Intermediate Financial Accounting I

CHAPTER 4
ACCOUNTING FOR INVENTORIES

4.1 Nature and Classification of inventories

Inventories are asset items that a company holds for sale in the ordinary course of business, or
goods that it will use or consume in the production of goods to be sold. The description and
measurement of inventory require careful attention. The investment in inventories is frequently
the largest current asset of merchandising (retail) and manufacturing businesses.
The major inventory account for merchandising business is merchandise inventory (which means
stock of items purchased with intention to be sold). Manufacturing companies have three major
types of inventories.

a. Raw material inventories

b. Work in progress inventories
c. Finished goods inventories

NB: All types of businesses have supplies inventories which is collection of consumable items.

3.1. Goods and Costs Included in Inventory

Goods Included in Inventory

Page 1
 Intermediate Financial Accounting I

Legal ownership title determines which inventories are to be included in accounting record of a
given organization. For items purchased or sold, legal ownership depends on shipping
agreements. There are two shipping agreements

1. Free on Board Shipping: legal ownership is transferred from seller to buyer at seller’s
place of business.
2. Free in Board Destination: legal ownership is transferred from seller to buyer at buyer’s
place of business.
Treatment for items on Transit

Items purchased and on transit under FOB Shipping are included in inventories while items sold
and on transit under free on board shipping are not included in inventories. Items purchased and
on transit under FOB destination are not included in inventories while items sold and on transit
under free on board shipping are included in inventories.

Treatment for Goods Under consignment Contract

Consignment contract is a contract under which one party transfers inventories to another party
who acts as sales agent. The party who is transferring inventories is known as consignor and the
party to whom inventories are transferred is known as consignee. Legal ownership title for goods
under consignment contract belongs to the consignor. Therefore, items transferred to another
party under consignment contract are included in accounting records while items received from
another party under consignment contract are not included.

Costs Included in Inventory

Product Costs

Product costs are those costs that “attach” to the inventory. As a result, a company records
product costs in the Inventory account. These costs are directly connected with bringing the
goods to the buyer’s place of business and converting such goods to a salable condition.
Such charges generally include
(1) costs of purchase, (2) costs of conversion, and (3) “other costs” incurred in bringing the
inventories to the point of sale and in salable condition.

Page 2
 Intermediate Financial Accounting I

Costs of purchase include:

1. The purchase price.

2. Import duties and other taxes.

3. Transportation costs.

4. Handling costs directly related to the acquisition of the goods.

Conversion costs for a manufacturing company include direct materials, direct labor, and
manufacturing overhead costs. Manufacturing overhead costs include indirect materials, indirect
labor, and various costs, such as depreciation, taxes, insurance, and utilities.

“Other costs” include those incurred to bring the inventory to its present location and condition
ready to sell, such as the cost to design a product for specific customer needs.

Period Costs

Period costs are those costs that are indirectly related to the acquisition or production of goods.
Period costs such as selling expenses, general and administrative expenses are therefore not
included as part of inventory cost.

Inventory Systems
Periodic inventory system

A periodic inventory system can be defined as a system of accounting for inventory in which the
cost of goods sold is determined and ending inventory balance is adjusted at the end of the
accounting period, not when merchandise is purchased or sold. Under this system, the quantity of
inventory on hand is determined only periodically. Hence, under a periodic inventory system, the
cost of goods sold is a residual amount that is dependent upon a physically counted ending
inventory.

Perpetual inventory System

A perpetual inventory system can be defined as a system of accounting for inventory which
involves detailed and continuous recording of the number of units of inventories and the costs of
each inventory purchase and sales transaction throughout the accounting period. Under this

Page 3
 Intermediate Financial Accounting I

system, a continuous record of changes in inventory is maintained in the inventory account and
the cost of goods sold account.
4.2. Valuation of inventories: A cost-basis approach
Inventory cost flow assumptions
The term cost flow refers to the inflow of costs when goods are purchased or manufactured and
to the outflow of costs when goods are sold. The cost remaining in inventories is the difference
between the inflow and outflow of costs. During a specific accounting period such as a year or a
month, identical goods may be purchased or manufactured at different costs. Accountants then
face the problem of determining which costs apply to items in inventories and which applies to
items that have been sold.
In selecting an inventory valuation method (or cost flow assumption), accountants are based on
the basis of matching costs with revenue, and the ideal choice is the method that “most clearly
reflects periodic income.”

