CHAPTER ONE

INVENTORIES
Inventories are asset items held for sale in the ordinary course of business or goods that will be
used or consumed in the production of goods to be sold. They are mainly divided into two major:
 Inventories of merchandising businesses
 Inventories of manufacturing businesses
In this unit only the determination of the inventory of merchandise purchased for resale
commonly called merchandise inventory will be discussed.

Importance of inventories
Merchandise purchased and sold is the most active elements in merchandising business, i.e. in
wholesale and retail type of businesses. This is due to the following reasons:

1. The sale of merchandise is the principal source of revenue for them.

2. The cost of merchandise sold is the largest deductions from sales.
3. Inventories (ending inventories) are the largest of the current assets or those firms.
1.1. Internal control of inventories
Two primary objectives of control over inventory are as follows:
1. Safeguarding the inventory from damage or theft.
2. Reporting inventory in the financial statements.

1. Safeguarding Inventory
Controls for safeguarding inventory begin as soon as the inventory is ordered. The following
documents are often used for inventory control:
 Purchase order
 Receiving report
 Vendor’s invoice

The purchase order authorizes the purchase of the inventory from an approved vendor.
The receiving report establishes an initial record of the receipt of the inventory. As soon as the
inventory is received, a receiving report is completed. To make sure the inventory received is
what was ordered, the receiving report is compared with the company’s purchase order. The
price, quantity, and description of the item on the purchase order and receiving report are then
compared to the vendor’s invoice. If the receiving report, purchase order, and vendor’s invoice
agree, the inventory is recorded in the accounting records. If any differences exist, they should be
investigated and reconciled.
Recording inventory using a perpetual inventory system is also an effective means of control.
The amount of inventory is always available in the subsidiary inventory ledger. This helps
keep inventory quantities at proper levels. For example, comparing inventory quantities with

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maximum and minimum levels allows for the timely reordering of inventory and prevents
ordering excess inventory.
Finally, controls for safeguarding inventory should include security measures to prevent damage
and customer or employee theft. Some examples of security measures include the following:
1. Storing inventory in areas that are restricted to only authorized employees.
2. Locking high-priced inventory in cabinets.
3. Using two-way mirrors, cameras, security tags, and guards.
2. Reporting Inventory
A physical inventory or count of inventory should be taken near year-end to make sure that the
quantity of inventory reported in the financial statements is accurate. After the quantity of
inventory on hand is determined, the cost of the inventory is assigned for reporting in the
financial statements. Most companies assign costs to inventory using one of three inventory cost
flow assumptions.
1.2 The effect of inventory errors on the financial statements
Inventories have effects on the current and the following period’s financial statements. If
inventories are misstated (understated or overstated), the financial statements will be distorted.

1.2.1 Effect of ending inventory on current period’s financial statements

Under a periodic inventory system, both the beginning and ending inventories appear in the
income statement. The ending inventory of one period automatically becomes the beginning
inventory of the next period. Thus, inventory errors affect the computation of cost of goods sold
and net income in two periods. The effects on cost of goods sold can be computed by entering
incorrect data in the formula and then substituting the correct data.
Ending inventory is the cost of merchandise on hand at the end of accounting period. Let us see
its effect on current period’s financial statements.
A. Effects on Income statement
a. Cost of goods (merchandise) sold =Beginning inventory + Net purchase – Ending
inventory
As you see, ending inventory is a deduction in calculation cost of merchandise sold. So, it has an
indirect (negative) relationship to cost of merchandise sold, i.e. if ending inventory is
understated, the cost of merchandise sold will be overstated, and if ending inventory is
overstated, the cost of merchandise sold will be understated.
b. Gross Profit = Net sales – Cost of merchandise sold
Here, the cost of merchandise sold had indirect relationship to gross profit. So, the effect of
ending inventory on gross profit is the opposite of the effect on cost of merchandise sold. That is,
if ending inventory is understated, the gross profit will be understated and if ending inventory is
overstated, the gross profit will be overstated. This is a direct (positive) relationship.

