•Inventory Accounting

For Merchandising
Business
 Income Measurement
• Principle is same like a service company –
Income Statement consists of (i) sales
revenue; (ii) COGS; (iii) Operating
expenses; & (iv) Non-operating items
 1. Revenue from Sales

• Accrual Accounting: revenue from sale of

merchandise is considered to be earned in
the accounting period, where ownership
of goods passes from seller to buyer: cash
& credit sales
• Net sales Revenue = Gross sales; less
Returns & Allowances
• Cash Sales: Debit Cash & Credit Sales
• Credit Sales: Debit Debtors & Credit Sales
 Revenue from Sales……..
• Sales Discounts: Cash discount for early
payments

• 2/10, n/30: buyer gets 2% discount for paying

within 10 days of the invoice date; alternatively
he may wait 30 days & pay the full invoice
amount without discount.

• When sales executed: Debit Debtors; Credit Sales

• When money recovered within discount period:

Debit Cash & Debit Sales Discount; Credit
Debtors
 Deciding on Discount
• A company buys goods for Rs.1,000 with terms 2/10,
n/30.
• By advancing payment by 20 days, the buyer can earn a
discount of Rs.20
• Equivalent to investing Rs.980 and earning Rs.20 in 20
days
• Equivalent Annual Rate of Interest = {(Number of days
in a year ÷ No. of days payments is advanced) X
(Discount % ÷ [100 – Discount %])} = 36.73%
• If the interest rate on borrowing is less than 36.73% p.a.,
the borrower would borrow & pay within the
discounted period to avail discount
 Common Freight Terms & Transportation
Costs
• In FOB shipping point, the buyer pays the freight & in
FOB destination, the seller pays the freight - Ownership
of the goods generally passes at the FOB point
• A separate Freight In account is used to record inward
freight charges incurred on merchandise purchased –
Debit Freight In A/c & Credit Cash A/c

• Normal balance of a Freight In A/c is a debit – it is an

Adjunct Account; an account the balance of which is
added to the balance of other account
• Adjunct Account is just the opposite of a contra
account, balance of which is deducted from another
account
 2. Computation of Cost of Goods Sold

1. Periodic Inventory System: A physical count is

made of merchandise in the ending inventory
account & the cost of inventory is determined.
Thus, accounts such as Purchases, purchase
returns, Allowances & Freight In are maintained
separately.
2. Perpetual Inventory System: A continuous
record of all purchases & sale of merchandise,
resulting in constant updating the amount of
inventory on hand. Here, accounts such as
Purchases, purchase returns, Allowances & Freight
In are not maintained – instead a single
Merchandise Inventory account is operated.
 2. Cost of Goods Sold
(Merchandising Inventory)
• In most of the merchandizing firms, inventory
is maintained under Periodic Inventory
System. The COGS under this system shall be:
Opening Inventory
Add, Purchases
Less, Purchases Returns &Allow.; & Discounts
Net Purchases
Add, Freight In
Net Cost of Purchases
Cost of Goods available for sale
Less, Closing Inventory
Cost of Goods Sold
 Can you compute the Cost of Goods
Sold?
• Beginning inventory – Rs. 11,000
• Purchases – Rs.2,10,000
• Purchases Returns & Allowances – Rs.7,000
• Purchases Discounts – Rs.3,000
• Freight In – Rs.18,000
• Ending Inventory- Rs.17,000
 3. Operating Expenses
• These are expenses other than the COGS,
interest and income tax, and are incurred
in running the normal business

