CHAPTER ONE

ACCOUNTING FOR INVENTORIES

In the last section of Principles of Accounting I, you have learned about the principles and
practices of accounting for receivables – one of the current asset items in the balance sheet of a
retail business. In this unit you will learn and discuss the concepts in accounting for 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
Inventories of merchandising businesses are merchandise purchased for resale in the normal
course of business. These types of inventories are called merchandise inventories. Inventories of
manufacturing businesses are businesses that produce physical output. They normally have
three types of inventories. These are: Raw material inventory, Work in process inventory,
finished goods inventory.
Raw material inventory -is the cost assigned to goods and materials on hand but not yet placed
into production. Raw materials include the wood to make a chair or other office furniture’s, the
steel to make a car etc.
Work in process inventory- is the cost of raw material on which production has been started but
not completed, plus the direct labor cost applied specifically to this material and allocated
manufacturing overhead costs.
Finished goods inventory- is the cost identified with the completed but unsold units on hand at
the end of each period.
In this unit, accounting for 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:
 The sale of merchandise is the principal source of revenue for them.
 The cost of merchandise sold is the largest deductions from sales.
 Inventories (ending inventories) are the largest of the current assets or those firms.
Because of the above reasons, inventories have effects on the current and the following period’s
financial statements. If inventories are misstated (understated of overstated), the financial
statements will be distorted.

1.1 Internal Control over Inventory

Inventories affect both the balance sheet and income statement. In the balance sheet, inventory is
frequently the most significant part of current asset. In the income statement, inventory is vital in
determining the result of operation of a particular period.
Therefore, good internal control over inventory must be maintained for two primary objectives:
Safeguarding the inventory and
Properly reporting it in the financial statements.

Page 1
Control over inventory should begin as soon as the inventory is received. A receiving report
should be completed by the company’s receiving department in order to establish initial
accountability for the inventory.
To make sure the inventory received is what was ordered, the receiving report should agree with
the company’s original purchase order for the merchandise. A purchase order authorizes the
purchase of an item from a vendor. Likewise, the price at which the inventory was ordered, as
shown on the purchase order, should be compared to the price at which the vendor billed the
company, as shown on the vendor’s invoice. After the receiving report, purchase order, and
vendor’s invoice have been reconciled, the company should record the inventory and related
account payable in the accounting records.

1.2. The effect of inventory errors on the financial statements

 Errors occasionally occur in taking or costing of inventory.
 Errors may be caused by failure to count or price the inventory correctly.
 Errors also may occur because proper recognition is not given to the transfer of legal title
that is in transit. When errors occur they affect both the balance sheet and income
statement.
1. Effect Of Ending Inventory On Current Period’s Financial Statements
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.
Income statement
Cost of goods (merchandise) sold =Beginning inventory + Net purchase – Ending inventory
From the formula, 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.

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.

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).

Balance Sheet
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.

Page 2
Liabilities- Inventory misstatement has no effect on liabilities.

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). i.e. positive relationship.

2. Effects of beginning inventory on current period’s financial statements

Beginning inventory is inventory balance that was left on hand in the previous period and
transferred to the current period. Its effect is summarized below:

Income Statement
Cost of merchandise sold= Beginning inventory + Net Purchases – Ending inventory
From this, 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).

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

Net income = Gross Profit – Operating expenses

The effect of beginning inventory on net income is the same as its effect on gross profit. +ve r/p

Balance sheet
Current assets – The inventory included in current assets is the ending inventory. So, beginning
inventory has no effect on current assets.
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.

3. Effect of ending inventory on the following period’s financial statements

The ending inventory of the current period will become the beginning inventory for the
following period. So, it will have the same effect as beginning inventory of the current period.
Let us summarize it.
Income statement of the following period
Cost of merchandise sold direct relationship
Gross profit indirect relationship
Net income indirect relationship
Balance sheet of the following period
The ending inventory of the current period will not have an effect on the following period’s
balance sheet items.