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c. Operating income = Gross Profit – Operating Expenses
Gross profit and operating income have direct relationships. Thus, the effect of ending inventory
on net income is the same as its effect on gross profit, i.e. direct (positive) effect (relationship).
Generally the following shows the effects of inventory errors on the current year’s income
statement.
When Inventory Error: Goods Sold is: Net Income is:
Overstates Ending inventory Understated Overstated
Understates Ending inventory Overstated Understated
B. Effects on Balance Sheet
Companies can determine the effect of ending inventory errors on the balance sheet by using the
basic accounting equation: Assets = Liabilities + Owner’s Equity.
1. Current assets - Ending inventory is part of current assets, even the largest. So, it has a
direct (positive) relationship to current assets. If ending inventory balance is understated
(overstated), the total current assets will be understated (overstated). Since current assets
are part of total assets, ending inventory has direct relationship to total assets.
2. Liabilities- No effect on liabilities. Inventory misstatement has no effect on liabilities.
3. Owners’ equity – The net income will be transferred to the owners’ equity at the end of
accounting period. Closing income summary account does this. So, net income has direct
relationship with owners’ equity at the end of accounting period. The effect-ending
inventory on owners’ equity is the same as its effect on net income, i.e. if ending
inventory is understated (Overstated), the owners’ equity will be understated
(Overstated).
Generally Errors in the ending inventory have the effects on the balance sheet shown below:
Ending Inventory Error Assets Equity
Overstated Overstated Overstated
Understated Understated Understated
1.2.2 Effects of ending inventory on following period’s financial 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 the
period will be misstated and so will the net income for the next period. The amount of the two
misstatement 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 next
period. At the end of the next period, assume no additional errors, both assets and owner’s equity
will be correctly stated.
A. Effects on Income Statement
1. Cost of merchandise sold= Beginning inventory + Net Purchases – Ending inventory
As you see, beginning inventory is an addition in determining cost of goods sold. It has direct
effect on cost of merchandise sold. That is, if the beginning inventory is understated
(Overstated), the cost of merchandise sold will be understated (Overstated)

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2. Gross Profit= Net Sales – Cost of merchandise sold
The effect of beginning inventory on gross profit is the opposite of the effect on cost of
merchandise sold, i.e. indirect (negative) relationship. If the beginning inventory is understated,
the gross profit will be overstated and if it is overstated, the gross profit will be understated.
3. Net income = Gross Profit – Operating expenses
The effect of beginning inventory on net income is the same as its effect on gross profit.
Its effect is summarized below:
Period 1 Period 2
Cost of Cost of
Inventory Error Goods Sold Net Income Goods Sold Net Income
Period 1 Ending
Inventory overstated Understated Overstated Overstated Understated
Period 1 Ending
Inventory understated Overstated Understated Understated Overstated

