Principles of Accounting

Chapter 4: Inventories
What are Inventories

Inventories are assets:

• items held for sale in the ordinary course of business, or

• goods to be used in the production of goods to be sold.

Businesses with Inventory

Merchandising Manufacturing
or
Company Company
Classification Of Inventories

Merchandising Manufacturing
Company Company
One Classification: Three
Classifications:
 Merchandise
Inventory  Raw Materials
 Work in Process
 Finished Goods

Regardless of the classification, companies report all inventories under

Current Assets on the balance sheet.
Basic Issues in Inventory Valuation

Valuing inventories requires determining

1. The physical goods to include in inventory (who owns
the goods?—goods in transit, consigned goods, special
sales agreements).
2. The costs to include in inventory
3. The cost flow assumption to adopt (specific identification,
average-cost, FIFO, retail, etc.).
Determining Inventory Quantities

Determining inventory quantities involves two steps:

(1) taking a physical inventory of goods on hand or maintaining a

‘continuous’ inventory count and

(2) determining the ownership of goods.

Determining Inventory Quantities

Physical Inventory taken for two reasons:

Perpetual System

• Check accuracy of inventory records.

• Determine amount of inventory lost (wasted raw materials,

shoplifting, or employee theft).

Periodic System

• Determine the inventory on hand

• Determine the cost of goods sold for the period.

Determining Inventory Quantities

Taking physical inventory involves counting, weighing, or measuring

each kind of inventory on hand.

Taken,

• when the business is closed or when business is slow,

• at end of the accounting period.

Determining Inventory Quantities

Determining Ownership of Goods

Goods in Transit
Consigned Goods
Determining Inventory Quantities

Determining Ownership of Goods

Goods in Transit
• Purchased goods not yet received.
• Sold goods not yet delivered.

Goods in transit should be included in the inventory of the company that has
legal title to the goods. Legal title is determined by the terms of sale.
Determining Inventory Quantities

Terms of Sale

Ownership of the goods passes

to the buyer when the public
carrier accepts the goods from
the seller.

Ownership of the goods

remains with the seller until
the goods reach the buyer.
Determining Inventory Quantities

Review Question
Goods in transit should be included in the
inventory of the buyer when the:
a. public carrier accepts the goods from the
seller.
b. goods reach the buyer.
c. terms of sale are FOB destination.
d. terms of sale are FOB shipping point.
Determining Inventory Quantities

Determining Ownership of Goods

Consigned Goods
In some lines of business, it is common to hold the goods of other
parties and try to sell the goods for them for a fee, but without taking
ownership of goods.
These are called consigned goods.
Valuation of Inventory

Inventory must be measured in the financial statements at the lower of:

• cost, or
• net realisable value (NRV).

Net realisable value is the

• amount that can be obtained from disposing of the inventory in the
normal course of business,
• less any further costs that will be incurred in getting it ready for sale or
disposal.
Valuation of Inventory – Example
Valuation of Inventory – Example
Cost of Inventories

The cost of inventories will consist of all the following costs.

a) Purchase cost
b) Costs of conversion
c) Other costs incurred in bringing the inventories to their present location and
condition
Cost of Inventories

Purchase Cost
a) Purchase price
b) Import duties and other taxes
c) Transport, handling and any other cost directly attributable to the acquisition of
finished goods, services and materials
d) Less any trade discounts, rebates and other similar amounts
Cost of Inventories

Costs of conversion
Costs of conversion of inventories consist of two main parts.
1. Costs directly related to the units of production, eg direct labour
2. Fixed and variable production overheads that are incurred in converting
materials into finished goods, allocated on a systematic basis.
Fixed production overheads are those indirect costs of production that remain
relatively constant regardless of the volume of production, eg the cost of factory
management and administration.
Variable production overheads are those indirect costs of production that vary
directly, or nearly directly, with the volume of production, eg indirect materials and
labour.
Cost Formulas

How to Determine Cost of Inventory

With some inventory items, particularly large and expensive items, it

might be possible to recognise the actual cost of each item.

In practice, however, this is unusual because the task of identifying the

actual cost for all inventory items is impossible because of the large
numbers of such items.

A system is therefore needed for measuring the cost of inventory.

Cost Formulas

The historical cost of inventory is usually measured by one of the

following methods:

• Specific Identification

• First-in, first-out (FIFO)

Cost Flow
• Last-in, first-out (LIFO) Assumptions

• Average-cost
Cost Formulas – Illustration 2

Assume that Houston Electronics uses a periodic inventory system.

A physical inventory at the end of the year determined that during the year Houston
sold 550 units and had 450 units in inventory at December 31.
Cost Formulas – Illustration 2

“First-In-First-Out (FIFO)”
Cost Formulas – Illustration 2

“Last-In-First-Out (LIFO)”
Cost Formulas – Illustration 2

“Average Cost”
Cost Formulas – Illustration 2

Financial Statement and Tax Effects

Cost Formulas - Illustration

On 1 January a company had an opening inventory of 100 units which cost Rs.50
each.

