CHAPTER ONE

INVENTORIES
1.1. Overview of Inventories: Inventory is used to indicate (1) merchandise held for sale in the
normal course of business and (2) materials in the process of production or held for production.
They are mainly divided into two major:
A) Inventories of merchandising businesses:
businesses: are merchandise purchased for resale in the normal
course of business. These types of inventories are called merchandise inventories.
B) Inventories of manufacturing businesses: 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
Note:
Note : In this chapter, we focus primarily on inventory of merchandise purchased for resale.
1.2. Internal Control of Inventories: The cost of inventory is a significant item in many
businesses’ financial statements. Not only must the cost inventory be determined, but good
internal control over inventory must also be maintained. Two primary objectives of internal control
over inventory are safeguarding the inventory and properly reporting it in the financial statements.
These internal controls can be either preventive or detective in nature. A preventive control is
designed to prevent errors or misstatements from occurring. A detective control is designed to
detect an error or misstatement after it has occurred.
Controls for safeguarding inventory include developing and using security measures to prevent
inventory damage or employee theft. For example, inventory should be stored in a warehouse or
other area to which access is restricted to authorized employees. The removal of merchandise
X
from the warehouse should be controlled by using requisition forms, which should be properly
authorized. The storage area should also be climate controlled to prevent damage from heat or
cold. Further, when the business is not operating or is not open, the storage area should be locked.

When shopping, you may have noticed how retail stores protect inventory from customer theft.
Retail stores often use such devices as two-way mirrors, cameras, and security guards. Using a
perpetual inventory system for merchandise also provides an effective means of control over
inventory. The amount of each type of merchandise is always readily available in a subsidiary
inventory ledger.
ledger. In addition, the subsidiary ledger can be an aid in maintaining inventory
quantities at proper levels.
Why is Inventory Control Important?
 Inventory is a significant asset and for many companies the largest asset.
 Inventory is central to the main activity of merchandising and manufacturing companies.
 Inventory must be protected from external risks (such as fire and theft) and internal fraud by employees.
 Mistakes in determining inventory cost can cause critical errors in financial statements.

1.3. Effect of Inventory Errors on Financial Statements: Any errors in the inventory count will affect
both the balance sheet and the income statement.
For example, an error in the physical inventory will misstate the ending inventory, current assets, and total assets on
the balance sheet. This is because the physical inventory is the basis for recording the adjusting entry for inventory
shrinkage. Also, an error in taking the physical inventory misstates the cost of goods sold, gross profit, and net income
on the income statement. In addition, because net income is closed to the owner’s equity at the end of the period,
owner’s equity will also be misstated on the balance sheet. This misstatement of owner’s equity will equal the
misstatement of the ending inventory, current assets, and total assets.
 Summary of Inventory Errors on Financial Statements:
If merchandise Cost of merchandise Gross profit & Net Ending owner’s
inventory is: sold is income are equity is
Overstated Understated Overstated Overstated
Understated Overstated Understated Understated
Illustration: Assume that in taking the physical inventory on December 31, 2006, Sapra Company
incorrectly recorded its physical inventory as $115,000 instead of the correct amount of $125,000.
 As a result, the merchandise inventory, current assets, and total assets reported on the December 31,
2006 balance sheet would be understated by $10,000 ($125,000 - $115,000). Because the ending
physical inventory is understated, the inventory shrinkage and the cost of merchandise sold will be
overstated by $10,000. Thus, the gross profit and the net income for the year will be understated by
$10,000. Since the net income is closed to owner’s equity at the end of the period, the owner’s equity on
the December 31, 2006 balance sheet will also be understated by $10,000.
The effects on Sapra Company’s financial statements are summarized as follows:
Amount of misstatement
Balance sheet:
Merchandise Inventory understated ………………………………………. $ (10,000)
Current assets understated …………………………………………………. (10,000)
Total assets understated ……………………………………………………. (10,000)
Owner’s equity understated ………………………………………………… (10,000)
Income Statement:
Cost of merchandise sold overstated ………………………………………. $ 10,000
Gross profit understated ……………………………………………………. X (10,000)
Net income understated …………………………………………………….. (10,000)
Exercise: At the end of 2006, the physical ending inventory of Melchor Co. was overstated by $25,000.
What is the effect of this error on the financial statements?
Solution: On the 2006 balance sheet, the merchandise inventory, current assets, total assets, and
owner’s equity are overstated by $25,000. On the income statement, the cost of merchandise sold is
understated by $25,000, and the gross profit and net income are overstated by $25,000.

