FUNDAMENTALS OF ACCOUNTING II

Chapter 1
Accounting for Merchandising Inventories

1.1 Inventories
Merchandise Inventory is items or commodities held for resale to customers in the
ordinary course of the business.
 In Merchandising Enterprise,
These items have two common characteristics:
1. They are owned by the company, and
2. They are in a form ready for sale to customers.
 In Manufacturing Enterprise,
Are classified in to three:
1. Finished Goods Inventory: consists of completed products ready for
sale. This inventory is similar to merchandise inventory.
2. Work in Process (Goods in process): consists of products in the process
of being manufactured but not yet completed.
3. Raw Materials Inventory: refers to the goods a company acquires to use
in making products.
In this course we will focus on the accounting principles and concepts of
merchandise inventory.

INVENTORY SYSTEMS
There are two inventory accounting systems used to collect information about cost of
goods sold and cost of inventory on hand. The two systems are called Periodic and
Perpetual.

1.2 Periodic Inventory System

A periodic inventory system requires updating the inventory account only at the end of
a period to reflect the quantity and cost of both goods on hand and goods sold. It does
not require continual updating of the inventory account. The company records the cost
of new merchandise in a temporary purchases account.

When merchandise is sold, revenue is recorded but the cost of the merchandise sold is
not yet recorded as a cost. When financial statements are prepared, the company takes
a physical count of inventory by counting the quantities of merchandise on hand, at the
end of the period. Cost of merchandise on hand is determined by relating the quantities
on hand to records showing each item’s original cost. The cost of merchandise on hand
is then used to compute cost of goods sold. The inventory account is adjusted to reflect
the amount computed from the physical count of inventory.

Periodic systems were historically used by companies such as hardware, drug, and
department stores that sold large quantities of low-value items. Without today’s
computers and scanners, it was not feasible for accounting systems to track such small
items as pencils, toothpaste, paper clips, socks, and Toothpicks through inventory and
into customers’ hands.
1.3 Perpetual Inventory System
A perpetual inventory system keeps a continual record of the amount of inventory on
hand. A perpetual system accumulates the net cost of merchandise purchases in the
inventory account and subtracts the cost of each sale from the same inventory account.
When an item is sold, its cost is recorded in a Cost of Goods Sold account.

With a perpetual system we can find out the cost of merchandise on hand at any time
by looking at the balance of the inventory account. We can also find out the current
balance of cost of goods sold anytime during a period by looking in the Cost of Goods
Sold account.

Under a perpetual system, the cost of each item is debited to the Merchandise
Inventory account when purchased. At the time of sale, the cost of each item is
transferred from the Merchandise inventory account to the Cost of Goods sold
account. Thus, the Cost of Goods Sold account at all times equals the cost of
merchandise sold during the period, and the Merchandise inventory account at all
times equals the cost of merchandise on hand.

MERCHANDIZE INVENTORY QUANTITIES AND COSTS

2.1 Determining Inventory Quantities
In order to prepare financial statement, it is necessary to determine the number of units
of inventory owned by the company at the statement date. For many companies,
determining inventory quantities consists of two steps; (1) taking a physical inventory
of goods on hand, and (2) determining the ownership of goods.

2.1.1 Taking a Physical Inventory

Taking a physical inventory involves actually counting, weighing, or measuring each
kind of inventory on hand.

To minimize errors in taking the inventory, a company should adhere to the following
Internal Control Principles by adopting certain procedures:
1. The counting should be done by employees who do not have custodial responsibility
for the inventory. (Segregation of Duties)
2. Each counter should establish the authenticity/accuracy of each inventory item, e.g.,
each box does contain a 25-inch television set and each storage tank does contain
gasoline. (Establishment of Responsibility)
3. There should be a second count by another employee. (Independent Internal
Verification)
4. Pre numbered inventory tags should be used, and all inventory tags should be
accounted for. (Documentation Procedures)

2.1.2 Determining Ownership of Goods

Before we can begin to calculate the cost of inventory, we need to consider the
ownership of goods: specifically, we need to be sure that we have not included in the
inventory any goods that do not belong to the company.

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 Goods In Transit
Goods are considered to be in transit when they are in the hands of a public carrier,
such as a railroad, trucking, or airline company at the statement date. Goods in transit
should be included in the inventory of the party that has legal title to the goods.