Page 3
1.3. Inventory costing methods
There are two principal systems of inventory accounting i,e. periodic and perpetual.
1. Periodic inventory system
Under this system there is no continuous record of merchandise inventory account. The
inventory balance remains the same throughout the accounting period, i.e. the beginning
inventory balance. This is because when goods are purchased, they are debited to the purchases
account rather than merchandise inventory account.

The revenue from sales is recorded each time a sale is made. No entry is made for the cost of
goods sold. So, physical inventory must be taken periodically to determine the cost of inventory
on hand and goods sold. The periodic inventory system is less costly to maintain than the
perpetual inventory system, but it gives management less information about the current status of
merchandise. This system is often used by retail enterprises that sell many kinds of low unit cost
merchandise such as groceries, drugstores, hardware etc.
The journal entries to be prepared are:
At the time of purchase of merchandise:
Purchases XX at cost
Accounts payable or cash XX
At the time of sale of merchandise:
Accounts receivable or cash XX at retail price
Sales XX
To record purchase returns and allowance:
Accounts payable or cash XX
Purchase returns and allowance XX

To record adjusting entry or closing entry for merchandise inventory:

Income Summary XX
Merchandise inventory (beginning) XX
To close beginning inventory

Merchandise inventory (ending) XX

Income summary XX
To record ending inventory

2. Perpetual inventory system

Under this system the accounting record continuously disclose the amount of inventory. So, the
inventory balance will not remain the same in the accounting period. All increases are debited to
merchandise inventory account and all decreases are credited to the same account. There are no
purchases and purchase returns and allowances accounts in this system. At the time of sale, the
cost of goods sold is recorded in addition to Journal entry for the sale. So, we can determine the
cost of inventory as well as goods sold from the accounting record. No need of physical counting
to determine their costs. Companies that sell items of high unit value, such as appliances or
automobiles, tended to use the perpetual inventory system.

Page 4
Given the number and diversity of items contained in the merchandise inventory of most
businesses, the perpetual inventory system is usually more effective for keeping track of
quantities and ensuring optimal customer service. Management must choose the system or
combination of systems that is best for achieving the company's goal.

Journal entries to be prepared are:

At the time of purchase of merchandise
Merchandise inventory XX at cost
Accounts payable/cash XX

At the time of sale of merchandise

Accounts receivable or cash XX at retail price
Sales XX
To record the sales

Cost of goods sold XX

Merchandise inventory XX at cost
To record cost of goods sold
Accounts payable or cash XX
Merchandise inventory XX
To record purchase returns and allowances
No adjusting entry or closing entry for merchandise inventory is needed at the end
of each accounting period.

Determining Actual Quantities in the Inventory

The physical count of inventory is needed under both inventory systems. Under periodic
inventory system, it is needed to determine the cost of inventory and goods sold. The inventory
account under a perpetual inventory system is always up-to-date. Yet events can occur where the
inventory account balance is different from inventory on hand. Such events include theft, loss,
damage, and errors. The physical count (sometimes called “taking an inventory”) is used to
adjust the inventory account balance to the actual inventory on hand. We determine a birr
(dollar) amount for physical count of inventory on hand at the end of a period by:
 Counting the units of each product on hand,
 Multiplying the count for each product by its cost per unit and
 Adding the cost for all products.

At the time of taking an inventory, all the merchandise owned by the business on the inventory
date, and only such merchandise, should be included in the inventory. The merchandise owned
by the business may not necessarily be in the warehouse. They may be in transit.

The legal title to the merchandise in transit on the inventory date is known by examining
purchase and sales invoices of the last few days of the current accounting period and the first few
days of the following accounting period. This legal title depends on shipping terms (agreements).
There are two main types of shipping terms. FOB shipping point and FOB destination.

Page 5
FOB shipping point- the ownership title passes to the buyer when the goods are shipped (when
the goods are loaded on the means of transportation, i.e. at the seller’s point). The purchaser is
responsible for freight charges.

FOB destination – the title passes to the buyer when the goods arrive at their destination, i.e. at
the buyer’s point.

So, in general, goods in transit purchased on FOB shipping point terms are included in the
inventories of the buyer and excluded from the inventories of the seller. And goods in transit
purchased on FOB destination terms are included in the inventories of the seller and excluded
from the inventories of the buyer.

