Days 12 & 13 Inventory

2. Perpetual and
1. Definition of
periodic inventory
inventory
systems

3. Purchase 4. Inventory
discounts errors

5. Valuation of
inventory

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Roadmap
1. Definition of inventory

2. Perpetual and periodic inventory systems

3. Purchase discounts

4. Inventory errors

5. Valuation of inventory

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1. Definition of Inventory
• Inventory includes goods awaiting sale, goods in
various stages of production and supplies.
• The nature of a firm’s inventory depends on its
business and the type of good or service it provides
to its clients. Inventory is a current asset.

Type of firm Composition of inventory

Manufacturing Raw materials, work in process, finished
goods, supplies
Wholesale and retail Merchandise, supplies
Service Supplies

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Roadmap
1. Definition of inventory

2. Perpetual and periodic inventory systems

3. Purchase discounts

4. Inventory errors

5. Valuation of inventory

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2. Inventory Systems
• Beginning inventory
• Cost of inventory on hand at beginning of period, as determined
by physical inventory count at end of previous period.
• Purchases
• Cost of inventory purchased during the period, including
purchase cost, transportation costs less any purchases discounts,
allowances or returns.

Beginning inventory + purchases=Goods available for sale

• Cost of goods sold
• Cost of inventory sold to customers during the period.
• Ending inventory
• Cost of inventory on hand at end of period, as determined by
physical inventory count.

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 Inventory Systems
Inventory systems are used to determine what goods are
available for sale (inventory) and what goods have been sold
(cost of goods sold). This information is available in dollars and
in number of units.

❖Perpetual inventory system

System of recording inventory-related transactions (purchases,
sales) wherein Inventory and Cost of goods sold accounts are
updated after each inventory-related transaction.

❖Periodic inventory system

System of recording inventory-related transactions (purchases,
sales) wherein Inventory and Cost of goods sold accounts are
updated only once per period after physical counts of inventory.

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Periodic vs. Perpetual Systems: Accounting
Event Perpetual system Periodic system

Purchase Dr. Inventory Dr. Purchases (expense)

Cr. AP or Cash Cr. AP or Cash

Sale Dr. AR or Cash Dr. AR or Cash

Cr. Revenue Cr. Revenue
Dr. Cost of goods sold
Cr. Inventory
Physical count Dr. Cost of goods sold Dr. Cost of goods sold
of inventory Cr. Inventory Dr. Inventory (end.)
(normally physical count<book Cr. Inventory (beg.)
balance due to shrinkage) Cr. Purchases

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 Periodic vs. Perpetual Example
Wilson’s January 1 inventory balance was $10,000.
During January there was one purchase of $19,000 with
cash. On January 20, goods costing $15,000 were sold for
cash $23,000. The January 31st ending inventory was
counted. The cost of inventory on hand was $13,500.

Required:
Prepare journal entries to record the above information and
cost of goods sold for the month, using
(a) a perpetual inventory system
(b) a periodic inventory system

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Event (a)Perpetual system (b)Periodic system

Purchase

Sale on Jan 20

Physical count
on Jan 31

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Roadmap
1. Definition of inventory

2. Perpetual and periodic inventory systems

3. Purchase discounts

4. Inventory errors

5. Valuation of inventory

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3. Purchase Discounts
Sellers may offer discounts for credit sales. This discount
is a reduction of the normal selling price and is attractive to
both the seller and the buyer.

For the buyer, it is a reduction to the cost of the goods and

services. For the seller, the cash is more quickly available
and the risk of collection is reduced.

The standard credit terms is 2/10, n/30, which means seller

expects payment in 30 days and offers a 2% discount if
payment is made within 10 days.

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Purchase Discounts Example
On October 1, 2016, CD Ltd. purchased product
from JMS Co. on credit. The total invoice amount
was $13,000. JMS offered credit terms of 2/10, n/30.

Required:
1. Prepare the journal entry to record the purchase for
CD.
2. Prepare the journal entry assuming the payment is
made on October 10, 2016.

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Purchase Discounts Example

1. Purchase

2. Payment made on Oct 10

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Roadmap
1. Definition of inventory

2. Perpetual and periodic inventory systems

3. Purchase discounts

4. Inventory errors

5. Valuation of inventory

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 4. Inventory Errors
An error (or errors) in taking inventory affects both
the balance sheet (Inventory value is misstated) and
the income statement (COGS is misstated).
Moreover, the error has an impact in the year of the
error and the year after.
Year 1 Year 2
Beginning inventory OK Error
+ Purchases OK OK
-Ending inventory Error OK
= Cost of goods sold Error Error

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Inventory Errors
For the year when error occurs
• The income statement: COGS is misstated.
• The balance sheet: both inventory and retained
earnings are misstated.

For the next year

• The income statement: COGS is misstated, and by
the same amount as in the first year, but in the
opposite direction.
• The balance sheet: Correct, unless there are other
errors

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Inventory Errors-Quick test
A company’s ending inventory is overstated by $10 in year 1.
Required: Please analyze the impact of this error on income
statement and balance sheet in year 1 and year 2

Year 1 Year 2
Beginning inventory OK
+ Purchases OK OK
-Ending inventory Overstated $10 OK
= Cost of goods sold

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 Inventory Errors Example
Year 1 Year 2
Sales $120 $131
Cost of goods sold 96 76
Other expenses 20 20
Net income 4 35
Retained earnings, January 1 47 51
Retained earnings, December 31 $51 $86
Inventory, January 1 (per count) $20 $44
Purchases 120 100
Inventory, December 31 (per count) 44 68

Year 1 ending inventory was understated by $12. The error was not
discovered until year 2. Storm uses a periodic inventory system.
Required: Prepare a correct statement of income and retained
earnings for years 1 and 2.