1.4. Inventory Cost Flow Assumptions: A major accounting issue arises when identical units of
merchandise are acquired at different unit costs during a period. In such cases, when an item is sold, it is
necessary to determine its unit cost so that the proper accounting entry can be recorded.
To illustrate, assume that three identical units of Item X are purchased during May, as shown below.
Item X Units Cost
May 10 Purchase 1 $9
18 Purchase 1 13
24 Purchase 1 14
Total 3 $36
Average cost per unit $12

Assume that one unit is sold on May 30 for $20. If this unit can be identified with a specific purchase, the specific
identification method can be used to determine the cost of the unit sold. For example, if the unit sold was purchased
on May 18, the cost assigned to the unit is $13 and the gross profit is $7 ($20 - $13). If, however, the unit sold was
purchased on May 10, the cost assigned to the unit is $9 and the gross profit is $11 ($20 - $9).
The specific identification method is not practical unless each unit can be identified accurately. An automobile
dealer, for example, may be able to use this method, since each automobile has a unique serial number. For many
businesses, however, identical units cannot be separately identified, and a cost flow must be assumed. That is, which
units have been sold and which units are still in inventory must be assumed.

There are three common cost flow assumptions used in business. Each of these assumptions is identified with an
inventory costing method, as shown below:
Cost Flow 1. Cost flow is in the 2. Cost flow is in the 3. Cost flow is an average of
Assumption order in which the costs reverse order in which the costs.
were incurred. the costs were incurred.

Inventory First-In, First-Out (FIFO) Last-In, First-Out (LIFO) Average cost

Costing
Method

X
Note:
 When the first-in, first-out (FIFO) method is used, the ending inventory is made up of the most recent costs.
 When the last-in, first-out (LIFO) method is used, the ending inventory is made up of the earliest costs.
 When the average cost method is used, the cost of the units in inventory is an average of the purchase costs.

1.5. Inventory Systems: There are two principal inventory systems, i.e. periodic and perpetual.
A) Periodic inventory system:
 Purchases of merchandise are debited to Purchases.
 Ending Inventory determined by physical count.
 At the time of sale no need of recording CGS
 Calculation of Cost of Goods Sold:

B) Perpetual inventory system: The perpetual inventory system provides a continuous record of Inventory and Cost of Goods Sold.
 Purchases of merchandise are debited to Inventory.
  Freight-in is debited to Inventory. Purchase returns and allowances and purchase
discounts are credited to Inventory.
 Cost of goods sold is debited and Inventory is credited for each sale.
 Subsidiary records show quantity and cost of each type of inventory on hand.
1.5.1. Inventory Costing Methods under a Periodic Inventory System: When the periodic inventory
system is used, only revenue is recorded each time a sale is made. No entry is made at the time of the sale to
record the cost of the merchandise sold. At the end of the accounting period, a physical inventory is taken to
determine the cost of the inventory and the cost of the merchandise sold.

As we illustrated in the preceding section, when identical units of an item are purchased at different unit
costs during a period, a cost flow must be assumed. In such cases, the FIFO, LIFO, or Average Cost method is
used. We illustrate each of these methods, assuming the following data:

Date Explanation Units Total cost

Jan. 1 Begin. Inventory 100 units at birr 10 1,000
Mar. 15 Purchase 200 units at birr 11 2,200
Sept. 24 Purchase 300 units at birr 12 3,600
Nov. 27 Purchase 400 units at birr 13 5,200
Available for sale during the year 1,000 12,000
A physical count on December 31 reveals that 550 of the 1,000 units have been sold.
Required: Compute CGS & CEI using FIFO, LIFO, & Average cost methods.
Solutions:
A) Using FIFO Method
This method of costing inventory is based on the assumption that costs should be charged against
revenue in the order in which they were incurred. Hence, the inventory remain is assumed to be
made up of the most recent costs and the cost of inventory
X sold is made up of the earliest costs.
i) CEI is computed as follows:
Most recent costs, Nov 27----------------400 units@13----------- Br. 5,200
Next Most recent costs, sept 24----------50 units@12------------ 600
Inventory, Dec 31, 2000----------450 units --------------- Br. 5,800
ii) CGS = CMAFS – CEI = 12,000 – 5,800 = 6,200
B) Using LIFO Method: This method of costing inventory is based on the assumption that costs should be
charged against revenue in the reverse-order in which they were incurred. Hence, the inventory remain is
assumed to be made up of the earliest costs and the cost of inventory sold is made up of the most recent costs.
i) CEI is computed as follows:
Earliest cost, Jan1------------------------ 100 units@10 -----------1,000
Next earliest cost, Mar15 -------------- 200 units@11 -----------2,200
Next earliest cost, sept.24 ------------- 150 units@12 -----------1,800
Inventory, Dec 31, 2000---------- 450 units --------------- 5,000
iii) CGS = CMAFS – CEI = 12,000 – 5,000 = 7,000
C) Average Cost Method: The average cost method is sometimes called the weighted average method.
When this meted is used, costs are matched against revenue according to an average of the unit cost of
goods sold. The same weighted average unit cost are used in determine the cost of the merchandise
inventory at the end various purchase of identical items, the average method approximates physical flow of
goods. The weighted average unit cost is determined by dividing the total cost of the units of each item
available for sale during the period by the related number of units of that item
Average unit cost = Total cost of gods available for sale
Total Number of units available for sale
 The weighted average unit cost is then multiplied with the units on hand to determine the
cost of the ending inventory
  Average unit cost =12,000 =12 per unit
1,000
 CEI = units on hand x AC/U = 450×12 = 5,400
 CGS = units sold x AC/U = 550 x 12 = 6,600
1.5.2. Inventory Costing Method under Perpetual System:
In a perpetual inventory system, as we discussed in a previous chapter, all merchandise increases
and decreases are recorded in a manner similar to recording increases and decreases in cash. The
merchandise inventory account at the beginning of an accounting period indicates the
merchandise in stock on that date. Purchases are recorded by debiting Merchandise Inventory and
crediting Cash or Accounts Payable. On the date of each sale, the cost of the merchandise sold is
recorded by debiting Cost of Merchandise Sold and crediting Merchandise Inventory.

Like the periodic inventory system, a cost flow assumption must be made when identical units are
acquired at different unit costs during a period. In such cases, the FIFO, LIFO, or Average Cost
method is used. We illustrate each of these methods, using the following information for XYZ
Company for the month of January, 2000:

Date Explanation Units Unit cost

Jan. 1 Begin. Inventory 20 $ 20
4 Sales 14 30
10 Purchase 16 12
22 Sales 8 20
28 Sales 4 16
30 Purchases 20 22
Required: Compute CGS & CEI using FIFO, LIFO, & Average cost methods.
Solutions: X
A) First- in, first–out (FIFO) method: In this method, costs are included in the merchandise sold in the order in which they were incurred.
Solution
Purchases Cost of merchandise sold Inventory
Date Quantity Unit Total Quantity Unit Total Quantity Unit Total
cost cost cost cost cost cost
Jan.1 20 20 400
4 14 20 280 6 20 120
10 16 12 192 6 20 120
16 12 192
22 6 20 120
2 12 24 14 12 168
28 4 12 48 10 12 120
30 20 22 440 10 12 120
20 22 440
Total 26 $472 30 $560
 Thus cost of merchandise sold = $ 472, cost of ending inventory = $560.
B) Last-in, First- out method (LIFO): When the LIFO method is used in a perpetual inventory system, the
cost of the units sold is the cost of the most recent purchases.
Solution
Purchases Cost of merchandise sold Inventory
Date Quantity Unit Total cost Quantity Unit Total Quantity Unit cost Total cost
 cost cost cost
Jan.1 20 20 400
4 14 20 280 6 20 120
10 16 12 192 6 20 120
16 12 192
22 8 12 96 6 20 120
8 12 96
28 4 12 84 6 20 120
4 12 48
30 20 22 440 6 20 120
4 12 48
20 22 440
Total 26 $ $460 30 $608
 Thus, cost of merchandise sold= $ 460, cost of ending inventory=$ 608
a) Average cost method
When the average cost method is 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.
This averaging technique also called a moving average
Solution
Purchases Cost of merchandise sold Inventory
Date Quantity Unit Total Quantity Unit Total Quantity Unit Total
cost cost cost cost cost cost
Jan 1 20 20 400
4 14 20
X 280 6 20 120
10 16 12 192 6 20 120
16 12 192
22 14.2 312
22 8 14.2 113 14 14.2 199