On the basis of this, the most widely used methods of inventory valuation are:

1. First-in, First-out (FIFO) Method

2. Last-in, First-out (LIFO) Method (not recommendable under IFRS)
3. Weighted-Average Method
4. Specific Identification Method
First-In, First-out method (FIFO)

The FIFO method assumes flows of costs based on the assumption that the oldest goods on hand
are sold first. To illustrate the application of the inventory costing methods, consider the
following data related to candy inventories of Sheger Merchandising Company for the month of
January, 2020.

Page 4
 Intermediate Financial Accounting I

Sheger Company
Record of Purchases of Item candy
For the month January 2020
Date Purchases Sales Balance (units on
Hand)
January 1 200
January 9 300 units @ Br 1.10 500
January 10 400 100
January 15 400 @ Br 1.16 500
January 18 300 200
January 24 100 @ Br 1.26 300

The beginning inventory on January 1 is acquired at Br. 1.00 each. Based on the information in
the schedule, the cost of goods available for sale is determined as follows:

Beginning inventory cost……………………………..200 x Br. 1.00 = Birr 200

Add: Purchases……………………………….300 x Br. 1.10 = Birr 330
400 x Br. 1.16 = Birr 464
100 x Br. 1.26 = Birr 126 920
Cost of goods available for sale…………………………………………..Birr 1, 120
Using the above data, under the periodic inventory system, the cost of ending inventory and the
cost of goods sold using FIFO is determined as follows:
Beginning inventory (200 units at Birr 1.00)……………………………..……………….Birr 200
Add: purchases during the period…………………………………………………………...….920
Cost of goods available for sale………………………………………………………....Birr 1, 120
Deduct: Ending inventory (300 units per physical inventory count):
100 units at Br. 1.26 (most recent purchases –Jan. 24)………… Br. 126
200 units at Br. 1.16 (next most recent purchase –Jan15)…………...232
Total ending inventory cost………………….………………………………………….……...358
Cost of goods sold (or issued)……………………………………………………………..Birr 762

Page 5
 Intermediate Financial Accounting I

Similarly, under the perpetual inventory system, the cost of ending inventory and cost of goods
sold using FIFO inventory costing is determined as follows:

Date Purchases Cost of Merchandise Balance (Units on

Sold Hand)
Units Unit Total Units Unit Total Units Unit Total
cost cost cost cost cost cost
January 200 Br. Br.
1 1.00 200
January 300 Br.1.10 Br.330 200 1.0 Br.
9 300 0 200
1.1 33
0 0
January 200 Br.1.00 Br.
10 200 1.10 200 100 1.1 11
22 0 0
0
January 400 1.16 464 100 1.1 11
15 400 0 0
1.1 46
6 4
January 100 1.10 11
18 200 1.16 0 200 1.1 23
23 6 2
2
January 100 1.26 126 200 1.1 23
24 100 6 2
1.2 12
6 6
Last-In, First-Out (LIFO)

Page 6
 Intermediate Financial Accounting I

The LIFO method is an inventory cost flow assumption whereby the goods purchased during the
last period are assumed to be the goods sold firstly so that the ending inventory consists of the
first goods purchased.
Using the data for Sheger Company, the cost of ending inventory and cost of goods sold under
the periodic system using LIFO is determined as follows:
Beginning inventory (200 units at Birr 1.00)……………………………..…………...…..Birr 200
Add: purchases during the period………………………………………………………...…….920
Cost of goods available for sale……………………………………….………………....Br. 1, 120
Deduct: Ending inventory (300 units per physical inventory count):
200 units at Br. 1.00 (oldest costs available, form Jan 1. inventory) ………Br. 200
100 units at Br. 1.10 (next oldest costs available, from Jan 9 purchase)…… 110
Ending inventory...................................................................................................................…...310
Cost of goods sold..................................................................................................………....Br. 810
Date Purchases Cost of Merchandise Inventory balance
sold
Units Unit Total Units Unit Total Units Unit Total
cost cost cost cost cost cost
January 200 Br. Br.
1 1.00 200
January 300 Br.1.10 Br.330 200 1.0 20
9 300 0 0
1.1 33
0 0
January 300 Br.1.10 Br.
10 100 1.00 330 100 1.0 10
10 0 0
0
January 400 1.16 464 100 1.0 10
15 400 0 0
1.1 46
6 4

