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Faculty of Accounting and Finance

Department of Accounting.
Rift Valley University Gelan Campus
Gelan, Oromia

FUNDAMENTAL ACCOUNTING II

SET BY: GUTETA MERERA (MA).

Email address: gutetamerera1234@[Link]
Cell: 0921051687 1
 CHAPTER ONE
Accounting for Inventories
Definition of Inventory:
• It refers to all the items, goods, merchandise and materials held by a business for selling in market to earn
a profit.
• 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.
– Inventory are usually the largest current asset of a business, and
– Proper measurement of them is necessary to assure accurate financial statement.
– If inventory is not appropriately measured, expense and revenues can not be properly matched.
Helpful hints: Regardless of the classification, Companies report all inventories under current assets of the
balance sheet.
• Inventories mainly divided into two major:
 Inventories of manufacturing businesses (In a manufacturing company, some inventory may not yet
be ready for sale. As a result, manufacturers usually classify inventory into three categories. These
are: (RM, WIP & FG)
 Inventories of merchandising businesses (They need only one inventory classification, merchandise
inventory)
Inventories of manufacturing businesses
– Manufacturing businesses are businesses that produce Physical output
– They normally have three types of inventories. These are:
1. Raw Material inventory:- goods and materials on hand but not yet placed into production
2. Work in process inventory: Started but not yet completed. 2
 …Cont’d
1. Raw Material Inventory
• are the basic goods that will be used in production but have not yet
been placed into production.
• Example: Wood for chair, steel for car, leather for shoes, cotton for clothes, Wheat
for flour powder and etc.
2. Work in process Inventory
– Is cost of raw material on which production has been started but
not yet completed
– direct labor cost applied specifically to this material and
– allocated manufacturing overhead costs.
3. Finished goods inventory
• is the cost identified with manufactured items that are completed and
ready for sale.
• In this unit only the determination of the inventory of merchandise
purchased for resale commonly called Merchandise inventory will be
discussed. 3
 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.
 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.

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 Internal Control of Inventories
• Internal controls are put in place to keep the company on course towards
growth and profitability and the achievement of its mission.
• The internal control system enables management to deal with rapidly
changing economic and competitive environment, selecting the best
options and planning for growth.
• The following topics related to the inventory internal control process:
1. Types of documents and records.
2. The major functions.
3. The key segregation of duties
1. Documents and Records Included in the Inventory Control Process
includes:
- Receiving report
- Inventory General Ledger
- Cost accumulation and variance report
- Inventory status report 5
 2. Functions in the Inventory Management Process
• Inventory management:
– It helps companies identify which and how much stock to order at
what time.
– It tracks inventory from purchase to the sale of goods. The practice
identifies and responds to trends to ensure there's always enough
stock to fulfill customer orders and proper warning of a shortage.
– Authorization of purchasing activity and maintenance of inventory
at appropriate levels; issuance of merchandise inventory purchase
requisitions to the purchasing department.
• Purchasing: Purchase of merchandise inventory.
• Purchased goods stores: Custody of purchased inventory
and issuance of merchandise inventory to the shipping
department.
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3. Key Segregation of Duties in the Inventory Management Process
and Possible Errors or Fraud
 Cash handling duties can be divided into four
stages: receiving, depositing, recording, and reconciling.
Ideally, all four stages would be performed by different
individuals.
Just like that, the inventory purchase, the
merchandise inventory stores function, the inventory
recording function and the responsibility for
supervising physical inventory should be separated.
Unless inventory is not properly controlled or
misstated (understated or overstated) the financial
statement will be distorted (misleading).
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 1.2 THE EFFECTS OF INVENTORY ON FINANCIAL STATEMENTS.