28 4 14.2 57 10 14.2 142

30 20 22 440 10 14.2 142

20 22.0 440
30 19.4 582
Total 26 $450 30 $582
 Cost of merchandise sold = 450, Cost of ending inventory =582
1.6. Valuation of Inventory at Other than Cost: As we indicated earlier, cost is the primary basis for valuing
inventories. In some cases, however, inventory is valued at other than cost. Two such cases arise when (a) the cost of
replacing items in inventory is below the recorded cost and (b) the inventory is not salable at normal sales prices. This
latter case may be due to imperfections, shop wear, style changes, or other causes.
a) Valuation at Lower of Cost or Market (LCM)P:
 If the cost of replacing an item in inventory is lower than the original purchase cost, the lower of cost or market
(LCM) method is used to value the inventory. Market, as used in lower of cost or market, is the cost to replace the
merchandise on the inventory date.
 The primary advantage of the lower of cost or market method is that gross profit (and net income) is reduced in
the period in which the market decline occurred.
 In applying the lower –of –cost-or- market method, the cost and replacement cost can be determined in one of
three ways.
 Cost and replacement cost can be determined for:-
 1) Each item in the inventory
2) Major classes or categories of inventory.
3) The inventory as a whole
Illustration: The following are the inventory of ABC motor sports, retailer.
Inventory Items Units on hand Cost per unit Market price

Item A:
X 50 Br. 15,000 Br. 14,000
Y 20 9,000 9,500
Item B:
W 10 10,000 11,200
Z 6 16,000 14,500

1) Separately to each individual item:

Inventory items Total cost
Total market
LCM
X Br. 750,000 Br. 700,000 Br. 700,000

Y 180,000 190,000 180,000

W
100,000 112,000
100,000

Z 96,000 87,000 87,000

X
Totals Br.1,
Br.1, 126, 000 Br.
1,089,000 Br. 1,067,000

 The market decline based on individual items (Br. 1,126,000 – Br. 1,067,000) = Br. 59,000

2) Major categories of items:

Inventory units
per
unit
Items on hand
cost market
Item A:
X 50
Br. 15,000 Br. 14,000
Y 20
9,000 9,500
Item B:
W 10
10,000 11,200
 Z 6
16,000 14,500
Solution:
1) Separately to each individual item:
Inventory items Total cost
Total market
LCM
X Br. 750,000
Br. 700,000 Br.
700,000
Y
180,000 190,000
180,000
W
100,000 112,000
100,000
Z
96,000 87,000
87,000
Totals Br.1,
Br.1, 126, 000 Br.
1,089,000 Br. 1,067,000
 The market decline based on individual items (Br. 1,126,000 – Br. 1,067,000) = Br. 59,000
2) Major categories of items:
Inventory Categories
Categories LCM
categories total cost
total market
Item A: Br. 930,000
Br. 890,000
X
Br. 890,000
Item B: 196,000
199,000
196,000
Totals Br.
1,126,000 Br. 1,089,000
Br. 1,086,000
 The market decline based on major categories (Br. 1,126,000 – Br. 1,086,000) = Br. 40,000
3) The inventory as a whole:: When LCM is applied to the whole of inventory, the market cost is Br. 1,089,000. Since
this market cost is Br. 37,000 lower than Br. 1,126,000 recorded cost, it is the amount reported for inventory on the
balance sheet.
b) Valuation at Net Realizable Value: Merchandise that is spoiled or damaged or that is out of
date, or that can be sold only at prices below cost should be written down. Such merchandise
should be valued at net realizable value. NRV - is the estimated selling price less any direct cost
of disposals such as sales commissions.
Example: - assume that damaged merchandise costing Birr 1,000 can be sold for only Birr 800, and direct selling
expenses are estimated to be Birr 150. This inventory should be valued at Birr 650 (Birr 800 - Birr 150).