Page 7
 Intermediate Financial Accounting I

January 300 1.16 34 100 1.0 10

18 8 100 0 0
1.1 11
6 6
January 100 1.26 126 100 1.0 10
24 100 0 0
100 1.1 11
6 6
1.2 12
6 6

4.3. Special inventory valuation methods

4.3.1. Inventory Valuation at Lower-of-Cost-or-Net Realizable Value (LCNRV)

Inventories are recorded at their cost. However, if inventory declines in value below its original
cost, a major departure from the historical cost principle occurs. Whatever the reason for a
decline obsolescence, price-level changes, or damaged goods a company should write down the
inventory to net realizable value to report this loss. A company abandons the historical cost
principle when the future utility (revenue- producing ability) of the asset drops below its original
cost.

Page 8
 Intermediate Financial Accounting I

Net realizable value (NRV)

The term net realizable value (NRV) refers to the net amount that a company expects to realize
from the sale of inventory. Specifically, net realizable value is the estimated selling price in the
normal course of business less estimated costs to complete and to make a sale.

To illustrate, assume that ABC Corporation has unfinished inventory with a sales value of Br.
1,000, estimated cost of completion of Br. 300. The net realizable value can be determined as
follows.

Inventory—sales value…………………………………………… Br. 1,000

Less: Estimated cost of completion and………..………………… 300
Net realizable value……………………………………………….. 700
A company estimates net realizable value based on the most reliable evidence of the
inventories’ realizable amounts (expected selling price, expected costs of completion, and
expected costs to sell).

To illustrate, ABC Restaurant computes its inventory at LCNRV.

Food Cost Net Realizable Value Final Inventory Value

Spinach ¥ 80,000 ¥120,000 ¥ 80,000
Carrots 100,000 110,000 100,000
Cut beans 50,000 40,000 40,000
Peas 90,000 72,000 72,000
Mixed vegetables 95,000 92,000 92,000
¥384,000

Final Inventory Value:

Spinach Cost (¥80,000) is selected because it is lower than net realizable value.
Carrots Cost (¥100,000) is selected because it is lower than net realizable value.

Page 9
 Intermediate Financial Accounting I

Cut beans Net realizable value (¥40,000) is selected because it is lower than cost.
Peas Net realizable value (¥72,000) is selected because it is lower than cost.
Mixed vegetables Net realizable value (¥92,000) is selected because it is lower than cost.
Methods of Applying LCNRV

LCNRV can be applied for:

1. Each individual items

2. Major groups
3. Total items

The above illustration indicates the case when LCNRV is applied for each individual item. If a
company follows a similar-or-related-items or total-inventory approach in determining LCNRV,
increases in market prices tend to offset decreases in market prices. To illustrate, assume that
ABC Restaurant separates its food products into two major groups, frozen and canned.

LCNRV by:
Cost LCNRV Individual Items Major Groups Total Inventory
Frozen
Spinach ¥ 80,000 ¥120,000 ¥ 80,000
Carrots 100,000 110,000 100,000
Cut beans 50,000 40,000 40,000
Total frozen 230,000 270,000 ¥230,000
Canned
Peas 90,000 72,000 72,000
Mixed vegetables 95,000 92,000 92,000
Total canned 185,000 164,000 164,000
Total ¥415,000 ¥434,000 ¥384,000 ¥394,000 ¥415,000

If ABC Restaurant applies the LCNRV rule to individual items, the amount of inventory is
¥384,000. If ABC Restaurant applies the rule to major groups, it jumps to ¥394,000. If the

Page 10
 Intermediate Financial Accounting I

company applies LCNRV to the total inventory, it totals ¥415,000. Why this difference?
When a company uses a major group or total-inventory approach, net realizable values
higher than cost offset net realizable values lower than cost.

