and
units to be commingled so that no individual units or costs are identified. When the
periodic inventory system is used the average cost method is known as the
weighted average method. The cost of the units for the period is calculated on the
basis of the cost of the beginning inventory and the average cost of the unit’s
purchased or manufactured, weighted accounting to the number of units at each
cost. In other words under the weighted average method, the average cost per unit
for the period is the cost of goods available for sale divided by the number of units
available. This average cost is used for both the ending inventory and the cost of
goods sold.
When a company uses the average cost method under a perpetual inventory system
(for costs as well as physical units) the same principle are applied, but it is known
as a moving average method because a new weighted average cost must be
calculated after each purchase. The new weighted average is computed in the same
way as in the weighted average method. That is under the moving average method,
the average cost per unit is the cost of the units available for sale after the purchase
divided by the number of units available for sale at that time.
This available cost is used to determine the cost each sale made until the next
purchase, at which time a new average cost must be calculated. The illustration for
both systems as follows:
Weighted Average cost flow Assumption
(Periodic Inventory system)
Cost of goods available for sale ($1000 + $1,720) ------------------------$ 2,720
Units available for sale ------------------------------------------------------------- 250
Average cost (cost ¿ number of units) ---------------------------------------$ 10.88
Ending inventory (110 units at $10.88) ---------------------------------------$ 1,197
Beginning + purchases - Ending = Cost of goods
Inventory Inventory Sold
$1000 + $ 1,720 - $1,297 = $1,423
 Moving Average cost flow assumption
(Perpetual inventory System)
April 1, Beginning Inventory --------------------- 100 units at $10 ------$1000
April 10, Purchases --------------------------------- 80 units at $11 ----------$880
April 10, Balance ---------------------------------- 180 units at $10.44 -----$1,880
April 18, Sales --------------------------------- (90) units at $10.44 ---------$(940)
April 18, Balance ---------------------------------- 90 units at $10.44 ---------$940
April 20, Purchases --------------------------------- 70 units at $12.00 -------$840
April 20, Purchases --------------------------------- 160 units at $11.125 --$1,780
April 27, Sales -------------------------------------- (50) units at $11.125 ----$(556)
April 30, Balance ------------------------------ ---- 110 units at $11.125 ----$1,224
Cost of goods sold (140 units at $11.125) ----------------------------------- $1,224
Lo2:- . Record inventory flows

Accounting for and reporting inventory under a perpetual system

In perpetual inventory system, all merchandise increase and decrease are recorded
in manner similar to the recording of increase and decrease in cash. The
merchandise inventories account at the beginning of an accounting period
indicated the merchandise in stock on that date. Purchase is recorded by debiting
merchandise inventory and crediting cash or account 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 K are available for sale
Item K units cost
Jan.1 Inventory 20 $ 20
4 Sale 14
 10 Purchase 16 21
22 Sale 8
28 Sale 4
30 Purchase 20 22
The firm used a perpetual inventory 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.LIFO C. average cost method.

FIFO method

Using cost, costs are included in the merchandise sold in the order in which they
were incurred.

Purchase Cost of merchandise sold Inventory

Date Quant Unit Total Quanti Unit Total Quanti Unit Total
ity cost cost ty cost cost ty cost cost
1 20 20 400
4 14 20 280 6 20 120
10 16 21 336 6 20 120
16 21 336
22 6 20 120 14 21 294
2 21 42
28 4 21 84 10 21 210
30 20 22 440 10 21 210
20 22 440
Total 26 $526 30 $650

Thus cost of merchandise sold= $526 cost of ending inventory=$650

LIFO method
When the LIFO method is used in a perpetual inventory system the cost of the
units sold is the cost of the most recent purchase
Purchase Cost of merchandise sold Inventory
Date Quant Unit Total Quanti Unit Total Quanti Unit Total
1 ity cost cost ty cost cost 20
ty 20
cost 400
cost
4 14 20 280 6 20 120
10 16 21 336 6 20 120
16 21 336
22 8 21 168 6 20 120
8 21 168
28 4 21 84 6 20 120
4 21 84
30 20 22 440 6 20 120
4 21 84
20 22 440
Total 26 $532 30 $644
Thus cost of merchandise sold= $532 cost of ending inventory=$644
Average cost method
When the average cost method 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 .these average techniques called a moving

average.
Purchase Cost of merchandise sold Inventory
Date Quant Unit Total Quanti Unit Total Quanti Unit Total
1 ity cost cost ty cost cost 20
ty 20
cost 400
cost
4 14 20 280 6 20 120
10 16 21 336 22 20.7 456
22 8 20.7 166 14 20.7 290
28 4 20.7 83 10 20.7 207
30 20 22 440 30 21.56 647
Total 26 $529 30 $647
Thus cost of merchandise sold= $529 cost of ending inventory=$647
 Lo3:- . Reconcile inventory records to general
ledgers

