Principle of Accounting II

CHAPTER -1 INVENTORIES Definition: - Inventory is used to designate 1. Merchandise held for sale in the normal course of business which is termed as merchandise inventory. 2. Materials in the process of production or held for production. Importance of inventories - It is the principal source of revenue for wholesale and retail businesses. - Cost of merchandise sold is the largest deduction from sells to determine net income. - A substantial part of merchandising firms resources is invested in inventory - It is the largest of the current assets on merchandisers businesses. Effect of Inventory Errors on Financial Statements Any error 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. 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 owners equity at the end of the period owners equity will also be misstated on the balance sheet. This misstatement of owners equity will equal the misstatement of the ending inventory, current asset and total assets. The effect of understatements and overstatements of merchandise inventory at the end of the period are demonstrated in the following three sets of condensed income statements and balance sheets. The first set of statements is based on a correct ending inventory of $60,000; The second set, on an incorrect ending inventory of 50,000; The third set, on an ending inventory of 70,000. In all three cases, net sales are 980,000, merchandise available for sale is $705,000, and operating expenses are $100,000. Income statement for the year Balance Sheet at the end of the year 1. Inventory at the end of the year correctly Stated $60,000 Net sales..980,000 Merchandise inventory. .$60,000 Cost of goods sold..645,000 Other asset..340,000 Gross profit......$335,000 Total asset.400,000 Expenses.100,000 Liabilities120,000 Net income235,000 Owners equity280,000 Total 400,000

Compiled by Mulugeta T. MU, Dept of Accounting and Finance (2012).

2. Inventory at the end of period incorrectly stated at $50,000: (understated by 10,000). Net sales..980,000 Merchandise inventory. .$50,000 Cost of goods sold..655,000 Other asset.340,000 Gross profit......$325,000 Total asset.... 390,000 Expenses.100,000 Liabilities120,000 Net income225,000 Owners equity270,000 Total 390,000 3. Inventory at the end of period incorrectly stated at $70,000 (overstated by $10,000). Net sales..980,000 Merchandise inventory. .$70,000 Cost of goods sold..635,000 Other asset.340,000 Gross profit......$345,000 Total asset... 410,000 Expenses.100,000 Liabilities120,000 Net income245,000 Owners equity290,000 Total 410,000 The effect of inventory on the following periods statements The inventory at the end of one period becomes the inventory for the beginning of the following period, thus, if the inventory is incorrectly stated at the end of the period, the net income of that period will be misstated and so will the net income for the following period. The amount of the two misstatements will be equal and in opposite directions. Therefore, the effect on net income of an incorrectly stated inventory, if not corrected, is limited to the period of the error and the following period. Example: assume no additional errors, both assets and owners equity will be correctly stated. Assume that the ending inventory for period one was understated by $10,000, and no other errors are made. The gross profit (and net income) would be understated for period one and overstated for period two by $10,000, indicates as follows: 2009 Correct
Net sale Merchandise inventory, jan 1 Purchase Merchandise available for sale Less merchandise inventory, dec 31 Cost of merchandise sold Gross profit Expense Net income 55,000 650,000 705,000 60,000 645,000 335,000 100,000 235,000 980,000 55,000 650,000 705,000 50,000 655,000 325,000 100,000 225,000

2010 Incorrect
980,000 50,000 700,000 750,000 70,000 680,000 420,000 120,000 300,000

Incorrect
1,100,000

Correct
1,100,000 60,000 700,000 760,000 70,000 690,000 410,000 120,000 290,000

Principle of Accounting II

In the illustration, the $10,000 understatement of inventory at the end of period one resulted in an over statement of the cost of goods sold and thus an understatement of gross profit by $10,000. On the balance sheet, merchandise inventory and owners equity would be understated by $10,000. Because the ending inventory of period one becomes the beginning inventory for period two, the cost of goods sold was understated and gross profit was overstated by $10,000 for period two. Both merchandise inventory and owners equity will be correct at the end of period two. Inventory Systems There are two principal system of inventory accounting. 1. Periodic 2. Perpetual. Periodic inventory system In this system, only the revenue from sales is recorded each time a sale is made. No entry will be made to record the cost of merchandise sold at the time of sale. Physical inventory will be taken to determine the cost of the ending inventory at the end of an accounting period. Perpetual inventory system Uses according records that continuously disclose the amount of the inventory. The cost of merchandise sold will be recorded each time a sale is made. Physical inventory is taken to compare the records with the actual quantities on hand.