There is also a problem with goods on consignment at the time of taking an inventory. Goods on
consignment to another party (agent) called the consignee. A Consignee is to sell the goods for
the owner usually on commission are included in the consignor’s inventories and excluded from
the consignee’s inventories.

1.4. Inventory cost flow assumptions

One of the most important decisions in accounting for inventory is determining the per unit costs
assigned to inventory items. When all units are purchased at the same unit cost, this process is
simple since the same unit cost is applied to determine the cost of goods sold and ending
inventory. But when identical items are purchased at different costs, a question arises as to what
amounts are included in the cost of merchandise sold and what amounts remain in inventory.
There are four methods commonly used in assigning costs to inventory and cost of merchandise
sold. These are:
 Specific identification  Last-in first-out (LIFO)
 First-in first-out(FIFO)  Weighted average

Inventory Costing Methods under Periodic Inventory System

A periodic inventory system determines cost of merchandise sold and inventory at the end of the
period. How we assign these costs to inventory and cost of merchandise sold affects the reported
amounts for both systems.
Let us see these costing methods under periodic inventory system based on the following
illustration

Illustration:
Smart Company began the year and purchased merchandise as follows:
Jan-1 Beginning inventory 80 units@ Br. 60 = Br. 4,800
Feb-2 Purchase 400 units@ 56 = 22,400
Sep-4 Purchase 160 units@ 50 = 8,000
Nov-20 Purchase 320 units@ 46 = 14,720
Dec-4 Purchase 240 units@ 40 = 9,600
Total 1,200 units Br.59, 520

Page 6
a. Specific Identification Method: When each item in inventory can be directly identified with
a specific purchase and its invoice, we can use specific identification (also called specific
invoice pricing) to assign costs. This method is appropriate when the variety of merchandise
carried in stock is small and the volume of sales is relatively small. We can specifically
identify the items sold and the items on hand.
Example: From the above illustration, the ending inventory consists of 300 units, 100 from each
of the last purchases. So, the items on hand are specifically known from which purchases they
are: Cost of ending inventories under specific identification method:
Br. 40 x 100 = Br. 4,000
Br. 46 x 100 = 4,600
Br. 50 x 100 = 5,000
300units Br. 13,600
Cost of Ending inventory cost = Br. 13,600
The cost of merchandise sold = Cost of goods available for sale - Ending inventory
= Br. 59,520 – Br. 13,600
= Br. 45,920

b. First-in, First-out (FIFO): This method of assigning cost to inventory and the goods sold
assumes inventory items are sold in the order acquired. This means the cost flow is in the
order in which the expenditures were made. So, to determine the cost of ending inventory, we
have to start from the most recent purchase and continue to the next recent. Because the first
purchased items (old purchases) are the first to be sold they are used (included) in the
computation of cost of goods sold. Example, easily spoiled goods such as fruits, vegetables
etc., must be sold near the time of their acquisition. So, the inventory on hand will be from
the recent purchases. As an example, consider the previous illustration. The cost of ending
inventory under FIFO method:
Br. 40 x 240 = Br. 9,600
Br. 46 x 60 = 2,760
300 units Br. 12,360
Cost of Ending inventory = Br. 12,360
Cost of merchandise sold = Br. 59,520 – Br. 12,360 = Br. 47,160

c. Last-In First-Out (LIFO): This method of assigning cost assumes that the most recent
purchases are sold first. Their costs are charged to cost of goods sold, and the costs of the
earliest purchases are assigned to inventory. The cost flow is in the reverse order in which
expenditures were made. In calculating the cost of goods sold, we will start from the earliest
purchases. As an example, take the previous illustration again and the cost of ending
inventory under LIFO method:
Br. 60 x 80 = Br. 4,800
Br. 56 x 220 = 12,320
300 units Br. 17,120
Ending inventory cost = Br. 17,120
Cost of merchandise sold = Br. 59,520 – Br. 17,120 = Br. 42,400

d. Weighted Average Method: This method of assigning cost requires computing the average
cost per unit of merchandise available for sale. That means the cost flow is an average of the

Page 7
 expenditures. To calculate the cost of ending inventory, we will calculate first the cost per
unit of goods available for sale.