B. Effects on Balance sheet

1. Current assets – The inventory included in current assets is the ending inventory. So,
beginning inventory has no effect on current assets.
2. Owners’ equity- If the effect comes from the previous year, the beginning inventory will not
have an effect on ending owners’ equity since the positive or negative effect of the previous
year will be netted off by the negative or positive effect of the current year. But if the error is
made in the current period, it will have indirect effect on ending owners’ equity.
Illustrations assume that ABC co. has a correct ending inventory of $20,000 in 2013. But the
co. recorded an incorrect ending inventory of $ 12,000 and 27,000. So show the effect of it on
both balance sheet and income statement for year 2013 and 2014. In all case net sales are
$200,000, merchandise available for sales$ 140,000, Other assets $80,000, expense $55,000 and
liability $ 30,000.
Solution
1) the correct amount of inventory recorded for the current year
Income statement balance sheet
Net sales……………….…. $200,000 Merchandise inventory……$20,000
Cost of merchandise sold… 120,000 other assets…………………80,000
Gross profit………………..$80,000 total assets…………………100,000
Expenses…………………….55, 000 liabilities……………………30,000
Net income………………...$ 25,000 owner’s equity…………….70, 000
Total……………………..100,000
2) inventory was understated by 8000 so the incorrect amount is $ 12,000
Income statement balance sheet
Net sales……………….…. $200,000 Merchandise inventory……$12,000
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 Cost of merchandise sold… 128,000 other assets…………………80,000
Gross profit………………..$72,000 total assets…………………92,000
Expenses…………………….55, 000 liabilities……………………30,000
Net income………………...$ 17,000 owner’s equity…………….62, 000
Total……………………..92,000
3) inventory was overstated by 7,000 so the incorrect amount is $ 27,000
Net sales……………….…. $200,000 Merchandise inventory……$27,000
Cost of merchandise sold… 113,000 other assets…………………80,000
Gross profit………………..$87,000 total assets…………………107,000
Expenses…………………….55, 000 liabilities……………………30,000
Net income………………...$ 32,000 owner’s equity…………….77, 000
Total……………………..107,000
In the following year if current year ending inventory is incorrect, then what will be the
effect. Assume purchase $ 10,000, net sales $200,000, ending inventory $5,000 and
expense $55,000
Case 1 inventory understated
Income statement
Net sales………………………………………$ 200,000
CMS
Beg. Inventory………………….12, 000
Purchase………………………...10,000
Merchandise available for sales…22,000
Less ending inventory…………… (5,000)
Cost of merchandise sold…………………… (.17, 000)
Gross profit…………………………………..$183,000
1.3. Inventory cost flow assumptions
An accounting issue arises when identical units of merchandise are acquired at different unit
costs during a period. In such cases, when an item is sold, it is necessary to determine its cost
using a cost flow assumption and related inventory cost flow method.
Three common cost flow assumptions
1. First-in, First-out (FIFO):- Cost flow is in the order in which the costs were incurred.
2. Last-in, First-out (LIFO):- Cost flow is in the reverse order in which the costs were
incurred.
3. Average Cost:- Cost flow is an average of the costs
Before we can begin discussing how costs flow through inventory, let’s review the two different
methods of recording inventory.
A. The perpetual method, and the most common method, continually updates the accounting
records for transactions involving inventory.
Perpetual inventory system
- Uses according records that continuously disclose the amount of the inventory.

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- Both the Revenue and 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.
B. On the other hand, the periodic method updates the accounting records only at the end of
the time period.
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.
To illustrate the cost flow assumptions, assume that three identical units of merchandise are
purchased during May, as follows:
Units cost
May 10 Purchase 1 $9
18 Purchase 1 13
24 Purchase 1 14
Total 3 $36
Average cost per unit: $12 ($36 ÷ 3 units)
Assume that one unit is sold on May 30 for $20.
Required: - Based on the given data compute CMS, Gross Profit and Cost of Ending inventory
by using FIFO, LIFO and Average Cost method.
Depending upon which unit was sold, the gross profit varies from $11 to $6 as shown below.
May 10 May 18 May 24
Unit Sold Unit Sold Unit Sold
Sales $20 $20 $20
Cost of merchandise sold 9 13 14
Gross profit $11 $7 $6
Ending inventory $27 $23 $22
($13 + $14) ($9 + $14) ($9 + $13)
Under the specific identification inventory cost flow method, the unit sold is identified with a
specific purchase. The ending inventory is made up of the remaining units on hand. The specific
identification method is not practical unless each inventory unit can be separately identified.
Under the first-in, first-out (FIFO) inventory cost flow method, the first units purchased are
assumed to be sold and the ending inventory is made up of the most recent purchases. In the
preceding example, the May 10 unit would be assumed to have been sold. Thus, the gross profit
would be $11, and the ending inventory would be $27 ($13 + $14).
Under the last-in, first-out (LIFO) inventory cost flow method, the last units purchased are
assumed to be sold and the ending inventory is made up of the first purchases. In the preceding
example, the May 24 unit would be assumed to have been sold. Thus, the gross profit would be
$6, and the ending inventory would be $22 ($9 + $13).