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 Inventory Errors Example

COGS=Beg inventory + Purchase- End inventory

Year 1 Year 2
Error Correct Error Correct
Sales $120 $131
Cost of goods sold 96 76
Other expenses 20 20
Net income 4 35
Retained earnings, Jan1 47 51
Retained earnings,Dec 31 51 $86
Inventory Errors
Year 1 Year 2
Effect Effect
Inventory, Jan. 1 Ok U
Purchases Ok OK
Goods available for sale OK U
Inventory, Dec. 31 U Ok
Cost of goods sold O U
NI U O
Beginning RE OK U
Ending RE U OK

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Roadmap
1. Definition of inventory

2. Perpetual and periodic inventory systems

3. Purchase discounts

4. Inventory errors

5. Valuation of inventory

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5. Valuation of Inventory
The quantity of inventory on hand can be determined by a
physical count.
The cost of that inventory becomes difficult to determine if
the acquisition cost of inventory has been changing over time
(i.e., there has been inflation or deflation).
Example: An electronics retailer buys a computer on January
1 for $850. On January 15, the retailer buys another
computer, identical to the first, for $750. On January 31, the
retailer sells one of the computers for $1,800. The other
computer remains in inventory. What is cost of goods sold
for the month, and what is the value of ending inventory?

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Inventory Costing Method
Specific identification
Definition
Keep track of each item in inventory (e. g., by serial number).
Identify each item sold (and its cost) to determine Cost of
goods sold; identify items left in inventory (and their costs) to
determine ending inventory.

Comments
Results in best possible matching of revenue and cost of
goods sold, although vulnerable to manipulation by
management who can choose strategically which items to sell.
This approach accurately represent the physical flow of
goods.
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Inventory Costing Method
First-in, first-out (FIFO)
Definition
Assume that the earliest purchases (the first in) in inventory
are first sold (the first out). The more recent purchases are in
ending inventory.
Jan 1: Purchase 1000 inventory, price for each unite is $50
Jan 5:Purchase 2000 inventory, price for each unite is $48
Jan 10: Sold 1500 inventory, what’s the costs of goods sold?
Comments
This approach “favors” the balance sheet: Most current costs
are included in cost of inventory, while oldest costs are in
Cost of goods sold. Net income is therefore (perhaps) less
relevant in that it reflects older inventory costs.

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 Inventory Costing Method
Average cost
cost of goods available for sale
Weighted average unit cost =
units available for sale
Cost of goods sold = units sold x weighted average unit cost
Ending inventory = units left x weighted average unit cost

Comments
One single, convenient, representative cost. Opportunity for
income manipulation: In a periodic system, Cost of goods
sold and inventory values might be affected by costs of units
that could not possibly have been sold (i. e., units purchased
at the end of the year).
Periodic and Perpetual system may have different costs allocated.
Periodic system—calculate weighted average unit cost once at the end of each period
Perpetual system—calculate weighted average unit cost after each purchase
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Inventory Costing Method
Average cost-example
Jan 1: Purchase 1,000 inventory, price for each unite is $50
Jan 5:Purchase 2,000 inventory, price for each unite is $48
Jan 10: Sold 1,500 inventory, what’s the costs of goods sold?
Jan 15: Purchase 1,000, price for each unite is 49
Jan 20: sold 1,000 inventory, what’s the costs of goods sold?

Compute Cost of Goods Sold under periodic and perpetual system.

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Cost of Goods Sold under periodic system?

Periodic system—calculate weighted average unit cost once at the end of each period

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Cost of Goods Sold under perpetual system?

Perpetual system—calculate weighted average unit cost after each purchase

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 Harrison Example
Harrison Corp. began operations Jan. 1, Year 1 and engaged in
the following inventory transactions:
Transaction Units Unit Cost
Beg. Inv. 0 $0
1 Purchase 60 20
2 Purchase 50 25
3 Sale 70
4 Purchase 40 28

Compute Cost of Goods Sold and Ending Inventory under:

(1) FIFO
(2) Average cost, periodic inventory system
(3) Average cost, perpetual inventory
29 system
Harrison Example

(1) FIFO

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Harrison Example

(2) Average cost, periodic inventory system

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 Harrison Example

(3) Average cost, perpetual inventory system

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FIFO vs. Average Cost
In case of inflation (price per unit increasing), FIFO
produces:
❖ Higher ending inventory
❖ Higher net income
❖ Lower cost of goods sold
In case of deflation (price per unit decreasing), average
cost produces:
❖ Higher ending inventory
❖ Higher net income
❖ Lower cost of goods sold

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Lower of Cost and Net Realizable Value
Inventory must be carried on the statement of financial
position at the lower of cost or net realizable value (i. e.,
selling price less estimated selling costs).

If net realizable value (e.g., $520,000) is lower than the

cost (e.g., 522,000) of inventory, following journal entry
is required to write down the balance of inventory to its
net realization value.
Dr. Cost of goods sold 2,000
Cr. Inventory 2,000
522,000 - 520,000 = 2,000

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Example
A Company has the following vehicles and their corresponding
costs and net realizable value. What’s the total value of the vehicles
on Balance sheet? Prepare journal entry to write down inventory if
necessary.

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Unethical behavior related to inventory
• If a manager’s position or bonus are tied to the
reported net income of a company, what
unethical behaviors related to inventory they
may do?

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