Days 12 & 13 Inventory

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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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 merchandise purchased during the period, including
sales tax and transportation costs, net of any purchases
discounts, allowances or returns.
 Goods available for sale
Beginning inventory + purchases; the cost of all goods that
could have been sold by the firm.
 Ending inventory
Cost of inventory on hand at end of period, as determined by
physical inventory count.

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Inventory Systems
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.
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.

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 Periodic vs. Perpetual Systems
Event Perpetual system Periodic system
Purchase Dr. Inventory Dr. Purchases
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 Dr. Cost of goods sold Dr. Cost of goods sold (plug)
count of Cr. Inventory Dr. Inventory (end.)
ending (if physical count<book Cr. Inventory (beg.)
inventory balance) Cr. Purchases

Closing entry Dr. Retained earnings Dr. Retained earnings

Cr. Cost of goods sold Cr. Cost of goods sold

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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. On
January 20, goods costing $15,000 were sold for
$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
periodic inventory system and (b) a perpetual inventory
system.

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Periodic vs. Perpetual Example
(a) Periodic inventory system

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Periodic vs. Perpetual Example
(b) Perpetual inventory system

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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

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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 or inventory shortage
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
The net effect of the error is to misstate income in
the year in which the error occurs. On the balance
sheet for the year of the error, both inventory and
retained earnings are misstated.

However, income in the next year is also misstated,

and by the same amount as in the first year, but in
the opposite direction. The second year’s balance
sheet is correct (unless there are other errors).

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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.
Prepare a correct statement of income and retained earnings for
years 1 and 2.

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Inventory Errors Example
The first step is to calculate the correct cost of goods sold for each
year. To do this, we must add $12 to year 1’s ending inventory and to
year 2’s beginning inventory.
Year 1 Year 2
Error Correct Error Correct
Inventory, Jan. 1 $20 $44
Purchases 120 100
Goods available for sale 140 144
Inventory, Dec. 31 44 68
Cost of goods sold $96 $76

Notice that the correction of the error has no effect on year 2’s
ending inventory.
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 Inventory Errors Example
Replacing the cost of goods sold figures in the statements of income and
retained earnings, we get:
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, Jan. 1 47 51
Retained earnings, Dec. 31 $51 $86

Notice that the correction of the error has no effect on Year 2’s ending
retained earnings.
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Inventory Errors
Year 1 Year 2
Effect Effect

Inventory, Jan. 1 Ok U
Purchases Ok OK
Goods available for OK U
sale U Ok
Inventory, Dec. 31 O U
Cost of goods sold U O
Gross Profit; IBT; NI OK U
Beginning RE U OK
Ending RE
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5. Valuation of Inventory and COGS

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.

Comments
This approach “favours” 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
Definition
Weighted average unit cost = cost of goods available for sale
/ 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).

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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 system

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Harrison Example

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Harrison Example
(3) Average cost, perpetual inventory system
Transaction Units Ave. Cost Total
Beginning balance 0 0 0
1. Purchase
Balance
2. Purchase
Balance
3. Sale
Balance
4. Purchase
Balance
Notice that in a perpetual system, average cost is
recalculated after every purchase.

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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.

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