Determining actual quantities in the inventory The first stage in the process of taking an inventory is to determine the quantity of each kind of merchandise owned by the enterprise. All of the merchandise owned by the business on the inventory date and only such merchandise should be included in the inventory. Determine who has legal title to merchandise in transit on the inventory date by examining purchase and sales invoices. Shipping terms: FOB shipping point title usually passes to the buyer when goods are shipped. FOB destination title doesnt pass to the buyer until the good are sold.

Consignments terms:
Compiled by Mulugeta T. MU, Dept of Accounting and Finance (2012).

Consignee acts as an agent of the consignor to sell the goods. Consignor retains title until the goods are sold.

Determining the cost of inventory: The cost of merchandise inventory is made up of the purchase price and all expenditures incurred in acquiring such merchandise, including transportation, customs duties, and insurance against losses in transit. Those cost that are difficult to associate with specific inventory items may be prorated on some equitable basis. On the other hand, if it is minor cost it can be treated as operating expense of the period. One of the most significant problems in determining inventory cost comes about when identical units of a certain commodity have been acquired at different unit cost prices during the period. In such a case it is necessary to determine the unit price of the items till on hand. At this time there are four methods commonly used in assigning costs to inventory and of goods sold. They are i.Use of specific identification number ii.First-in-first-out; iii.Last-in, first-out; iv.Weighted average. The three most common assumptions of determining the cost of merchandise sold are as follows: 1. Cost flow is in the order in which the expenditures were made first- in, first out. 2. Cost flow is in the reverse order in which the expenditures were made last in, first out. 3. Cost flow is an average of the expenditures. Inventory costing methods under a periodic 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 merchandise sold. First- in first- out method (FIFO) This method of costing inventory is based on the assumption that costs should be changed against revenue in the order in which they were incurred. Hence, the inventory remain is

Principle of Accounting II

assumed to be made up of the most recent costs and the cost of inventory sold is made up of the earliest costs. Example: - The units of an item available for sale during the year were as follows (Assume selling price of $ 50) Jan.1 inventor Mar.4 purchase 35 units at $ 23 10 units at $ 25 $805 $250 840 750 2,645

Aug.20 purchase 30 units at $28 Nov.30 purchase 25 units at $ 30 100

The physical count on December 31 shows that 45 units of the particular commodity are on hand. In accordance with the assumption that the inventory is composed of the most recent costs, the cost of the 45 units is determined as follows: FIFO method: (55 units were sold). Most recent cost, Nov. 30..25 units at $30. $750 Next most recent costs, Aug. 2020 units at $28. $560 Inventory, Dec. 31 1,310 Deduction of the inventory of 1,310 from the 2,645 of merchandise available for sale yields 1,335 as the cost of merchandise sold, which represents the earliest costs incurred for this commodity. Or Earliest cost jan1. 35 units at $ 23 $ 805 250 280 1335 Next earliest cost Mar 4, 10 units at $ 25 Next earliest cost Aug 20 10 units at $ 28 Cost of merchandise sold 55

The cost of inventory at Dec 31= $ 2,645-1,335 = $ 1,310 In most businesses, there is a tendency to dispose of goods in the order of their acquisition. This would be particularly true of perishable merchandise and goods in which style or model changes are frequent. Thus, the FIFO, methods is generally in harmony with the physical movement of merchandise is an enterprise. Last In, FirstOut method In this method of costing is based on the assumption that the most recent cost incurred should be charged against revenue. Hence the inventory remaining is assumed to be composed of the earthiest costs. Based on the above example the 45 units of inventory is determined in the following manner:
Compiled by Mulugeta T. MU, Dept of Accounting and Finance (2012).