Recording Net Realizable Value Instead of Cost

One of two methods may be used to record the income effect of valuing inventory at net
realizable value. One method, referred to as the cost-of-goods-sold method, debits cost of
goods sold for the write-down of the inventory to net realizable value. As a result, the
company does not report a loss in the income statement because the cost of goods sold
already includes the amount of the loss. The second method, referred to as the loss
method, debits a loss account for the write-down of the inventory to net realizable value.
Assume that the following data is for XYZ Company.
Cost of goods sold (before adjustment to net realizable value) €108,000
Ending inventory (cost) 82,000
Ending inventory (at net realizable value) 70,000

The cost-of-goods-sold method hides the loss in the Cost of Goods Sold account. The loss
method, by identifying the loss due to the write-down, shows the loss separate from Cost of
Goods Sold in the income statement.

Cost-of-Goods-Sold Method
Sales revenue €200,000
Cost of goods sold (after adjustment to net realizable value*) 120,000

Page 11
 Intermediate Financial Accounting I

Gross profit on sales € 80,000

Loss Method
Sales revenue €200,000
Cost of goods sold 108,000
Gross profit on sales 92,000
Loss due to decline of inventory to net realizable value 12,000
€ 80,000
*Cost of goods sold (before adjustment to net realizable value)
€108,000
Difference between inventory at cost and net realizable value (€82,000 − 12,000
€70,000)
Cost of goods sold (after adjustment to net realizable value) €120,000

Instead of crediting the Inventory account for net realizable value adjustments, companies
generally use an allowance account, often referred to as Allowance to Reduce Inventory
to Net Realizable Value. For example, using an allowance account under the loss method,
XYZ makes the following entry to record the inventory write-down to net realizable value.
Loss Due to Decline of Inventory to Net Realizable Value 12,000
Allowance to Reduce Inventory to Net Realizable Value 12,000
When reporting inventories on statement of financial position, XYZ Company reports as follows:

Inventory (at cost) €82,000

Less: Allowance to reduce inventory to net realizable value 12,000
Inventory at net realizable value €70,000

Recovery of Inventory Loss

In periods following the write-down, economic conditions may change such that the net
realizable value of inventories previously written down may be greater than cost, or there may

Page 12
 Intermediate Financial Accounting I

be clear evidence of an increase in the net realizable value. In this situation, the amount of the
write-down is reversed, with the reversal limited to the amount of the original write- down.

Continuing the XYZ company’s example, assume that in the subsequent period, market
conditions change, such that the net realizable value increases to €74,000 (an increase of
€4,000). As a result, only €8,000 is needed in the allowance. Ricardo makes the following
entry, using the loss method.

Allowance to Reduce Inventory to Net Realizable Value 4,000

Recovery of Inventory Loss (€74,000 − €70,000) 4,000
The allowance account is then adjusted in subsequent periods, such that inventory is reported at
the LCNRV.

The following illustration shows the net realizable value evaluation for ABC Company and
the effect of net realizable value adjustments on income.
Adjustment of Effect on
Inventory Inventory at Net Amount Required in Allowance Net
Date at Cost Realizable Allowance Account Account Balance Income
Value

Dec. 188,000 176,000 12,000 12,000 inc. Decrease

31,
2017
Dec. 194,000 187,000 7,000 5,000 dec. Increase
31,
2018
Dec. 173,000 174,000 0 7,000 dec. Increase
31,
2019
Dec. 182,000 180,000 2,000 2,000 inc. Decrease
31,
2020

Page 13
 Intermediate Financial Accounting I

If prices are falling, the company records an additional write-down. If prices are rising, the
company records an increase in income. We can think of the net increase as a recovery of a
previously recognized loss. Under no circumstances should the inventory be reported at a
value above original cost.

4.4. Gross profit method of Estimating Inventories

The gross profit method uses the estimated gross profit for the period to estimate the inventory at
the end of the period. The gross profit is estimated from the preceding year, adjusted for any
current-period changes in the cost and sales prices. The gross profit method is applied as follows:
Step 1: Determine the merchandise available for sale at cost.
Step 2: Determine the estimated gross profit by multiplying the net sales by the gross profit
percentage.
Step 3: Determine the estimated cost of merchandise sold by deducting the estimated gross profit
from the net sales.
Step 4: Estimate the ending inventory cost by deducting the estimated cost of merchandise sold
from the merchandise available for sale.
To illustrate, assume that XYZ Corporation has a beginning inventory of Br. 60,000 and
purchases of Br. 200,000, both at cost on May, 2020. Sales at selling price amount to Br.
280,000. The gross profit on selling price is 30 percent. XYZ applies the gross margin method as
follows.

