CHAPTER 4

ACCOUNTING FOR INVENTORIES

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.
• Raw material inventories
• Work in progress inventories
• Finished goods inventories
• NB: All types of businesses have supplies inventories
which is collection of consumable items.
Goods and Costs Included in Inventory
Goods Included in Inventory
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.
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
The journal entries to be made 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 allowances:

Accounts payable or cash XX
Purchase returns and allowances XX
 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. system, a continuous record of
changes in inventory is maintained in the inventory
account and the cost of goods sold account
1. At the time of purchase of merchandise
Merchandise inventory XX at cost
Accounts payable/cash XX
To record cost of Merchandise purchased
2. At the time of sale of merchandise
Accounts receivable or cash XX at retail price
Sales XX
To record the sale
Cost of goods sold XX
Merchandise inventory XX at cost
To record the cost of merchandise sold or cost of sale

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.
 Valuation of inventories
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.
 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
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 Sold Balance (Units on Hand)
Units Unit cost Total cost Units Unit cost Total cost Units Unit cost Total cost
January 1 200 Br. 1.00 Br. 200
January 9 300 Br.1.10 Br.330 200 1.00 Br. 200
300 1.10 330
January 10 200 Br.1.00 Br. 200
200 1.10 220 100 1.10 110
January 15 400 1.16 464 100 1.10 110
400 1.16 464
January 18 100 1.10 110
200 1.16 232 200 1.16 232
January 24 100 1.26 126 200 1.16 232
100 1.26 126
 Last-In, First-Out (LIFO)
•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):
100 units at Br. 1.00 (oldest costs available, form Jan 1. inventory) ………Br. 100
100 units at Br. 1.16 (next oldest costs available, from Jan 9 purchase)…… 116
100 units at Br. 1.26 (next oldest costs available, from Jan 24 purchase)…… 126
Ending inventory...................................................................................................................
…...342
Cost of goods sold..................................................................................................………....Br.
778
Date Purchases Cost of Merchandise sold Inventory balance
Units Unit cost Total Units Unit cost Total Units Unit cost Total
cost cost cost
January 1 200 Br. 1.00 Br. 200

January 9 300 Br.1.10 Br.330 200 1.00 200

300 1.10 330

January 300 Br.1.10 Br. 330

10 100 1.00 100 100 1.00 100

January 400 1.16 464 100 1.00 100

15 400 1.16 464

January 300 1.16 348 100 1.00 100

18 100 1.16 116

January 100 1.26 126 100 1.00 100

24 100 1.16 116
100 1.26 126
 Special inventory valuation methods

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.
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.
cost> NRV measure inventory at NRV
COST < NRV measured in ventory at cost
decreasing inventory value
NRV = selling price – selling cost
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.
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 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€108,000
value)

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
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 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
Allowance to Reduce Inventory to Net Realizable Value 4,000
needed in the allowance. Ricardo makes the following entry, using the loss
method.
Recovery of Inventory Loss (€74,000 − €70,000) 4,000
The following illustration shows the net realizable
value evaluation for ABC Company and the effect of
net realizable value adjustments on
Inventory Inventory at Net Amount Required in
income
Adjustment of Effect on
Allowance Account Net Income
at Cost Realizable Value Allowance Account
Date Balance
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
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.
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 follow
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
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)
•The markup on cost is 25 percent (Br.0.20/Br 0.80).
Markup percentage is calculated by dividing an item's gross
profit by its cost, where the gross profit is the item's price (or
revenue) minus the cost to produce the item or purchase it for

resale. To put the result in percentage points, multiply by 100.

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
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%
 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
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
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
• 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
 In addition, a number of special items require careful analysis
 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.