 Unfortunately, errors occasionally occur in accounting for

inventory.
 In some cases, errors are caused by failure to count or price
the inventory correctly.
 In other cases, errors occur because companies do not
properly recognize the transfer of legal title to goods that
are in transit.
 When errors occur, they affect both the income statement
and the statement of financial position.
 In the following page an error on inventory and its impact
on each of the financial statement is presented in the
following page:
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 I. Income statement effects
 Under a periodic inventory system, both the beginning and ending
inventories appear in the multiple 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.
Beginning
Inventory
+ Cost of
Goods - Ending
Inventory = Cost of
Goods Sold
purchased

 If the error understates beginning inventory, cost of goods sold will be

understated. If the error understates ending inventory, cost of goods
sold will be overstated.
9
 … cont’d
When Inventory Error: Cost of Goods Sold Is: Net Income Is:
Understates Beg. inventory Understated Overstated

Overstates Beg. Inventory Overstated Understated

Understates Ending Inventory Overstated Understated
Overstates Ending Inventory Understated Overstated

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Review Question

1. Understating ending inventory will overstate:

a. assets

b. cost of goods sold

c. net income

d. stockholders’ equity 11
 II. Statement of Financial Position Effects
• Companies can determine the effect of ending inventory
errors on the current period statement of financial position
by using the basic accounting equation:
Assets = Liabilities + Equity.
• Errors in the current period ending inventory have the
effects shown below:
Ending Inventory Asset Liability Equity
Error

Overstated Overstated No effect Overstated

Understated Understated No effect Understated

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 1.3 Cost of inventories and Inventory Systems
1.3.1 Cost of inventories
• The cost of inventories shall comprise all costs of purchase,
costs of conversion and other costs incurred in bringing the
inventories to their present location and condition.
Cost of inventory categorized as:
A. Costs of purchase: The costs of purchase of inventories
comprise the purchase price, import duties and other taxes
and transport, handling and other costs directly attributable to
the acquisition of finished goods, materials and services.
B. Costs of conversion: The costs of conversion of inventories
include costs directly related to the units of production, such
as direct labor.
They also include a systematic allocation of fixed and variable
production overheads that are incurred in converting materials into
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finished goods.
 1.3.2 Inventory Recording System
(Periodic System Verses Perpetual System)
• Recording inventory related transaction can be made using
Periodic inventory system or Perpetual Inventory System.
1. Periodic inventory system
 Under a periodic inventory system, a company determines
the quantity of inventory on hand only periodically, as the
name implies.
 It records all acquisitions of inventory during the accounting
period by debiting the Purchases account.
 Companies that use the periodic system take a physical
inventory at least once a year.

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 …Cont’d
– The journal entries to be prepared are:
1. At the time of purchase of merchandise:
Purchases…………. XX at cost
Accounts payable or cash…….. XX
2. At the time of sale of merchandise:
Accounts receivable or cash…. XX at retail price
Sales……………………… XX
3. To record purchase returns and allowance:
Accounts payable or cash……….. XX
Purchase returns and allowance………. XX
4. 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 15
b. Perpetual Inventory System
• Companies keep detailed records of the cost of each inventory purchase and
sale.
• The perpetual inventory system provides a continuous record of the balances
in both the Inventory account and the Cost of Goods Sold account.
• The accounting features of a perpetual inventory system are as follows.
1. Purchases of merchandise for resale or raw materials for production are
debited to Inventory rather than to Purchases.
2. Freight-in is debited to Inventory, Transportation-in account. Purchase
returns and allowances and purchase discounts are directly credited to
Inventory rather than to separate accounts.
3. Cost of goods sold is recorded at the time of each sale by debiting Cost of
Goods Sold and crediting Inventory at cost.
4. A subsidiary ledger of individual inventory records is maintained as a
control measure. The subsidiary records show the quantity and cost of each
type of inventory on hand. Management must choose the system or
combination of systems that is best for achieving the company's goal.
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Journal entries under perpetual system are presented in the following page:
 …Cont’d
– Journal entries to be prepared are:
1. At the time of purchase of merchandise
Merchandise inventory………………. XX at cost
Accounts payable/cash …………….XX
2. 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
3. To record purchase returns and allowances
Accounts payable or cash……………XX
Merchandise inventory……………XX at cost
4. To record purchase discount taken
Accounts payable………………..XX
Merchandise Inventory……………XX at cost
5. To record cash paid for transportation under FOB shipping point
Merchandise Inventory ………………XX
Cash ………………………………………………….XX
 No adjusting entry or closing entry for merchandise inventory is needed at the end of each
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 Illustration
• In its beginning inventory on Jan 1, 2017, Glory Company had 120
units of merchandise that cost Br. 8 per unit. The following
transactions were completed during 2017.
• February 5: Purchased on credit 150 units of merchandise at Br. 10 per
unit.
• 9: Returned 20 detective units from February 5 purchases to the
supplier.
• June 15: Purchased for cash 230 units of merchandise at Br 12 per unit.
• September 6: Sold 220 units of merchandise for cash at a price of Br.
16 per unit. These goods are: 120 units from the beginning inventory
and 100 units for February Purchases.
• December 31: 260 units are left on hand, 30 units from February 5
purchases.
• Required: Prepare general journal entries for Glory Company to record
the above transactions and adjusting or closing entry for merchandise
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 Solution
Date Periodic inventory system Perpetual inventory system