 Legal title is determined by the terms of sale, as shown below:

1. When the terms are FOB (Free On Board) shipping point, ownership of the goods
passes to the buyer when the public carrier accepts the goods from the seller.
2. When the terms are FOB Destination, legal title to the goods remains with the
seller until the goods reach the buyer.

Significant errors may occur in determining inventory quantities if goods in transit at

the statement date are ignored.
 Assume, for example, that Hargrove Company has 20,000 units of inventory on
hand on December 31 and the following goods in transit:
(1) Sales of 1,500 units shipped December 31 FOB destination, and
(2) Purchases of 2,500 units shipped FOB shipping point by the seller on
December 31.
 Hargrove has legal title to both the units sold and the units purchased.
Consequently, inventory quantities would be understated by 4,000
units (1,500 + 2,500) if units in transit are ignored.

 Consigned Goods
In some lines of business, it is customary to acquire merchandise on consignment.
Under a consignment arrangement, the holder of the goods (called the consignee) does
not own the goods. Ownership remains with the shipper of the goods (called the
consignor) until the goods are actually sold to a customer. Because consigned goods
are not owned by the consignee, they should not be included in the consignee’s
physical inventory count. Conversely, the consignor should include merchandise held
by the consignee as part of its inventory.

2.2 Inventory Costing

With a reliable physical count of the inventory (considering both goods in transit and
consigned goods), we are now ready to assign costs to the inventory.

2.2.1 Determining Inventoriable Cost

All expenditures necessary to acquire the goods and to make them ready for sale are
included as inventoriable costs. Inventoriable costs may be regarded as a pool of costs
that consists of two elements:
(1) The cost of the beginning inventory, and
(2) The cost of goods purchased during the year.

The sum of these two elements equals the cost of goods available for sale. The
individual items included in cost of goods purchased are shown below

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Item Account Title Effect on Inventoriable Cost
Invoice Price Purchases Increase
Freight Charges Paid by Purchaser Freight-in Increase
Purchase Discounts Taken by Purchaser Purchase Discounts Decrease
Purchase Returns and Allowances Purchase Returns &
Allowance Granted Decrease
by the Seller
2.2.2 Allocating Inventoriable Costs
 To illustrate, assume that General Suppliers Inc. has a cost of goods available for sale of
Br120,000, based on a beginning inventory of Br20,000 and cost of goods purchased of
Br100,000. The physical inventory indicates that 5,000 units are on hand. The costs
applicable to the units are Br3.00 per unit. The allocation of the pool of costs is shown
below. As shown, the Br120,000 of goods available for sale is allocated Br15,000 to ending
inventory and Br105,000 to cost of goods sold.
Pool of costs
Cost of Goods Available For Sale
Beginning Inventory Br 20,000
Cost of goods Purchased 100,000
Cost of Goods Available For Sale Br 120,000

Step 1 Step 2
Ending Inventory Cost of Goods sold
Unit Total Cost of Goods available for sale Br 120,000
Units Cost Cost Less: Ending Inventory 15,000
5,000 Br3.00 Br15, 000 Cost of Goods sold Br 105,000

3. Assigning Costs of Inventory

3.1 Inventory Costing Methods under a Periodic inventory System
3.1.1 Using Actual Physical Flow Costing – Specific Identification
This method tracks the actual physical flow of the goods. Each item of inventory is
marked, tagged, or coded with its “specific’ unit cost. Items still in inventory at the
end of the year are specifically costed to arrive at the total cost of the ending
inventory.
Assume, for example, that Southland Music Company purchases three 46-inch
television sets at costs of Br700, Br750, and Br800, respectively. During the
year, two sets are sold at Br1, 200 each. At December 31, the company
determines that the Br750 set is still on hand. Accordingly, the ending inventory
is Br750 and the cost of goods sold is Br1, 500 (Br700 + Br800).

Specific identification is possible when a company sells a limited variety of high-unit

cost items that can be clearly identified from the time of purchase through the time of
sale. Examples of such companies are automobile dealerships (cars, trucks, and vans),
music stores (pianos and organs), and antique shops (tables and cabinets). Under this
method, the ending inventory is reported at actual cost and the actual cost of goods
sold is matched against sales revenue.