Average cost per unit = Cost of goods available for sale

Total units available for sale
Then the weighted average unit cost is multiplied by units on hand at the end of the period to
calculate the cost of ending inventory. Also, the same average unit cost is applied in the
computation of cost of goods sold. From the above example,
Weighted average unit cost = Br. 59,520 = Br. 49.60
1,200
Ending inventory cost = Br. 49.60x 300 = Br. 14,880
Cost of merchandise sold = Br. 59,520-Br. 14,880 = Br. 44,640

Comparison of Inventory costing methods

If the cost of units and prices at which they are sold remains stable, all the four methods yield the
same results. But if prices change, the three methods usually yield different amounts for:
 Ending inventory
 Cost of merchandise sold
 Gross profit or net income
In periods of rising (increasing) prices: (or if there is inflationary
trend):
FIFO yields: Higher ending inventory
Lower cost of merchandise sold
Higher gross profit (net income)
LIFO yields: Lower ending inventory
Higher cost of merchandise sold
Lower gross profit (net income)
Weighted average yields the results between the two.

In periods of declining (decreasing) prices:

FIFO yields: Lower ending inventory
Higher cost of merchandise sold
Lower gross profit or net income
LIFO yields: Higher ending inventory
Lower cost of merchandise sold
Higher gross profit or net income
Weighted average- between the two
Selecting the Inventory costing methods
Factors considered while selecting inventory costing methods.
1 Balance sheet effect
2 Income statement effect
3 taxes effect
1 . Balance sheets effect
FIFO method in the period of inflation the costs allocated to the ending inventory will
approximate their current cost. LIFO works conversely. The major short coming of LIFO method

Page 8
is that in the period of inflation, the costs allocated to the ending inventory may be significantly
understated in terms of current cost.
2 . Income statement effects
In the period of inflation, FIFO produces a higher net income because the lower unit costs of the
first units purchased is matched against revenues. To the management higher net income is an
advantage because it causes extra users to view the company more favorably. In addition, if
management bonuses are based on net income FIFO will provide the base for higher bonuses.
And also the taxes have imposed on the net income of the entity (i.e. higher tax imposed for high
net income and vice versa).

Inventory Costing Methods under Perpetual Inventory System

Under perpetual inventory systems we will apply the inventory costing methods each time sale of
merchandise is made. We calculate the cost of goods (merchandise) sold and inventory on hand
at the time of each sale. This means the merchandise inventory account is continually updated to
reflect purchase and sales.
Illustration: The beginning inventory, purchases and sales of Hayyuko Company for the month
of December are as follows:
Dec Units Cost (in Birr)
1 Inventory 15 10
6 Sale 5 -
10 Purchase 10 12
20 Sale 8 -
25 Purchase 8 12.5
27 Sale 10 -
30 Purchase 15 14

1. First-in first-out Method

The assignment of costs to goods sold and inventory using FIFO is the same for both the
perpetual and periodic inventory systems; because each withdrawal of goods is from the oldest
stock on hand. The oldest is the same whether we use periodic inventory system or perpetual
inventory system.
Let us calculate the cost of goods sold and ending inventory under perpetual inventory system
from the above illustration.
Perpetual – FIFO
Date Purchase Cost of merchandise sold Inventory
Qty. TC TC Qty UC TC Qty UC TC
Dec. 1 15 10.00 150.00
6 5 10.00 50.00 10 10.00 100.00
10 10.00 100.00
10 10 12.00 120.00 10 12.00 120.00
20 8 10.00 80.00 2 10.00 20.00
10 12.00 120.00
2 10.00 20.00
25 8 12.50 100.00 10 12.00 120.00
8 12.50 120.00