February 5 Purchase………….1,500 Inventory ……………..1,500

A/P…………………1,500 A/P ………………………….1,500
-To record purchase of merchandise inventory on credit of Br. 1,500
February 9 A/P…………………. 200 A/P …………………………..200
Purch. return & allow….200 Inventory …………………….200
- To record return of 20 unit @ br. 10 each defective inventory
June 15 Purchase ……………2,760 Inventory…………………2,760
Cash………………….2,760 Cash……………………….2,760
- To record purchase of inventory on cash (230 unit @br. 12 each)
Sept. 6 Cash ………………….3,520 Cash ………………….3,520
Sales Revenue………….3,520 Sales Revenue………….3,520
- To record sales revenue of merchandise sold
No entry Cost of goods sold……………1,960
Inventory……………………..1,960
- To record the cost of merchandise sold
Dec. 31 Income summary ………… 960 No adjusting entry
Inventory (beginning bal.)...960
Inventory (ending bal.)…3060
Income summary ………3060
-To record the update of inventory ledger

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 Determining Inventory Quantities
• Determining actual inventory quantities involves two steps:
1. Taking a Physical Inventory
 Companies take a physical inventory at the end of the accounting
period.
 Taking a physical inventory involves actually counting, weighing, or
measuring each kind of inventory on hand.
2. Determining control (ownership) of Goods
 One challenge in computing inventory quantities is determining what
inventory a company controls.
 To determine ownership of goods, two questions must be answered:
 Do all of the goods included in the count belong to the company?
 Does the company control any goods that were not included in the count?

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 Determining Inventory Quantities
Physical Inventory taken for two reasons:
• Perpetual System
1. Check accuracy of inventory records.
2. Determine amount of inventory lost due to wasted raw
materials, shoplifting, or employee theft.
• Periodic System
1. Determine the inventory on hand.
2. Determine the cost of goods sold for the period.

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 GOODS IN TRANSIT
• Purchased goods not yet received.
• Sold goods not yet delivered.
• Goods in transit should be included in the inventory of the company that has legal title to the
goods. Legal title is determined by the terms of sale.

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 CONSIGNED GOODS
• Goods on consignment are goods shipped by the
owner, called the consignor, to another party, the
consignee.
• A consignee sells goods for the owner.
• To hold the goods of other parties and try to sell
the goods for them for a fee, but without taking
ownership of the goods.
• Many car, boat, and antique dealers sell goods on
consignment, why?

