One of The Largest Current Assets Inventory

INVENTORIES and COST OF GOODS SOLD
-One of the largest current assets of a retail or wholesale store is the

inventory of merchandise.
-Sale of merchandise is the major source of revenue.
-In merchandising company inventory consists of all goods owned and
held for sale to customers.(ie it has only one category of inventory-
saleable)
-Inventory is converted into cash within the operating cycle and so
regarded as a current asset.
-Listing on the balance sheet:
Cash
Marketable Securities
Accounts Receivable
Inventory
-In manufacturing company 3 types of inventory:
Materials Inventory
Work in Process Inventory
Finished Goods
THE FLOW OF INVENTORY COSTS

Two entries in perpetual inventory system:
Debit Credit
1) A/C Receivable 10,000
Sales 10,000
2) Cost of Goods Sold 7,500

Inventory 7,500
Identical inventory items are purchased at different costs. So the

question arises which costs should be assigned to identical inventory
items at hand and cost of goods sold.
Several different inventory valuation methods are acceptable under

GAAP/IFRS.
Which unit did we sell? For identical products it really does not
matter. Inventory items sold do not have to be identified
specifically.
So the seller makes an assumption as to the sequence in which
units are withdrawn from the inventory.
Cost flow assumptions widely used:
1) FIFO(First-in-first-out): Assumption is that goods sold are the
first units that were purchased & remaining inventory comprise
of most recent purchases.
2) Average Cost: This assumption values all units of inventory at
average per-unit cost ie it assumes units are withdrawn from
the inventory in random order.
3) LIFO(Last-in-first-out): Assumption is that units sold are the
ones most recently acquired. The remaining inventory is
assumed to consist of the earliest purchases.
The above cost flow assumptions need not reflect actual physical
movement of company’s merchandise.
DATA
5th Jan 2011 Purchased 2 generators @$1000/unit.

5th Feb 2011 Purchased 3 generators @$1200/unit.
1st March 2011 sold 1 generator
Which cost should be included in Cost of Goods Sold & assigned to Inventory.
AVERAGE
FIFO
LIFO
SPECIFIC IDENTIFICATION METHOD
a)This method can be used when the actual cost of individual units of
merchandise can be determined from the accounting records.
b)It is best suited to inventories of high-priced , low-volume items.
c)This method exactly parallels the physical flow of goods.
d)If each item in the inventory is unique (ie each item is different from
the others ) specific identification is the logical choice. Eg. paintings.
OTHER METHODS OF INVENTORY VALUATION ARE APPLICABLE TO
IDENTICAL/ HOMOGENEOUS PRODUCTS
In case of identical inventory items physical flow of goods is not
relevant. It does not matter (physically) which unit is sold first.
ADVANTAGES & SHORTCOMINGS OF EACH INVENTORY VALUATION
METHOD
Average Cost Method

Advantages
-In case of nails or wheat grains (same quality) which are
homogeneous.
-the average method recognizes that it is not necessary to know
exactly which nail or grains were sold to calculate CGS and inventory.
-It is not possible to manipulate profit merely by selecting the specific
items to be delivered to the customer (which is possible in specific
identification method).
Shortcomings
-Changes in current replacement costs of inventory are concealed as
these are averaged with older costs.
First-in First-out Method(FIFO)
FIFO assumes that first purchases are sold first. So in inflationary
conditions it assigns lower (older) costs to CGS and higher (more
recent) costs to the goods remaining in the inventory.
Advantages
-Inventory is valued at recent purchase costs. This asset appears in the
balance sheet at a value closely approximating its current replacement
cost.
-Professional CEOs (employed; not an owner) can report somewhat
higher profits (than would be reported under other valuation methods)
and can take credit for better performance.
Disadvantages
-Reporting higher profit results in paying more income taxes.
-Some accountants & decision makers believe that FIFO tends to
overstate profits. Revenue is based on current market conditions where
as CGS is based on older (lower) costs.
Last-in , First-out Method(LIFO)
In this case the assumption is that most recently purchased units are
sold first and that the older units remain in inventory.
Advantages
Supporters of LIFO contend that profit should be based on current
market conditions. Current revenue is offset by current cost of
merchandise.
Income tax considerations, provide the main reason for the popularity
of the LIFO method. In situation of rising prices ‘most recent’ costs are
also the highest costs. By reporting highest CGS, the LIFO method
usually results in lower taxable income.
Shortcoming
During periods of rising inventory replacement costs, the LIFO method
results in lowest valuation of inventory.
ENTRIES AT THE TIME OF SALE IF SELLING PRICE IS $ 1,600 PER UNIT & THE
INVENTORY VALUATION METHOD IS:
FIFO
DR CR
A/C RECEIVABLE 1,600
SALES 1,600
Dr Cr
COST OF GOODS SOLD 1,000
INVENTORY 1,000
AVERAGE
SALES 1,600
INVENTORY 1,120
LIFO
SALES 1,600
INVENTORY 1,200
PERODIC INVENTORY:
Gross Profit Method of Estimating Inventory
Why estimate inventory using GP method?
Physical count
a) Time Consuming
b) Will cost money (manpower cost)
C) May have to close business (stop sales) during counting of inventory.
ESTIMATION OF INVENTORY BY GP METHOD:
First workout previous year’s GP ratio = GP/sales = 40% (example)
Therefore CGS/Sales = 60%
If current year sales = Rs 2,000,000

