Intermediate accounting

1. 8-1
CHAPTER 4
ACCOUNTING FOR
INVENTORIES

2. 8-2
After studying this chapter, you should be able
to:
LEARNING OBJECTIVES
1. Identify major classifications of inventory.
2. Distinguish between perpetual and periodic inventory systems.
4. Determine the goods included in inventory
5. Understand the items to include as inventory cost.
6. Describe and compare the methods used to price inventories

3. 8-3
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.
Merchandising
Company
Manufacturing
Company
Businesses with Inventory
or
Classification
4.1 Nature and Classification of inventories

4. 8-4
Manufacturing companies have three major types of inventories.
 A. Raw material inventories
 B. Work in progress inventories
 C. Finished goods inventories
Classification
INVENTORY ISSUES
LO 1

5. 8-5
INVENTORY ISSUES

6. 8-6
 4.2. 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.
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.

7. 8-7
 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.
 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.

8. 8-8
 Costs Included in Inventory
 Product Costs; 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
A. 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

9. 8-9
 B. Conversion costs for a manufacturing company
include direct materials, direct labor, and
manufacturing overhead costs.
 C. 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.

10. 8-10
 4.3.Valuation of inventories: A cost-
basis approach
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

11. 8-11
 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.

12. 8-12
 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: Purchase.
 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

13. 8-13
 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

14. 8-14
 Under the perpetual inventory system,

15. 8-15
 Last-In, First-Out (LIFO)-
 Inventory cost flow assumption whereby the goods
purchased during the last period are assumed to be
the goods sold firstly.
 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):
 200 units at Br. 1.00 (oldest costs available, form Jan 1. inventory)
………Br. 200
 100 units at Br. 1.10 (next oldest costs available, from Jan 9 purchase)……
110
 Ending inventory...............................................................................…...310
 Cost of goods sold..............................................................…....Br. 810

16. 8-16

17. 8-17
 4.4.Special inventory valuation methods
 4.4.1. 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.
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.
 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.

18. 8-18
 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 ………..…… 300
 Net realizable value………………………………….700
 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

19. 8-19
 Methods of Applying LCNRV, LCNRV can be
applied for:
 1. Each individual items
 2. Major groups
 3. Total items

20. 8-20
 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.

21. 8-21
 4.2.Gross profit method of Estimating Inventories
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 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.

22. 8-22
 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

23. 8-23
 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 0.80The 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).

24. 8-24
 Conversely, assume that the gross profit on selling
price is 20 percent. What is the markup on cost?
 Cost + Gross profit = Selling price
C + .20SP = SP=C = (1 - .20) SP=C = .80
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
Gross Profit on Selling Price Percentage Markup on Cost
Given: 20% .20/1.00 − .20 = 25%
Given: 25%
.25/1.00 + .25 = 20%

25. 8-25
 4.3.Retail method of Estimating Inventories
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,

26. 8-26
 Mark down less markdown cancellation is referred to
as net markdowns.
Retail Inventory Method with Markups and
Markdowns.
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

27. 8-27
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

28. 8-28
Cost Retail
Beginning inventory € 500 € 1,000
Purchases (net) 20,000 35,000
Merchandise avalable for sale 20,500 36,000
Add: Markups €3,000
Less: Markup cancellations
Net markups
1,000
2,000
20,500 38,000
(A) Cost-to-retail ratio = 53.9% 20,500/38,000
Deduct:
Markdowns
Less: Markdown cancellations
Net markdowns
€20,500
2,500
(2,000)
500
37,500
(B) Cost-to-retail ratio = 54.7%
€20,500/37,500
Deduct: Sales (net) 25,000
Ending inventory, at retail €20,500 €12,500

29. 8-29
 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 during freight-in, purchase returns and
allowances, and purchase discounts treat as follows as
 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
considered as a reduction of the cost of purchases.