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 3.1.2 Using Assumed Cost Flow Methods
Because specific identification is often impractical, other cost flow methods are
allowed. These differ from specific identification in that they assume flows of costs
that may be unrelated to the physical flow of goods. For this reason we call them
assumed cost flow methods or cost flow assumptions. They are:
1. First-in, first-out (FIFO).
2. Last-in, first-out (LIFO).
3. Average cost.
To illustrate these three inventory cost flow methods, we will assume that RIFT
Valley Electronics uses a periodic inventory system and has the information
shown below for its Z202 Astor condenser.
RIFT VALLEY ELECTRONICS
Z202 Astro Condensers

Date Explanation Units Unit Cost Total Cost

1/1 Beginning inventory 100 Br10 Br 1,000
4/15 Purchase 200 11 2,200
8/24 Purchase 300 12 3,600
11/27 Purchase 400 13 5,200
Total 1,000 Br12, 000
During the year, 550 units were sold and 450 units are on hand at December 31.
 First-In, First-Out (FIFO)
The FIFO Method assumes that the earliest goods purchased are the first to be sold.
FIFO often parallels the actual physical flow of merchandise because it generally is
good business practice to sell the oldest units first. Under the FIFO method, therefore,
the costs of the earliest good purchased are the first to be recognized cost of goods
sold. The allocation of the cost of goods available for sale at RIFT Valley Electronics
under FIFO is shown below:
Pool of costs
Cost of Goods
Available for Sale
Unit Total
Date Explanation Units Cost Cost
Beginning
1/1 Inventory 100 Br 10 Br 1,000
4/15 Purchase 200 11 2,200
8/24 Purchase 300 12 3,600
11/27 Purchase 400 13 5,200
Total 1,000 Br 12,000
Step 1 Step 2
Ending Inventory Cost of Goods sold
Unit Total
Date Units Cost Cost
11/27 400 Br 13 Br 5,200 Cost of Goods Available For Sale Br 12,000
8/24 50 12 600 Less: Ending Inventory 5,800
Total 450 Br 5,800 Cost of Goods Sold Br 6,200

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 Note that the ending inventory is based on the latest units purchased. That is, the cost
of the ending inventory is obtained by taking the unit cost of the most recent purchase
and working backward until all units of inventory have been costed.
We can verify the accuracy of the cost of goods sold by recognizing that the first units
acquired are the first units sold. The computations for the 550 units sold are shown
below:
Date Units Unit Cost Total Cost
1/1 100 x Br10 = Br1,000
4/15 200 x 11 = 2,200
8/24 250 x 12 = 3,000
Total 550 = Br 6,200
 Note that ending inventory of Br5,800 and the cost of goods sold of Br6,200
equals cost of goods available for sale Br.12, 000
 Last-In, First-Out (LIFO)
The LIFO method assumes that the latest goods purchased are the first to be sold.
LIFO seldom coincides with the actual physical flow of inventory. Under the LIFO
method, the costs of the latest goods purchased are the first to be recognized as cost of
goods sold. The allocation of goods available for sale at RIFT Valley Electronics
under LIFO is shown below:
Pool of Costs
Cost of Goods Available
For Sale
Unit Total
Date Explanation Units Cost Cost
1/1 Beginning Inventory 100 Br 10 Br 1,000
4/15 Purchase 200 11 2,200
8/24 Purchase 300 12 3,600
11/27 Purchase 400 13 5,200
Total 1,000 Br 12,000

Step 1 Step 2
Ending
Inventory Cost of Goods sold
Unit Total
Date Units Cost Cost
1/1 100 Br 10 Br 1,000 Cost of Goods available for sale Br 12,000
4/15 200 11 2,200 Less: Ending Inventory 5,000
8/24 150 12 1,800 Cost of Goods sold Br 7,000
Total 450 5,000

Under the LIFO method, the cost of the ending inventory is obtained by taking the unit
cost of the earliest goods available for sale and working forward until all units of
inventory are costed. As a result, the first costs assigned to ending inventory are costs
of the beginning inventory.