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Under the average inventory cost flow method, the cost of the units sold and in ending
inventory is an average of the purchase costs. In the preceding example, the cost of the unit sold
would be $12 ($36 ÷ 3 units), the gross profit would be $8 ($20 - $12), and the ending inventory
would be $24 ($12 × 2 units).
1.4. Inventory costing methods under a perpetual and periodic inventory system
When identical units of an item are purchased at different unit costs, an inventory cost flow
method must be used. This is true regardless of whether the perpetual or periodic inventory
system is used.
A. Inventory Costing Methods under a Perpetual Inventory System
The FIFO, LIFO, and average cost methods are illustrated under a perpetual inventory system.
Illustration determines the cost of merchandise sold and ending inventory by using FIFO, LIFO,
and average methods. Assume the selling price of each unit is $ 30
Item X Units Cost
Jan. 1 Inventory 100 $20
4 Sale 70
10 Purchase 80 21
22 Sale 40
28 Sale 20
30 Purchase 100 22
A. First-In, First-Out Method
When the FIFO method is used, costs are included in cost of merchandise sold in the order in
which they were purchased. This is often the same as the physical flow of the merchandise.
Purchase Cost of Merchandise sold Inventory
Date quantity Unit Total Quantity Unit Total quantity Unit Total
cost cost cost cost cost cost
Jan 1 100 20 2000
4 70 20 1400 30 20 600
10 80 21 1680 30 20 600
80 21 1680
22 30 20 600
10 21 210 70 21 1470
28 20 21 420 50 21 1050
30 100 22 2200 50 21 1050
100 22 2200
31 balance 2630 3250

Cost of merchandise sold Jan. 31 inventory

B. Last-In, First-Out Method
When the LIFO method is used, the cost of the units sold is the cost of the most recent purchases.
The LIFO method was originally used in those rare cases where the units sold were taken from

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the most recently purchased units. However, for tax purposes, LIFO is now widely used even
when it does not represent the physical flow of units and not allowed by IFRS.
Purchase Cost of Merchandise sold Inventory
Date quantity Unit Total Quantity Unit Total quantity Unit Total
cost cost cost cost cost cost
Jan 1 100 20 2000
4 70 20 1400 30 20 600
10 80 21 1680 30 20 600
80 21 1680
22 40 21 840 30 20 600
40 21 840
28 20 21 420 30 20 600
20 21 420
30 100 22 2200 30 20 600
20 21 420
100 22 2200
31 balance 2,660 3,220

Cost of merchandise sold Jan. 31 inventory

C. Average Cost Method
When the average cost method is used in a perpetual inventory system, an average unit cost for
each 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.
date Purchase Cost of goods sold Inventory
Date quantity Unit Total Quantity Unit Total quantity Unit Total
cost cost cost cost cost cost
Jan 1 100 20 2000
4 70 20 1400 30 20 600
10 80 21 1680 110 20.73 2280
22 40 20.73 829.2 70 20.73 1451.1
28 20 20.73 414.6 50 20.73 1036.5
30 100 22 2200 150 21.58 3237
31 balance 2,643.8 3,237

Cost of merchandise sold Jan. 31 inventory

B. Inventory Costing Methods Under a Periodic Inventory 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 the merchandise sold.