Page 9
 27 2 10.00 20.00 2 12.00 24.00
8 12.00 96.00 8 12.50 100.00
2 12.00 24.00
30 15 14.00 210.00 8 12.50 100.00
5 14.00 210.00
23 246.00 25 334.00
So, the cost of merchandise sold and ending inventory under perpetual- FIFO method are Br. 246
and Br. 334 respectively.
Let us see them under Periodic - FIFO method:
Units on hand = units available for sale – units sold
= (15 + 10 + 8 + 15) – (5+ 8 + 10) = 48 - 23 = 25
Cost of ending inventory = Br. 14 x 15 = Br. 210
Br. 12.50 x 8 = 100
Br. 12 x 2 = 24
Br. 334
Cost of goods available for sale = Br. 120 + Br. 100 + Br. 210 = Br. 580
Cost of goods sold = Br. 580 – Br. 334 = Br 246
So, the same results of cost of gods sold and ending inventory under both inventory systems.

2. Last-in, First-Out method

Unlike FIFO method, different results may occur under periodic and perpetual inventory system.
The most recent purchases change when new purchase occurs. Let us calculate first the cost of
goods sold and ending inventory for the above illustration under perpetual inventory system.
Then, we will see the results under periodic inventory system.
Perpetual - LIFO
Date Purchase Cost of merchandise sold Inventory
Qty. TC TC Qty. UC TC Qty. UC TC
Dec.1 15 10.00 150.00
6 5 10.00 50.00 10 10.00 100.00
10 10 12.00 120.00 10 10.00 100.00
10 12.00 120.00
20 8 12.00 96.00 10 10.00 100.00
2 12.00 24.00
25 8 12.50 100.00 10 10.00 100.00
2 12.00 24.00
8 12.50 100.00
27 8 12.50 100.00 10 10.00 100.00
2 12.00 24.00
30 15 14.00 210.00 10 10.00 100.00
15 24.00 210.00
23 270.00 25 310.00

So, the cost of merchandise sold and ending inventory under perpetual inventory system are Br.
270 and Br. 310 respectively. The results under Periodic-LIFO inventory system are:
Cost of ending inventory = Br. 10 x 15 = Br. 150
Br. 12 x 10 = 120
25 units Br. 270

Page 10
Cost of merchandise sold = Br. 580 - 270 = Br. 310, as you can see, the results are different
under periodic & perpetual inventory systems.

3. Weighted average cost method.

Under this method, the average unit cost is calculated each time purchased is made to be applied
on the sales made after the purchases. The results may be different under periodic and perpetual
inventory system. Let us calculate the cost of merchandise sold and ending inventory comes out
from the previous illustration under perpetual inventory system.
Average Cost Method (Moving Average)
Date Purchase Cost of merchandise sold Inventory
Qty UC TC Qty UC TC Qty UC TC
Dec.1 15 10.00 150.00
6 5 Br. 10.00 50.00 10 10.00 100.00
10 10 12.00 120.00 20 11.00* 220.00
20 8 11.00 88.00 12 11.00 132.00
25 8 12.00 100.00 20 11.60@ 232.00
27 10 11.60 116.00 10 11.60 116.00
30 15 14.00 210.00 15 13.04# 326.00
23 254.00 25 13.04 326.00

* 11 = (100+120)/(10+10)
@11.6 = (132+100)/(12+8)
#13.04 = (116+210)/(10+15)

So, the cost of goods sold and ending inventory under perpetual inventory system are Br. 254.00
and Br. 326.00, respectively. The results under periodic-average inventory system are:
Weighted average unit cost = Br. 580/48 = Br. 12.08
Ending inventory cost = Br. 12.08 x 25 = Br. 302
Cost of merchandise sold = Br. 580 – Br. 302 = Br. 278 so, the result is different under
periodic and perpetual inventory systems.

1.5. Valuation of inventory at other than cost

Additional valuation Issues for inventories:

 Valuation at lower of cost or market (LCM)

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
Page 11
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:

a. Separately to individual item
b. To major categories of items
c. 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.