Cost
Merchandise inventory, May 1…………………………………………………………Br. 60, 000
Purchases in May (net)……………………………………………………………….... 200,000
Merchandise available for sale…………………………………………………………. 260,000
Sales for May (net)……………………………………….Br. 280,000
Less: Estimated Gross profit (30% of Br.280, 000)……... 84,000
Estimated cost of merchandise sold……………………………………………………. 196,000
Estimated merchandise inventory, May 31……………………………………………...Br.64, 000

Page 14
 Intermediate Financial Accounting I

The gross profit method is useful for estimating inventories for monthly or quarterly financial
statements. It is also useful in estimating the cost of merchandise destroyed by fire or other
disasters.

Although companies normally compute the gross profit on the basis of selling price, we should
understand the basic relationship between markup on cost and markup on selling price. For
example, assume that a company marks up a given item by 25 percent. What, then, is the gross
profit on selling price? To find the answer, assume that the item sells for Br.1. In this case, the
following formula applies.
Cost + Gross profit = Selling price
C + .25C = SP
(1 + .25)C = SP
1.25C = 100%
C = Br 0.80
The gross profit equals Br.0.20 (Br.1.00 - Br.0.80). The rate of gross profit on selling price is
therefore 20 percent (Br.0.20/Br.1.00).
Conversely, assume that the gross profit on selling price is 20 percent. What is the markup on
cost? To find the answer, again assume that the item sells for Br.1. Again, the same formula
holds:
Cost + Gross profit = Selling price
C + .20SP = SP
C = (1 - .20) SP
C = .80 (Br.1.00)
C = Br 0.80
The markup on cost is 25 percent (Br.0.20/Br 0.80). Formulas Relating to Gross Profit are:
Gross profit on selling price = Percentage markup on cost
100% + Percentage markup on cost

Percentage mark-up on cost = Gross profit on selling price

100% − Gross profit on selling price

Page 15
 Intermediate Financial Accounting I

To understand how to use these formulas, consider their application in the following
calculations.
Gross Profit on Selling Price Percentage Markup on Cost
Given: 20% .20/1.00 − .20 = 25%
Given: 25% .25/1.00 − .25 = 33.33%
.25/1.00 + .25 = 20% Given: 25%
.50/1.00 + .50 = 33.33% Given: 50%

4.4.1. Retail method of Estimating Inventories

There are four steps in applying retail inventory method for valuation including,

Step 1: Determine the total merchandise available for sale at cost and retail.
Step 2: Determine the ratio of the cost to retail of the merchandise available for sale.
Step 3: Determine the ending inventory at retail by deducting the net sales from the
merchandise available for sale at retail.
Step 4: Estimate the ending inventory cost by multiplying the ending inventory at retail by
the cost to retail ratio

To illustrate, assume that Ambassador Company used retail method of valuing ending inventory.
The following data is extracted from the accounting records of the Company for the month of
July, 2020.
Cost Retail
Beginning inventories…………………………………..Br. 40, 000 Br. 50, 000
Net Purchases……………………………….………….... 150, 000 200, 000
Required: Based on the above information, compute the estimated amount of ending inventory
at cost.