Earliest costs, Jan. 1 .........35 units at $ 23..$ 805 Next earliest costs, Mar.4 10 units at $ 25 $ 250 Inventory, Dec. 31 45..1,055 Deduction of the inventory of $1,055 from the $2,645 of merchandise available for sale yields $1,590 as the cost of merchandise sold, which represents the most recent costs incurred for this particular commodity. Or Most recent cost Nov.30 Cost of merchandise sold Average cost method The average cost method is sometimes called the weighted average method. When this meted is used, cost is matched against revenue according to the weighted average unit costs of the goods sold. The same weighted average unit cost are used in determine the cost of the merchandise remaining in the inventory. The weighted average unit cost is determined by dividing the total cost of the identical units of each commodity available for sale during the period by the related number of units of that commodity. Average unit cost = total cost of the available units Number of units = $ 2,645 = $26.45 100 units The cost of ending inventory at Dec 31= 45* $26.45 = 1190.25 Cost of merchandise sold =55 units at 26.45 = $ 1,454.75 Or 2,645-1,190.25=1,454.75 Accounting for and reporting Inventory under a perpetual system In a perpetual inventory system, all merchandise increases and decreases are recorded in a manner similar to the recording of increases and decreases in cash. The merchandise inventory account at the beginning of an accounting period indicated the merchandise in stock on that date. Purchases are recorded by debiting merchandise inventory and crediting cash or accounts payable, on the data of each sale the cost of merchandise sold is recorded by debiting cost of merchandise sold and crediting merchandise Inventory. 25 units at $ 30 $750 840 1590 55 Next most recent costs, Aug 20 30 units at 28

The cost of inventory at Dec 31 = $ 2,645- $ 1,590 = $1055

Principle of Accounting II

Example: - the following units of item X are available for sale. Item X Jan 1 4 10 22 28 30 inventory sale purchase sale sale purchase units 20 14 18 8 6 20 22 21 cost $ 20

The firm used a perpetual inventor system, and there are 30 units of one item on hand at end of the year. What is the total cost of goods sold and ending inventory according to: A. FIFO B. LIFO C. Average Cost Method First- in, first out (FIFO) method Using cost, costs are included in the merchandise sold in the order in which they were incurred.
Purchases Date Quantity 1 4 10 18 21 378 14 20 280 Unit cost Total cost Quantity Unit cost Total cost Quantity 20 6 6 18 22 28 30 20 Balance 22 440 $568 $650 6 2 6 20 21 21 120 42 126 16 10 10 20 21 21 21 22 Unit cost 40 20 20 21 120 120 378 336 210 210 440 Total cost 400 Cost of merchandise sold Inventory

Thus cost of merchandise sold = $ 568, cost of ending inventory = $ 650. 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.

Compiled by Mulugeta T. MU, Dept of Accounting and Finance (2012).

Date Quantity 1 4

Purchases Unit cost Total cost

Cost of merchandise sold Quantity Unit cost Total cost Quantity 20 14 20 280 6 6

Inventory Unit cost 20 20 20 21 20 21 20 21 20 21 22 84 120 84 440 120 120 378 120 210 120 Total cost 400

10

18

21

378

18 6

22

21

168

10 6

28

21

126

4 6 4

30

20

22

440

20

Balance

$574

$644

Thus, cost of merchandise sold: $ 574, cost of ending inventory $ 644 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 is called a moving average. Average cost method:Purchases Date Quantity Jan 1 4 10 22 28 18 21 378 8 6 20.75 20.75 166 124.5 14 20 280 Unit cost Total cost Quantity Unit cost Total cost Quantity 20 6 24 16 10 Unit cost 20 20 20.75 20.7 20.7 120 498 332 207 Total cost 400 Cost of merchandise sold Inventory