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To illustrate the use of the FIFO method in a periodic inventory system, we use the same data
for Item X as in the perpetual inventory example. The beginning inventory entry and purchases
of Item X in January are as follows:
I. First-In, First-Out Method
Item X Units Cost
Jan. 1 Inventory 100 $20 $ 2000
10 Purchase 80 21 1680
30 Purchase 100 22 2200
Available for sale during month 280 $5880
The physical count on January 31 shows that 150 units are on hand. Using the FIFO method, the
cost of the merchandise on hand at the end of the period is made up of the most recent costs.
Most recent costs, January 30 purchase 100 units at $22 $2,200
Next most recent costs, January 10 purchase 50 units at $21 1,050
Inventory, January 31 150 units $3,250
Deducting the cost of the January 31 inventory of $3,250 from the cost of merchandise available
for sale of $5,880 yields the cost of merchandise sold of $2,630, as shown below.
Beginning inventory, January 1……………………………………………$2,000
Purchases ($1,680 + $2,200) ………………………………………………..3,880
Cost of merchandise available for sale in January …………………………$5,880
Less ending inventory, January 31………………………………………….. 3,250
Cost of merchandise sold …………………………………………………..$2,630
II. Last-In, First-Out Method
When the LIFO method is used, the cost of merchandise on hand at the end of the period is made
up of the earliest costs. Based on the same data as in the FIFO example, the cost of the 150 units
in ending inventory on January 31 is determined as follows:
Beginning inventory, January 1 100 units at $20 $2,000
Next earliest costs, January 10 50 units at $21 1,050
Inventory, January 31 150 units $3,050
Deducting the cost of the January 31 inventory of $3,050 from the cost of merchandise available
for sale of $5,880 yields the cost of merchandise sold of $2,830, as shown below.
Beginning inventory, January 1……………………………………………………. $2,000
Purchases ($1,680 + $2,200)………………………………………………………..3,880
Cost of merchandise available for sale in January………………………………… $5,880
Less ending inventory, January 31…………………………………………………. 3,050
Cost of merchandise sold………………………………………………………….. $2,830
III. Average Cost Method
The average cost method is sometimes called the weighted average method. The average cost
method uses the average unit cost for determining cost of merchandise sold and the ending
merchandise inventory. If purchases are relatively uniform during a period, the average cost
method provides results that are similar to the physical flow of goods.
The weighted average unit cost is determined as follows:
Average Unit Cost = Total Cost of Units Available for Sale
Units Available for Sale
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To illustrate,we use the data for Item X as follows:
Average Unit Cost =Total Cost of Units Available for Sale = $5,880
Units Available for Sale 280 units
Average Unit Cost = $21 per unit
The cost of the January 31 ending inventory is as follows:
Inventory, January 31: $3,150 (150 units ×$21)
Deducting the cost of the January 31 inventory of $3,150 from the cost of merchandise available
for sale of $5,880 yields the cost of merchandise sold of $2,730, as shown below.
Beginning inventory, January 1 ……………………………………………………. $2,000
Purchases ($1,680 +$2,200)………………………………………………………… 3,880
Cost of merchandise available for sale in January…………………………………. $5,880
Less ending inventory, January 31………………………………………………….. 3,150
Cost of merchandise sold………………………………………………………….. $2,730
The cost of merchandise sold could also be computed by multiplying the number of units sold by
the average cost as follows: Cost of merchandise sold: $2,730 (130 units × $21)
1.5 Valuation of Inventory at other than Cost
A. Valuation at Lower of Cost or Market
It was explained how costs are assigned to ending inventory and cost of goods sold using one of
four costing methods (FIFO, LIFO, Weighted average, or specific identification). Yet, the cost of
inventory is not necessarily the amount always reported on a balance sheet. Accounting
principles require that inventory be reported at the market value of replacing inventory when
market is lower than cost. Merchandise inventory is then said to be reported on the balance sheet
at the lower of cost or market (LCM).
In applying LCM, cost is the acquisition price of inventory computed using one of the historical
cost methods - specific identification, FIFO, LIFO, and Weighted average; market is defined as
the current market value (cost) of replacing inventory. It is the current cost of purchasing the
same inventory items in the usual manner. It is important to know that market is not defined as
the sales prices. A decline in market cost reflects a loss of value in inventory. This is because the
recorded cost of inventory is higher than the current market cost. When this occurs, a loss is
recognized. This is done by recognizing the decline in merchandise inventory from recorded cost
to market cost at the end of the period.
LCM is applied in one of three ways:
(1) Separately to individual item
(2) To major categories of items
(3) To the whole of inventory
The less similar the items are that make up inventory, the more likely it is that companies apply
LCM to individual items. Advances in technology further encourage the individual item
application.
Illustration
The following are the inventory of ABC motor sports, retailer.
Inventory units per unit
Item on hand cost market
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Cycles:
Roadster ………………………..50……………Br. 15,000…….Br. 14,000
Sprint……………………………20…………………9,000……….. 9,500
Off Road:
Trax-4……………………………10………………… 10,000………..11,200
Blaz’m…………………………… 6………………… 16, 000……….14, 500
Let us see LCM computation under the three ways:
(1) Separately to each individual item
Inventory items Total cost Total market LCM
Roadster………………………. Br. 750,000…………….Br. 700,000…….. Br. 700,000
Sprint …………………………..180,000……………….. 190,000…………..180,000
Categories subtotal…………... Br. 930,000……………Br. 890,000
Trax-4…………………………. 100,000…………………112,000………….. 100,000
Blaz’m…………………………. 96,000…………………87,000 87,000
Categories subtotal…………… Br. 196,000……………..Br. 199,000
Totals………… …..Br.1, 126,000……………….Br. 1,089,000……… Br. 1,067,000
(2) Major categories of items
Inventory Categories Categories LCM
Categories total cost total market
Cycles …………………. Br. 930,000……………Br. 890,000…………Br. 890,000
Off. Road……………………196,000……………….199,000……………..196,000
Totals ………………….Br. 1,126,000……………..Br. 1089,000………..Br. 1,086,000
When LCM is applied to the whole of inventory, the market cost is Br. 1,089,000. Since this
market cost is Br. 37,000 lower than Br. 1,126,000 recorded cost, it is the amount reported for
inventory on the balance sheet. When LCM is applied to individual items of inventory, the
marked cost is Br. 1,067,000. Since market is again less than Br. 1,126,000 cost, it is the amount
reported for inventory. When LCM is applied to the major categories of inventories, the market
is Br. 1,086,000 which is also lower than cost.
B. 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
1.6 Estimating Inventory Cost
In practice, an inventory amount is estimated for some purposes. At the time when it is
impossible to take a physical inventory or to maintain perpetual inventory records.