Units on Per unit

Inventory Items hand Cost (Br) Market (Br)
Cycles: Roadster 50 15,000 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:

a. Separately to each individual item

Inventory Items TC (Br) Total Mkt (Br) LCM (Br)

Roadster 750,000 700,000 700,000
Sprint 180,000 190,000 180,000
Categories subtotal 930,000 890,000
Trax-4 100,000 112,000 100,000
Blaz’m 96,000 87,000 87,000
Categories subtotal 196,000 199,000
Totals 1,126,000 1,089,000 1,067,000

b. Major categories of items

Inventory categories Categories Categories LCM (Br)
TC(Br) Total Mkt (Br)
Cycles 930,000 890,000 890,000
Off Road 196,000 199,000 196,000
Totals 1,126,000 1,089,000 1,086,000

c. Whole of inventories
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

Page 12
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.

 Valuation at Net Realizable Value

As you would expect, merchandise that is out of date, spoiled, or damaged or that can be sold
only at prices below cost should be written down. Such merchandise should be valued at net
realizable value. Net realizable value is the estimated selling price less any direct cost of
disposal, such as sales commissions. For example, assume that damaged merchandise costing
$1,000 can be sold for only $800, and direct selling expenses are estimated to be $150. This
inventory should be valued at $650 ($800 - $150), which is its net realizable value.

1.6 Estimating Inventory Cost

In practice, an inventory amount is estimated for some purposes;
Example
 When it is impossible to take a physical inventory or to maintain perpetual inventory
records.
 When 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.
 When a catastrophe such as a five has destroyed the inventory. In such case, to ask
claims from insurance companies it needs estimation of inventory.
To estimate the cost of inventory, two common methods are used. These are retail method and
gross profit method.

a. 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:
1. Calculate the cost to retail ratio
Cost to retail ratio = Cost of merchandise available for sale
Retail Price of GAFS
2. Calculate the ending inventory at retail price
Ending inventory at retail price = retail price of GAFS – Net Sales
3. Calculate the estimated cost of ending inventory
Estimated cost of ending inventory = Cost to retail ration X Ending inventory at retail
Example:
Cost Retail
Beginning inventory……………….. Br. 25,000 Br. 40,000
Purchases during the period (net)…… 125,000 160,000
Sales during the period (net)………... - 140,000

The ending inventory is estimated as follows under retail method:

Solution:
(1) Cost retail ration = Br. 25,000 + Br. 125,000 = 0.75
Br. 40,000 + Br. 160,000
(2) Ending inventory at retail = (Br. 40,000 + Br. 160,000) – Br. 140,000 = Br. 60,000
(3) Estimated ending inventory at cost = 0.75 X Br. 60,000 = Br. 45,000

Page 13
 b. Gross profit method
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:
1. The gross profit rate is estimated and then estimated gross profit is calculated.
Estimated gross profit = Gross profit rate X Sales
2. Cost of merchandise sold is estimated
Estimated CGS = Net Sales - Estimated gross profit
3. Calculate the estimated cost of ending inventory
Estimated cost of ending inventory = CGAFS – Estimated CGS.
Example:
Beginning inventory (cost) ………………….. Br. 36,000
Net purchases during period (cost) …………... 204,000
Net sales during the period …………………... 220,000
Estimated gross profit rate …………………… 40%

The ending inventory is estimated as follows under gross profit method:

(1) Estimated gross profit = 0.4 X 220,000 = Br. 88,000
(2) Estimated CGS = 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
1.7 Presentation of Merchandise Inventory on the Balance Sheet

Merchandise inventory is usually presented in the Current Assets section of the balance sheet,
following receivables. Both the method of determining the cost of the inventory (fifo, lifo, or
average) and the method of valuing the inventory (cost or the lower of cost or market) should be
shown. It is not unusual for large businesses with varied activities to use different costing
methods for different segments of their inventories. The details may be disclosed in parentheses
on the balance sheet or in a footnote to the financial statements. Exhibit 8 shows how
parentheses may be used.

A company may change its inventory costing methods for a valid reason. In such cases, the effect
of the change and the reason for the change should be disclosed in the financial statements for
the period in which the change occurred.
Partial Balance Sheet:
Milko Company
Balance Sheet
December 31, 2015
Asset
Current assets:
Cash $ 19,400
Accounts receivable $80,000
Less allowance for doubtful accounts 3,000 77,000
Merchandise inventory––at lower of cost (FIFO), or Market 216,300

Page 14