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 Inventory costing methods
Inventory is accounted for at cost.
• Cost includes all expenditures necessary to acquire goods
and place them in a condition ready for sale.
• For example, freight costs incurred to acquire inventory are
added to the cost of inventory, but the cost of shipping
goods to a customer are a selling expense.
• Unit costs are applied to quantities to compute the total cost
of the inventory and the cost of goods sold using the
following costing methods:
– Specific identification
– Cost flow assumptions==First-in, first-out (FIFO)
==Average-cost
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 I. Specific Identification
• Specific identification calls for identifying each item sold
and each item in inventory.
• IFRS actually requires that the specific identification method
be used where the inventory items are not interchangeable
(i.e., can be specifically identified).
• Specific identification matches actual costs against actual
revenue.
• Thus, a company reports ending inventory at actual cost.
• In other words, under specific identification the cost flow
matches the physical flow of the goods.
• NB: Instead, rather than keep track of the cost of each
particular item sold, most companies make assumptions,
called cost flow assumptions, about which units were sold.25
 Illustration:
Crivitz TV Company purchases three identical 50-inch
TVs on different dates at costs of £700, £750, and
£800. During the year Crivitz sold two sets at £1,200
each. These facts are summarized below.
Illustration 6-3: Data for Inventory Costing Example
Purchases
February 3 1TV @700
March 5 1TV @750
May 22 1TV @800
Sales
June 1 2TVs @2400 (1,200X2+
26
 … Cont’d
• If Crivitz sold the TVs it purchased on February 3
and May 22, then its cost of goods sold is £1,500
(£700 + £800), and its ending inventory is £750.

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 II. Cost Flow Assumptions
• Because specific identification is often
impractical, other cost flow methods are
permitted.
• There are two assumed cost flow methods:
1. First-in, first-out (FIFO)
2. Average-cost

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29
 Inventory Cost Flow Methods in Periodic Inventory Systems

FIRST-IN, FIRST-OUT (FIFO)

Costs of the earliest goods purchased are the first to
be recognized in determining cost of goods sold.
Often parallels actual physical flow of merchandise.
Companies obtain the cost of the ending inventory
by taking the unit cost of the most recent purchase
and working backward until all units of inventory
have been costed.

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31
32
 Cont’d
AVERAGE-COST
 Allocates cost of goods available for sale on the basis of
weighted-average unit cost incurred.
 Applies weighted-average unit cost to the units on hand to
determine cost of the ending inventory.

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34
35
 Inventory Cost Flow Assumptions in Perpetual Inventory Systems

• Data for Lin Electronics’ Astro condensers. Illustration 6A-1

• Assuming the Perpetual Inventory System, compute CGS and Ending

Inventory under FIFO and Average-cost.
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 FIRST-IN-FIRST-OUT (FIFO)
• Illustration 6A-2: Perpetual System—FIFO

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 Average-Cost
• Illustration 6A-3: Perpetual System—Average-cost method

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 Tax Effects of Cost Flow Methods
• Either of the two cost flow assumptions is
acceptable for use. For example,
• adidas (DEU) and Lenovo (CHN) use the average-
cost method, whereas
• Syngenta Group (CHE) and Nokia (FIN) use
FIFO.
A recent survey of IFRS companies, approximately
60% use the average-cost method,
40% use FIFO, and
23% use both for different parts of their
inventory. 39
40
 TAX EFFECTS
• Both inventory and net income are higher
when companies use FIFO in a period of
inflation.
• Average Cost results in the lower income taxes
(because of lower net income) during times of
rising prices.

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 Lower-of-Cost-or-Net Realizable Value
When the value of inventory is lower than its cost
Companies must “write down” the inventory to its
net realizable value.
Net realizable value: Amount that a company
expects to realize (receive from the sale of
inventory).

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 Cont’d
• Illustration: Assume that Gao TV has the following lines
of merchandise with costs and market values as indicated.
• Illustration 6-11: Computation of lower-of-cost-or-net
realizable value.

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