Estimating Inventory cost

In practical an inventory amount may be need in order to prepare an income
statement when it is impractical or impossible to take a physical inventory or to
maintain perpetual inventory records the amount of inventory on hand can be
estimated.
The two commonly used methods of estimating inventory cost are:-
1. The retail method
2. The gross profit method
1. Retail Methods
The retail method of estimating the cost of inventories is used primary by retailing
enterprises. Under the periodic inventory system, the cost of the ending inventory
is subtracted from the total cost of goods available for sale to compute the cost of
goods sold. Under the retail method, a record of goods available for sale at selling
prices is kept separate at selling prices. The ending inventories valued at selling
prices then are reduced to estimated cost by multiplying the inventories at selling
price by the cost percentage computed for the accounting period.
Illustration of Retail Method
The retail method of estimating inventories (at average cost) is illustrated by the
following simplified example for ABC Company.
ABC Company
Estimate of Inventories by Retail Method
End of current year
Cost Retail
Beginning inventories ---------------------------- $ 40,000 $50,000
Net Purchases -------------------------------------- $ 150,000 200,000
Goods available for sale ------------------------- $ 190,000 250,000
Cost percentage ($190,000 ¿ $250, 00) -------- $ 76%
Less: Sales and normal shrinkage ---------------------------------------------
220,000
Ending inventories at retail--------------------------------------------------- $30,000
Ending inventories at
Cost ($30,000x0.76) ---------------------------------- $22,800

2. Gross profit method

The gross profit method is useful for several purposes.
a. To control and verify the validity of inventories cost.
b. To estimate interim inventory valuations between physical counts, and
c. To estimate the inventory cost when necessary information normally used is
lost or unavailable.
The procedure involved is one of reducing sales to a cost basis; that is cost of
goods sold is estimate. The estimated cost of goods sold then is subtracted from the
cost goods available for sale to compute the estimated cost of the ending
inventories.
In the events that both merchandise and inventory records are destroyed by fire.
The inventory cost may be estimated by use of gross profit method. The gross
profit and cost of good sold percentage are obtained from prior year’s financial
statements, which presumably are available.
 Lo4:- Prepare inventory schedules and ad hoc reports

Gross profit Method is really a “Cost percentage” Method

The key step in the application of the gross profit method is the development of an
accurate cost percentage, obtained by deduction of the gross profit rate from 100%.
Frequently the best available measure is an average of the cost percentages for
recent years adjusted for any changes in costs and selling prices that have been
taken place in the current year.
Illustration
The following data are given for ABC Company for the year ended Dec 31, year 3.
Beginning inventories ------------------------------------------- $ 40,000
Net Purchases ----------------------------------------------------- 200,000
Net sales ------------------------------------------------------------- 225,000
Average cost percentage for the past two years ----------- 80%
Then by assuming that the cost percentage for year 4 remained at 80% the cost of
the inventories on Dec 31, year 3 is estimated as follows
ABC Corporation
Estimate of cost of inventories by gross profit method
December 31, year 3
Beginning inventories, at cost ------------------------------------ $ 40,000
Add: Net purchases ------------------------------------------------- 200,000
Cost of goods available for sale ---------------------------------- $240,000
Less: Estimated cost of goods sold:
 Net sales ---------------------------------------- $225,000
 Cost percentage ------------------------------- 0.80 180.000
Estimated ending inventories at cost --------------------- $60,000
Some times the gross profit percentage is stated as a percentage of cost. In such
situations the gross profit percentage must be restated to a percentage of net sales
to compute the cost percentage (based on sales).
Illustration
The gross profit is stated as 25% of cost, and then computes the cost percentage in
terms of sales.
Solution
 25% =1/4 gross profit based on cost.
 Add: Numerator of fraction to denominator to make 1/5
 1/5 = 20% of gross profit based on net sales.
Or
Let x=cost as percentage of net sales 0.25x=gross profit percentage (based
on co