30 Balance

20

22

440 $570.5

30

21.57 $647

647

Cost of merchandise sold = 529, Cost of ending inventory =647

Principle of Accounting II

Comparing inventory costing methods (Optional) Since a different cost flow is assumed for each of the three alternatives method of costing inventories, the three methods have yielded a different amount for:1. the cost of the merchandise sold for the period 2. the gross profit (and net income ) for the period, and 3. the ending inventory Example: - Using the preceding example for the periodic inventory system, the following partial income statements indicate the effect of each method when prices are rising. Partial income statements FI FO Net sales (50*55 unit) $2,750 Cost of March sold. Beginning inv Purchases Mer avail For sale Less ending inventor Cost of merch sold Gross profit $805 1,840 $2,645 1,310 $1,335 $ 1,415 $ 805 1,840 $2,645 1,190.25 $1454.75 $1345.25 $805 1,840 $2,450 1,055 $1,590 $1,460 AVERAGE COST $2,750 LIFO $2,750

The FIFO method yielded the lowest amount for the cost of merchandise sold and the highest amount for gross profit (and net income). It also yielded the highest amount for ending inventory.

The LIFO method yielded the highest amount for cost of goods sold, and the lowest amount for gross profit (and net income), and the lowest amount for ending inventory. The average cost method yield results that were b/n those of LIFO and FIFO. Corresponds to the actual physical flow of goods. Less subject to manipulation than other recent costs Ending inventory is shown at the most recent costs Older cost is matched against revenues. In periods of rising prices, can result in higher income taxes. 9

Uses of FIFO

Disadvantages of FIFO

Compiled by Mulugeta T. MU, Dept of Accounting and Finance (2012).

Uses of LIFO Matches current cost against current sales revenue. During periods of rising prices, using LIFO offers an income tax saving b/c LIFO reports the lowest net income. Disadvantages of LIFO Seldom conforms to actual flow of goods. During periods of rising prices, the ending inventors are low (quite different from its current replacement cost). Reported income is generally lower in periods of rising prices. Amounts for cost of goods sold and ending inventory fall b/n FIFO and LIFO values. B/S values are close to FIFO values (current replacement values) Valuation of inventory at other than cost Cost is the primary basis for valuating inventories. In some cases however, inventor is values at other than cost. This is 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 which may be due to imperfections, shop wear, style changes, and other causes. Valuation at lower of cost or Market (LCM) If the cost of replacing inventory is lower than its recorded purchase cost, the lower of- cost-ormarket (LCM) method is used to value the inventory. Market, as used in lower of cost or market, is the cost to replace the inventory. The market value is based on normal quantities that would be purchased from suppliers. The lower-of-cost-or-market method can be applied in one of three ways. The cost, market price, and any declines could be determined for the following: 1. Each item in the inventory. 2. Each major class or category of inventory. 3. Total inventory as a whole. The amount of any price decline is included in the cost of merchandise sold. This, in turn, reduces gross profit and net income in the period in which the price declines occur. This matching of price declines to the period in which they occur is the primary advantage of using the lower-of-cost-or-market method. Example: - On the basis of the following data, determine the value of inventory at the lower of Uses of average cost method.

Principle of Accounting II

cost or market. Commodity Inventory Quantity A B C D E Answer ______Total_____ Commodity Inventory Quantity A B C D E 10 17 12 15 30 Unit cost Unit market Price $ 325 110 275 51 95 Price $320 115 260 45 100 3,250 1,870 3,300 765 2,850 3,200 1,955 3,120 675 3,000 $11,950 3,200 1,870 3,120 675 2,850 $11,715 Cost Market LCM 10 17 12 15 30 Unit Cost Price $ 325 110 275 51 95 Unit Market Price $320 115 260 45 100