During the month it made the following
purchases:
• 5 April: 300 units at Rs. 60 each
• 14 July: 500 units at Rs. 70 each
• 22 October: 200 units at Rs. 80
each.
During the period it sold 800 units as
follows:
• 9 May: 200 units
• 25 July: 200 units
• 23 November: 200 units
• 12 December: 200 units

This means that it has 300 units left (100 + 300 + 500 + 200 – (200 + 200 + 200
+ 200 + 200)) but what did they cost?
Cost Formulas - Illustration

There are various techniques that have been developed to answer this question.
The easiest of these is called FIFO (first in first out).
This approach assumes that the first inventory sold is always the inventory that was
bought on the earliest date. This means closing inventory is always assumed to be
the most recent purchased.
In the above example a FIFO valuation would assume that the 300 items left were
made up of the 200 bought on 22 October and 100 of those bought on 14 July
giving a cost of Rs. 23,000 {(200 @ 80) + (100 @ 70)}
Cost Formulas - Illustration
The weighted average method calculates a new average cost per unit after each purchase. This is then
used to measure the cost of all issues up until the next purchase. (Perpetual Inventory System)
Cost Formulas - Solution
Cost Formulas – Solution (Perpetual)
Cost Formulas – Solution (Perpetual)
Inventory Errors

Common Cause:
• Failure to count or price inventory correctly.
• Not properly recognizing the transfer of legal title to goods in transit.

Inventory errors affect both the Statement of Comprehensive Income and

Statement of Financial Position.
Inventory Errors – Profit and Loss Account

Inventory errors affect the computation of cost of goods sold and profit.
Inventory Errors – Profit and Loss Account

Inventory errors affect the computation of cost of goods sold and profit in two
periods.
An error in ending inventory of the current period will have a reverse effect on net
income of the next accounting period.
Over the two years, the total net income is correct because the errors offset each
other.
The ending inventory depends entirely on the accuracy of taking and costing the
inventory.
 Inventory Errors – Profit and Loss Account
2010 2011
Incorrect Correct Incorrect Correct
Sales $ 80,000 $ 80,000 $ 90,000 $ 90,000
Beginning inventory 20,000 20,000 12,000 15,000
Cost of goods purchased 40,000 40,000 68,000 68,000
Cost of goods available 60,000 60,000 80,000 83,000
Ending inventory 12,000 15,000 23,000 23,000
Cost of good sold 48,000 45,000 57,000 60,000
Gross profit 32,000 35,000 33,000 30,000
Operating expenses 10,000 10,000 20,000 20,000
Net income $ 22,000 $ 25,000 $ 13,000 $ 10,000

Combined income for 2-year ($3,000) $3,000

period is correct. Net Income Net Income
understated overstated
Inventory Errors – Balance Sheet

Inventory errors affect assets and retained earnings / capital.

 Inventory Errors – Example
The owners of Health Foods are offering the business for sale. The partial income statements of business for the three years
of its existence are summarized below.
2015 2014 2013
Net Sales ($) 875,000 840,000 820,000
Cost of goods sold ($) 481,250 487,200 480,000
Gross Profit ($) 393,750 352,800 340,000
Gross profit margin 45% 42% 41%
In negotiations with prospective buyers of the business, the owners of Health Foods are calling attention to the rising trends of
the gross profit and the gross profit percentage as favorable elements.
Assume that you are retained by a prospective purchaser of the business to make an investigation of the fairness and
reliability of the enterprise’s accounting records and financial statements. You find everything in order except for the following:
(1) An arithmetic error in the computation of inventory at the end of 2013 had caused a $40,000 understatement in that
inventory, and
(2) a duplication of figures in the computation of inventory at end of 2015 had caused an overstatement of $81,750 in that
inventory.
The company uses the periodic inventory system, and these errors had not been brought to light prior to your investigation.
Instructions: Prepare a revised three-year abbreviated income statement summary.
Inventory Management

Inventory management is a double-edged sword.

High Inventory Levels - may incur high carrying costs (e.g., investment, storage,
insurance, obsolescence, and damage).
Low Inventory Levels – may lead to stockouts and lost sales.
Estimating Inventories

Gross Profit Method

The gross profit method estimates the cost of ending inventory by applying a gross
profit rate to net sales.
Estimating Inventories

Gross Profit Method – Computation of Gross Profit Percentage

To see how to compute a gross profit percentage, assume that an article cost
€15 and sells for €20, a gross profit of €5.

Profit Margin Profit Markup

Estimating Inventories

Gross Profit Method – Illustration

Kishwaukee Company’s records for January show net sales of $200,000, beginning
inventory $40,000, and cost of goods purchased $120,000. The company expects
to earn a 30% gross profit rate on sales. Compute the estimated cost of the ending
inventory at January 31 under the gross profit method.
Estimating Inventories

Retail Inventory Method

Company applies the cost-to-retail percentage to ending inventory at retail prices to
determine inventory at cost.
Estimating Inventories

Retail Inventory Method – Illustration

Note that it is not necessary to take a physical inventory to determine the estimated
cost of goods on hand at any given time.
Estimating Inventories

Retail Inventory Method – Example

Between The Ears (BTE.com) is a popular Internet music store. During the current year, company’s cost of
goods available for sale amounted to $462,000. The retail sales value of merchandise amounted to
$840,000. Sales for the year were $744,000.

Instructions
a. Using the retail method, estimate
(1) the cost of goods sold during the year and
(2) the inventory at the end of the year.

b. At year-end, BTE.com takes a physical inventory. The general manager walks through warehouse
counting each type of product and reading its retail price into a recorder. From recorded information,
another employee prepares a schedule listing the entire ending inventory at retail sales prices. The
schedule prepared for the current year reports ending inventory at $84,480 at retail sales prices.

Required: Use the cost ratio computed in part a to reduce the inventory counted by the general manager
from its retail value to an estimate of its cost.