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  Proof of the costs allocated to cost of goods sold is shown in below:
Date Units Unit Cost Total Cost
11/27 400 x Br13 = Br5, 200
8/24 150 x 12 = 1,800
Total 550 = Br7, 000

Note that the cost of the last goods in is the first to be assigned to cost of goods sold.
Under a periodic inventory system, which we are using here, all goods purchased
during the period are assumed to be available for the first sale regardless of the date of
purchase.

 Average Cost
The average cost method assumes that the goods available for sale are homogeneous.
Under this method, the allocation of the cost of goods available for sale is made on the
basis of the weighted average unit cost incurred. The formula and sample computation
of the weighted average unit cost is:

Cost of Goods Total Units Weighted

Available Available Average
For Sale ÷ For Sale Unit Cost
$ 12,000 $ 1,000 $ 12.00

=
The weighted average unit cost is then applied to the units on hand to determine the
cost of the ending inventory. The allocation of the cost of goods available for sale at
RIFT Valley Electronics using average cost is shown below.

Pool of Costs
=
Cost of Goods Available For Sale

Unit Total
Date
1/1
4/15
8/24
Explanation
Beginning Inventory
Purchase
Purchase
Units
100
200
300
= Cost
Br 10
11
12
Cost
Br 1,000
2,200
3,600
11/27 Purchase 400 13 5,200
Total

Step 1
Ending Inventory
1,000

=
Step 2
Cost of Goods sold
Br 12,000

=
Br12,000 ÷ 1,000 = Br12.00 Cost of Goods Available For Sale Br12,000
Unit- Total- Less: Ending Inventory 5,400
Units Cost Cost Cost of Goods Sold Br 6,600
450 X Br12.00 = Br5,400
We can verify the cost of goods sold under this method by multiplying the units sold

=
by the weighted average unit cost (550 x Br12 = Br 6,600).

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 3.2 . INVENTORY COSTING METHODS UNDER PERPETUAL
INVENTORY SYSTEM

To illustrate the application of the three assumed cost flow method (FIFO), average
cost, and LIFO), we will use the date shown below for module X 268l4 Econo
Radios in the Glorious Company

Date Purchases Sale Balance in units

April 3 4,000@$8.00 4,000
April 10 12,000@$8.80 1 6,000
April 26 8,000 units 8,000
April 29 4,000@$8.30 12,000

 Specification Identification Method:

The amount of costs assigned to inventory and cost of good sold is the same under
perpetual and periodic system when using specific identification. This is because
specification identification precisely defines which units are in inventory and which
are sold.

 Using Cost Flow Assumption:

 First-In, First-Out (FIFO)

Under FIFO, the cost of earliest goods on hand prior to each sale is changed to cost of
good sold. Therefore, the cost of good sold on April 26 consists of the items purchased
on April 3 and April 10. The inventory on a FIFO method Perpetual System is shown
below:

Date Purchases Sales Balance

April 3 (4,000 @ $8.00) $32,000 (4,000 @8.00) $ 32,000

April 10 (12,000@ $8.80) $105,600 (4,000 @ 8.00)
(12,000@$8.80) $137,600
April 26 (4,000 @ $8.00)
(4,000 @ $8.80) = 67,200 (8,000 @ $ 8.80) $70,400
April 29 (4,000 @ $8.30) $ 33,200 (8,000 @ $ 8.80)
(4,000 @ $8.30) $103,600

 The ending inventory in this situation is $ 103,600 and the cost of good sold is
$67,200 [(4,000 @$8.80)+( 4,000 @$8.00)].

For this particular example, the results under FIFO in a perpetual system are the same
as in a periodic system. Regardless of the system, the first cost in are the first assigned
to cost of goods sold.

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  Last In, First Out (LIFO)
Under the LIFO Method using a Perpetual System, the cost of the most recent
purchase prior to sales is allocated to the units sold.
Therefore, the cost of the goods on April 26 consist entirely of goods from the April
10 Purchase.
The Ending Inventory on a LIFO method is computed in the next illustration.
Date Purchase Sales Balance
April 3 (4,000 @ $ 8.00) $ 32,000 (4,000 @8.00) $ 32,000

(4,000 @8.00)
April 10 (12,000 @ $ 8.80) $105,600 (12,000 @ $8.80) $137,600

April 26 8,000@ $8.80

($70,400) (4,000 @ $8.00)
(4,000 @ $8.80) $ 67,200

April 29 (4,000 @ $8.30) $33,200 (4,000 @ $8.00)

(4,000 @ $8.80) $100,400
(4,000 @ $8.30)

The use of LIFO in Perpetual System will usually produce cost allocations that differ
from using LIFO in a periodic system. In a Perpetual System, the last units incurred
prior to each sale are allocated to cost of goods sold. In contrast, in a periodic system,
the last units incurred during the period are allocated to cost of goods sold.