Terminologies under Retail Method

1. Original selling price: The price at which goods originally are offered for sale.
2. Markup: The original or initial margin between the selling price and cost. It is also referred
to as gross margin or mark-on.
3. Additional Markup: An increase above the original selling price

Page 16
 Intermediate Financial Accounting I

4. Markup cancellation: a reduction in the selling price after there has been an additional
markup. The reduction does not reduce the selling price below the original selling price.
Additional markups less markup cancellation are referred to as net markups.
5. Mark down: a reduction in selling price bellow original selling price.
6. Markdown cancellation: an increase in the selling price, following the new selling price
above the original selling price. Mark down less markdown cancellation is referred to as net
markdowns. Neither a markup cancellation nor a markdown cancellation can exceed the
original markup or markdown.
Illustration

To illustrate these concepts, consider that Alex Clothing Store recently purchased 100 dress
shirts from ABC Incorporation. The cost for these shirts was Br 1,500, or Br 15 a shirt. Alex
Clothing established the selling price on these shirts at Br 30 a shirt. The shirts were selling
quickly in anticipation of Valentine’s Day, so the manager added a mark-up of Br 5 per shirt.
This mark-up made the price too high for customers, and sales slowed. The manager then
reduced the price to Br 32. At this point we would say that the shirts at Alex Clothing have had a
mark-up of Br 5 and a mark-up cancellation of Br 3. Right after Valentine’s Day, the manager
marked down the remaining shirts to a sale price of Br 23. At this point, an additional markup
cancellation of Br 2 has taken place, and a Br 7 markdown has occurred. If the manager later
increases the price of the shirts to Br 24, a markdown cancellation of Br 1 would occur.

Retail Inventory Method with Markups and Markdowns

Retailers use markup and markdown concepts in developing the proper inventory valuation at the
end of the accounting period. To obtain the appropriate inventory figures, companies must give
proper treatment to markups, markup cancellations, markdowns, and markdown cancellations.

There are two approaches to calculate cost ratio

a. A cost ratio can be computed after markups and markup cancellations but before
markdowns.
b. A cost ratio after both markups and markdowns (and cancellations).
Consider the following example for Sunshine company

Cost Retail
Beginning inventory € 500 € 1,000
Purchases (net) 20,000 35,000
Markups 3,000
Markup cancellations 1,000
Markdowns 2,500

Page 17
 Intermediate Financial Accounting I

Markdown cancellations 2,000

Sales (net) 25,000

Cost Retail
Beginning inventory € 500 € 1,000
Purchases (net) 20,000 35,000
Merchandise available for sale 20,500 36,000
Add: Markups €3,000
Less: Markup cancellations 1,000
Net markups 2,000
20,500 38,000
€20,500
(A) Cost-to-retail ratio = = 53.9%
€38,000
Deduct:
Markdowns 2,500
Less: Markdown cancellations (2,000)
Net markdowns 500
€20,500 37,500
€20,500
(B) Cost-to-retail ratio = = 54.7%
€37,500
Deduct: Sales (net) 25,000
Ending inventory, at retail €12,500
Ending inventory at cost= (Ending inventory at retail)*(Cost to retail ratio)

Approach A: 12,500*0.539= 6,737.5

Approach B: 12,500*0.547= 6,837.5

Special Items Relating to Retail Method

The retail inventory method becomes more complicated when we consider such items as
freight-in, purchase returns and allowances, and purchase discounts. In the retail method,
we treat such items as follows.

Freight costs are part of the purchase cost.

Purchase returns are ordinarily considered as a reduction of the price at both cost and
retail.
Purchase discounts and allowances usually are considered as a reduction of the cost
of purchases.
In addition, a number of special items require careful analysis:

Page 18
 Intermediate Financial Accounting I

 Transfers-in from another department are reported in the same way as purchases
from an outside enterprise.
 Normal shortages (breakage, damage, theft, shrinkage) should reduce the retail
column because these goods are no longer available for sale. Such costs are reflected
in the selling price because a certain amount of shortage is considered normal in a
retail enterprise. As a result, companies do not consider this amount in computing the
cost-to- retail percentage. Rather, to arrive at ending inventory at retail, they show
normal shortages as a deduction similar to sales.
 Abnormal shortages, on the other hand, are deducted from both the cost and retail
columns and reported as a special inventory amount or as a loss. To do otherwise
distorts the cost-to-retail ratio and overstates ending inventory.
 Employee discounts (given to employees to encourage loyalty and better
performance) are deducted from the retail column in the same way as sales. These
discounts should not be considered in the cost-to-retail percentage because they do
not reflect an overall change in the selling price.
The following Illustration shows some of these concepts for Extreme Sport Apparel
Company.

Page 19
Intermediate Financial Accounting I

Page 20