CGS = 2,000,000 x 0.6 = Rs 1,200,000
Beginning Inventory (1/1/10) Rs. 100,000

Purchases during 2010 1,300,000
Total Goods Available for Sale 1,400,000
Less: Cost of Goods Sold (estimated) 1,200,000
Ending Inventory 200,000
STEPS IN ESTIMATING ENDING INVENTORY BY GROSS PROFIT METHOD
THE RETAIL METHOD OF ESTIMATING INVENTORY:
Cost Ratio = Cost of goods available for sale = 1,680,000 = 70%

Sales value of goods available for 2,400,000
sale (at current retail prices)
Current CGS = Actual Sale x Cost Ratio

=Rs. 2,000,000 x70%
=Rs. 1,400,000
Cost of Goods Available For Sale – CGS = 1,680,000 – 1,400,000

=Ending Inventory = Rs. 280,000
STEPS FOR ESTIMATING INVENTORY BY RETAIL METHOD
Inventory Turnover Rate:

Beginning Inventory (1/1/10) =Rs. 150,000
Ending Inventory (31/12/10) =Rs. 250,000
Rs. 400,000
Average Inventory during 2010 = 400,000/2 = 200,000

Inventory Turnover = Cost of Goods Sold
Average Inventory
= 1,200,000 = 6 times per year

200,000
This shows how quickly inventory is sold.
No. of days of inventory = 365/6 = 61days

Average Inventory is sold in 61 days.
Taking Physical Inventory:
Inventory is physically counted to adjust perpetual inventory record for

unrecorded shrinkage losses due to:
1. Theft
2. Spoilage
3. Breakage
How to Record Shrinkage Losses (example):
As per perpetual record inventory at year end (31/12/2011) was as

follows:
2 units purchased on Nov 2 at $ 90 = $ 180
98 units purchased on Dec 10 at $ 100= 9,800
100 units cost = $ 9,980
Physical Count showed only 90 units (i.e. loss of 10 units)

We will have to calculate value of the shrinkage by applying the
valuation method already being used by the company.
If the shrinkage is relatively small CGS is debited otherwise Inventory

Shrinkage Loss is debited(materiality concept).
LIFO
10 units at $100= $1000 (shrinkage loss)

Debit Credit
Inventory Shrinkage Loss or CGS 1,000
Inventory 1,000
LOWER OF COST or MARKET

At times some portion of inventory may become obsolete for reasons
other than those listed above or its price may decline in the market. No
asset is worth more than its current economic value. So it is valued at
lower of cost or market. For example if inventory value declines by
$1,200.
Dr Cr
CGS/Loss from Write-down of Inventory 1,200
Inventory 1,200
Goods in Transit
When does the title(ownership) of goods passes from seller to buyer?
Depends on shipment terms.

If terms are FOB shipping point, the title of goods passes to the buyer
at the point of shipment and the goods belong to the buyer while in
transit.
If the terms are FOB destination point, the title of the goods does not
pass until the goods reach the destination, and the goods belong to the
seller while in transit.
Overview (IAS 2.10)
The costs that one should capitalize (add) to the
inventory account include the:
• costs to purchase the inventory,
• costs to convert the inventory (for manufacturing units), &
• other costs
required in order to bring the inventory to its present
location and condition.

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INVENTORIES and COST OF GOODS SOLD

-One of the largest current assets of a retail or wholesale store is the

THE FLOW OF INVENTORY COSTS

2) Cost of Goods Sold 7,500

Identical inventory items are purchased at different costs. So the

Several different inventory valuation methods are acceptable under

5th Jan 2011 Purchased 2 generators @$1000/unit.

SPECIFIC IDENTIFICATION METHOD

Average Cost Method

ESTIMATION OF INVENTORY BY GP METHOD:

First workout previous year’s GP ratio = GP/sales = 40% (example)

Therefore CGS/Sales = 60%

If current year sales = Rs 2,000,000

Beginning Inventory (1/1/10) Rs. 100,000

Cost Ratio = Cost of goods available for sale = 1,680,000 = 70%

Current CGS = Actual Sale x Cost Ratio

Cost of Goods Available For Sale – CGS = 1,680,000 – 1,400,000

STEPS FOR ESTIMATING INVENTORY BY RETAIL METHOD

Inventory Turnover Rate:

Average Inventory during 2010 = 400,000/2 = 200,000

= 1,200,000 = 6 times per year

No. of days of inventory = 365/6 = 61days

Inventory is physically counted to adjust perpetual inventory record for

How to Record Shrinkage Losses (example):

As per perpetual record inventory at year end (31/12/2011) was as

Physical Count showed only 90 units (i.e. loss of 10 units)

If the shrinkage is relatively small CGS is debited otherwise Inventory

10 units at $100= $1000 (shrinkage loss)

LOWER OF COST or MARKET

Depends on shipment terms.

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