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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.
3. Monthly or quarterly financial statements are needed, but a physical inventory is taken
only once a year.
Example
1) Monthly income statements are needed. It may be too costly, to take physical inventory. This
is especially the case when periodic inventory system is used.
2) When a catastrophe such as a fire has destroyed the inventory. In such case, to ask claims
from insurance companies, there is a need of estimated inventory.
To estimate the cost of inventory, two methods are used. These are retail method and gross profit
method.
1.6.1 Retail method of inventory costing
This method is mostly used by retail business. The estimate is made based on the relationship
between the cost and the retail price of merchandise available for sale.
The steps to be followed are:
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.
The cost to retail ratio = Cost of merchandise available for sale X 100%
Retail Price of merchandise available for sale
Step 3. Determine the ending inventory at retail price.
Ending inventory at retail price = retail price of merchandise available for sale – net sales
Step 4. Estimate the ending inventory cost by multiplying the ending inventory at retail by
the cost to retail ratio.
Estimated cost of ending inventory = Cost to retail ratio X Ending inventory at retail
Example: on the basis of the following data, estimate the cost of the merchandise inventory
at September 30 by the retail method
at Cost at Retail
Sep. 1, beginning inventory Br. 25,000 Br. 40,000
Purchases in September (net) 125,000 160,000
Sales in September (net) 140,000
(2) Cost retail ratio = Br. 25,000 + Br. 125,000 = 0.75 X 100% = 75%
Br. 40,000 + Br. 160,000

(3) Ending inventory at retail = (Br. 40,000 + Br. 160,000) – Br. 140,000 = Br. 60,000
(4) Estimated ending inventory at cost = 0.75 X Br. 60,000
= Br. 45,000
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.

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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.
1.6.2 Gross profit methods
This method uses an estimate of the gross profit realized during the period to estimate the cost of
inventory. The gross profit rate may be estimated based on the average of previous period’s gross
profit rates.
The steps are as follows:
Step 1. Determine the merchandise available for sale at cost.
Step 2. Determine the estimated gross profit.
Estimated gross profit = Gross profit rate X Sales
Step 3. Determine the estimated cost of merchandise sold.
Estimated cost of merchandise sold = Sales - Estimated gross profit
Step 4. Estimate the ending inventory cost.
Estimated cost of ending inventory =
Cost of merchandise available for sale – Estimated cost of merchandise sold.
Example: - The merchandise inventory was destroyed by fire on October 20. The following data
were obtained from the accounting records.
Oct. 1, beginning inventory (cost) – Br. 36,000
Net purchases during October (cost) 204,000
Net sales during October 220,000
Estimated gross profit rate is 40%
Required: Estimate the cost of merchandise destroyed:
The ending inventory is estimated as follows:
(1) Estimated gross profit = 0.4 X 220,000
= Br. 88,000
(2) Estimated cost of merchandise sold
= Br. 220,000 – Br. 88,000
= Br. 132,000
(3) Estimated cost of ending inventory
= (Br. 36,000 + 204,000) – Br. 132,000
= Br. 240,000 – Br. 132,000
= Br. 108,000
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.
1.7. Presentation of merchandise Inventory on the Balance Sheet
Merchandise inventory is usually reported in the Current Assets section of the balance sheet. In
addition to this amount, the following are reported:
1. The method of determining the cost of the inventory (FIFO, LIFO, or average)
2. The method of valuing the inventory (cost or the lower of cost or market)

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