1.7. Estimating Inventory Cost: It may be necessary for a business to know the amount of inventory when
perpetual inventory records are not maintained and it is impractical to take a physical inventory. For
example, a business that uses a periodic inventory system may need monthly income statements, but taking
a physical inventory each month may be too costly. Moreover, when a disaster such as a fire has destroyed
the inventory, the amount of the loss must be determined. In this case, taking a physical inventory is
impossible, and even if perpetual inventory records have been kept, the accounting records may also have
been destroyed. In such cases, the inventory cost can be estimated by using (a) the retail method or (b) the
gross profit method.
A) Retail Method of Estimating Inventory Cost:
 Retail method is based on relationship between cost of merchandise available for sale and the retail price.
 Retail prices of all merchandise must be accumulated and totaled.
 Inventory at retail is calculated at retail price of merchandise available for sale less net sales at retail.
 Ratio is calculated as cost divided by retail price.
 Inventory at retail price times cost ratio equals estimated cost of inventory.
Illustration-1.3: In June Xyz Company has the following information from its record:
Cost Retail
June 1. Merch. inventory $ 19,400 $ 36,000
June1-30 purchasers (net) 42,600 64,000
June 1-30 sales (net) 70,000
Required: using the retail method determine the ending inventory
Solution:
Cost Retail
Merchandise inventory June 1 $ 19,400 $ 36,000
Purchases in June (net) 42,600 64,000
Merchandise available for sale $ 62,000 100,000
Less: Sales for June (net) (70,000)
Merchandise inventor, June 30, at retail 30,000
Ratio of cost to retail price: 62,000 = 62%
100,000
Merchandise inventory, June 30, at estimated cost
(30,000×62%) 18.600
In estimating the percent of cost to selling price, the assumption is that the mix of the items in the ending
inventory is the same as the entire stock of merchandise available for sale. One of the, major advantages of
the retail method is that it provides inventory figures forXuse in preparing monthly or quarterly statements
when the periodic system is used. The retail method may also is used as an aid to taking physical inventory.
B) Gross Profit Method of Estimating Inventories: This method is used to estimate the inventory at the
end of the period. The gross profit is usually estimated from actual rate for the proceeding year, adjusted for
any changes made in the cost and sales price during the current period. By using the gross profit rate, the
dollar amount of sales for the period can be divided in to its two components: gross profit and cost of
merchandise sold. The cost of merchandise sold is then deducted from the cost merchandise available for
sale to yield the estimated cost of the inventory.
Illustration-1.4: The merchandise inventory of Xyz Company was destroyed by fire on October 20. The
following data were obtained from the accounting records:
Jan 1 merchandise inventory--------------------------- $57,000
Jan 1 – Oct20 purchases (net) -------------------------- 180,000
Sales (net) --------------------------------- 250,000
Estimated gross profit rate ------------------------------ 30%
Required; Estimate the cost of merchandise destroyed by fire using gross profit method
Solution:
Merchandise inventory, January 1 ------------------------------- $ 57,000
Purchase (net) -------------------------------------------------------- 180,000
Merchandise available for sales ----------------------------------- $237,000
Sales (net) ---------------------------------- $250,000
Less estimated gross profit
(250,000×30%) ----------------------- (75,000)
Estimated cost of merchandise sold ----------------------------- $175,000
Estimated merchandise inventory, Oct 20 ----------------------- $62,800
X