• Usually grouped into Selling &

Administrative expenses
 Key Relationships
• Net sales = Sales – Sales Returns & Allowances
• Net Purchases = Purchases – Purchases Returns &
Allowances - Purchase Discounts
• Net Cost of Purchases = Net Purchase + Freight In
• COGS = Beginning Inventory + Net Cost of Purchases
– Closing Inventory
• Gross Profit = Net Sales – COGS
• Operating Expenses = Selling Expense+
Administrative Expenses
• Profit Before Interest & Tax (PBIT) = Gross Profit –
Operating Expenses
• Profit before Tax (PBT) = PBIT – Interest Expenses +
Interest Income
• Net Profit = Profit before Tax – Income Tax
 READYWARE
• After completing a degree in fashion technology,
Chandrika set up READYWARE to sell designer
dresses - invested Rs.2,00,000 in cash
• Used Rs.60,000 to buy store equipment
• The store opened for business on July 1
• During the month, she paid Rs.6,27,000 for
merchandise and Rs.34,000 towards operating
expenses
• Withdrew Rs.1,10,000 for personal purposes.
Her month-end Balance sheet was as follows
 READYWARE………..
• Balance Sheet as on July 31, 20xx
Assets (In Rs.)
Cash 1,68,000
Debtors (for sales) 2,32,000
Merchandise Inventory 1,75,000
Stores Equipment 60,000
Less, Depreciation (1,000) 59,000
6,34,000
Liabilities & OE
Creditors (for merchandise) 1,96,000
Chandrika, Capital 4,38,000
6,34,000
 READYWARE………..
• Required:
1. Calculate for July (a) the Net Profit, (b)
COGS, (c) Sales & (d) Collection from
customers
2. Prepare the July, 20xx profit & loss
account
Inventory Accounting
for Manufacturing
Business
 Manufacturing Inventories &
Flows
Raw Materials InventoryUsed
Opening Inventory of materials
Add, Purchases (adjusted with returns &
carrying cost)
Less, Closing Inventory
Raw Materials Used (As per Periodic
Method) Transferred as W-I-P Inventory
 Manufacturing Inventories &
Flows………..
• Work In Process Inventory Used
• Opening Inventory of W-I-P
• Add, Transferred from R-M-I
• Add, Conversion Cost
• Less, Closing Inventory of W-I-P
• Cost of Goods Manufactured
• Transferred to Finished Goods Inventory
 Manufacturing Inventories &
Flows……….
• Finished Goods Inventory Used
• Opening Inventory of Finished goods
• Add, Transferred from W-I-P
• Less, Closing Inventory of Finished goods
• Finished goods inventory used for Sales
(COGS)
 Perpetual Inventory System
• In most of the manufacturing firms the
inventory is maintained under perpetual
inventory system & the COGS is computed
accordingly.

• This system updates the merchandise inventory

account after each purchase & sale.

• This system can be operational with any one of

the following four methods: 1) WAC, 2)FIFO,
3)LIFO, 4) Specific Identification Method.
 1. WAC Method
• Appropriate when the goods available for sale are
homogenous or when it is difficult to make a cost flow
assumption
• Average cost is computed by dividing the cost of goods
available for sale, which consists of the beginning
inventory and all purchases, by the number of units
available for sale
• The weighted average unit cost, which results from this
computation is applied to the units in the ending
inventory
• Criticism – Assigns no more importance to current prices
than past prices paid several days/ months ago
 2. FIFO Method
• Assumes that the first units acquired are first units sold

• Thus the cost of ending inventory is that of the most

recent purchases – inventory value reflects the
conditions prevalent in the balance sheet

• Criticism – Improper matching of cost with revenue

since the COGS is computed on the basis of old prices
which are probably unrealistic

• Under inflation, FIFO produces higher net profit though

much of the profit results from matching current
revenues with low purchase price paid in the past
 3. LIFO Method
• Assumes that last units acquired are the first
units sold
• So the cost in the ending inventory is that of the
earliest purchases
• Ending inventory – Rs.1,700; COGS – Rs.8,400
• Ensures that current revenues are matched with
the most recent purchase prices, thus resulting in
realistic reported profits
• Criticism – Balance sheet value of inventories
may be outdated & unrealistic
 4. Specific Identification Method
• Assigns specific costs to each unit sold and each unit on
hand – may be used if the units in the ending inventory
can be identified as coming from specific purchases

• Particularly suited to inventories of high-value, low-

volume items, e.g. automobiles, jewellery etc. – each unit
in inventory must be affixed with an identification tag

• It matches the cost to the physical flow of inventory &

eliminates the effect of cost flow assumptions on
reported net profit
 Comparing Alternative Methods
1. In a period of constant prices, all four methods show
identical results

2. LIFO (not allowed in India) reports lowest gross profit

in a period of rising prices as it charges highest costs to
the goods sold

3. FIFO does a fair job of matching current selling prices

& COGS which is closer to current replacement costs,
but often produces an outdated inventory value

4. Both LIFO and WAC allow a business to manipulate

net profit by changing the timing of additional charges

5. For income tax purposes, a business is free to adopt

any method of inventory valuation acceptable for
accounting – Once adopted, the method must be
followed consistently
 Periodic vs. Perpetual Systems

• As per matching concept both the approaches

match COGS with Sales revenue.

• Under Periodic Inventory System, ending

inventory is obtained by a physical count, and
the COGS is obtained by deduction.

• Under Perpetual Inventory System, both

amounts are obtained directly from inventory
records.