Total . $12035 2. Valuation at net realizable value

Merchandise that is out of date, spoiled, or damaged can often be sold only at a price below its original cost. Such merchandise should be valued at its net realizable value. Net realizable value is determined as follows: Net Realizable Value = Estimated Selling Price - Direct Costs of Disposal Direct costs of disposal include selling expenses such as special advertising or sales commissions on sale. To illustrate, assume the following data about an item of damaged merchandise: Original cost $1,000 Estimated selling price 800 Selling expenses 150 The merchandise should be valued at its net realizable value of $650 as shown below. Net Realizable Value = $800 - $150 = $650 Example: Assume that damaged merchandise costing 1,500 can be sold for only $ 1,250, and direct selling expenses are estimated to be $ 175. This inventory should be valued at $ 1075 ($ 1,250-$ 175)
Compiled by Mulugeta T. MU, Dept of Accounting and Finance (2012).

11

Presentation of Merchandise inventory all the balance sheet

Merchandise inventory is usually presented in the current asset section of the balance sheet, following receivables. Both the method of determining the cost of inventory (fifo, lifo, or average) and the method of valuing the inventory (cost or the lower of cost or market) should be show. The details may be disclosed in parentheses on the balance sheet or in a foot note to the financial statements. The company may change its inventory costing methods for valid reason. In such cases, the effect of the change and the reason for the change should be disclosed in the financial statements for period in which the change occurred.

Estimating Inventory Cost

In practical an inventory amount may be need in order to prepare an income statement when it is impractical or impossible to take a physical inventory or to maintain perpetual inventory records, the amount of inventory on hand can be estimated. The two commonly used methods of estimating inventory cost are 1. The retail method 2. The gross profit method. Retail method of inventory costing A business may need to estimate the amount of inventory for the following reasons: 1. Perpetual inventory records are not maintained. 2. A disaster such as a fire or flood has destroyed the inventory records and the inventory. only once a year. The two widely used methods of estimating inventory cost. 1. Retail Method of Inventory Costing The retail inventory method of estimating inventory cost requires costs and retail prices to be maintained for the merchandise available for sale. A ratio of cost to retail price is then used to convert ending inventory at retail to estimate the ending inventory cost. The retail inventory method is applied as follows: 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. 3. Monthly or quarterly financial statements are needed, but a physical inventory is taken

Principle of Accounting II

Example: on the basis of the following data, estimate the cost of the merchandise inventory at June 30 by the retail method Cost June 1. Merchandise inventory 1-30 purchasers (net) 1-30 sales (net) Solution: Cost Merchandise inventory June 1 Purchases in June (net) Merchandise available for sale 1,620,000 Sales for June (net) Merchandise inventor, June 30, at retail Merchandise inventory, June 30, at estimated cost (480.000*64%)................................................................................307,200 When estimating the cost to retail ratio, the mix of items in the ending inventory is assumed to be the same as the merchandise available for sale. If the ending inventory is made up of different classes of merchandise, cost to retail ratios may be developed for each class of inventory. An advantage of the retail method is that it provides inventory figures for preparing monthly statements. Department stores and similar retailers often determine gross profit and operating income each month, but may take a physical inventory only once or twice a year. Thus, the retail method allows management to monitor operations more closely. 1,140,000 480,000 Ratio of cost to retail price: 1,036,800 = 64% $ 428,300 608,500 $1,036,800 Retail $ 670,500 949,500 1,620,000 $428,300 608,500 Retail $ 670,500 949,000 1,140.000

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 follows: 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 Compiled by Mulugeta T. MU, Dept of Accounting and Finance (2012). 13

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. Example: The merchandise inventory was destroyed by fire on October 20. The following data were obtained from the accounting records. Jan 1 merchandise inventory Jan 1 Oct purchases (net) Sales (net) Estimated gross profit rate Solution: Merchandise inventory, January Purchase (net) Merchandise available for sales Sales (net) Less estimated gross profit (1,080,000*36%) (388,800) ($691,200) $318,800 Estimated cost of merchandise sold Estimated merchandise inventory, Oct 20 $1,080,000 $160.000 850,000 $1,010,000 $ 160,000 850,000 1,080,000 36%

Required: Estimate the cost of merchandise destroyed:

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.