 Average Cost
The average cost method in perpetual inventory system is called the moving average
method. Under this method a new average is computed after each purchase. The
average cost is computed by dividing the cost of goods available for sale by the units
on hand. The average cost is then applied to: (1) The units sold, to determine the cost
of good sold, and (2) the remaining units on hand, to determine the ending inventory
amount. The application of the average cost method for Glorious Company is shown
below:

Date Purchases Sales Balance

April 3 (4,000 @ $8.00) $ 32,000 (4,000 @ $ 8.00) $32,000
April; 10 (12,000 @ $ 8.80) $105,600 (16,000 @ $8.60) $137,600
April 26 (8,000 @ $ 8.60) (8,000 @ 8.60) $ 68,800
($68,800)
April 29 (4,000 @ $8.30) $ 33,200 (12,000 @ $8.50) $102,000

As indicated above, a new average is computed each time a purchase is made. On

April 10, after 12,000 units are purchased for $105,600, a total unit of 16,000 for $
137,600 is on hand. The average unit cost is $137,600 divided by 16,000, or $8.60.
Accordingly, the unit cost of the 8,000 units sold on April 26 is shown at $ 8.60, and
the total cost of goods sold is $68,800. On April 29, following the purchase of 4,000
units for $33,200, there are 12,000 unites in hand costing $102,000
($68,800+$33,200). The new average cost is $8.50 ($102,000 ÷12,000)

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 4. Other Methods of Valuing Inventory
Special circumstances sometimes call for inventory valuation methods other than those
presented in this section. For example, consider to following situations:

4.1.1 Valuing Inventory at the Lower of Cost or Market (LCM)

When the value of inventory is lower than its cost, the inventory is written down to its
market value. This is accomplished by valuing the inventory at the lower of cost or
market (LCM) in the period in which the price decline occurs. LCM is an example of
the accounting concept of conservatism. Conservatism means that when choosing
among accounting alternatives, the best choice is to select the method that is least
likely to overstate assets and net income.

Under the LCM basis, market is defined as current replacement cost, not selling price.
For a merchandising company, market is the cost of purchasing the same goods at the
present time from the usual suppliers in the usual quantities. Current replacement cost
is used because a decline in the replacement cost of an item usually leads to a decline
in the selling price of the item. The lower of market basis may be applied to:
(1) Individual Items of Inventory,
(2) Major Categories of Inventory,
(3) Total Inventory.
For example, assume that Len’s TV has the following lines of merchandise with costs
and market values as indicated. LCM produces the following three results:
Lower of Cost or Market by:
Individual Major Total
Cost Market Items Categories Inventory
Television set
Consoles Br 60,000 Br 55,000 Br 55,000
Portables 45,000 52,000 45,000
Total 105,000 107,000 Br 105,000
Video Equipment
Recorders 48,000 45,000 45,000
Movies 15,000 14,000 14,000
Total 63,000 59,000 59,000
Total Inventory Br 168,000 Br166,000 Br159,000 Br 164,000 Br 166,000

The amount (Br. 159,000) entered in the individual items column is the lower of the
cost or market amount for each item. For the major categories column, the amount (Br.
164,000) is the lower of total cost or total market for each category. Finally, the
amount (Br, 166,000) for the total inventory column is the lower of the cost or marker
for the entire inventory.

4.1.2 Valuation at Net Realizable Value

Obsolete, spoiled, or damaged merchandise and other merchandise that can be sold
only at prices below cost should be valued at net realizable value. For this purpose, net
realizable value is the estimated selling price less any direct cost of disposition, such
as sales commissions.

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To illustrate, assume that damaged merchandise that had a cost of Br1,000 can be sold
for only Br800, and direct selling expenses are estimated at Br150.
 This inventory would be valued at Br 650 (Br800 - Br150), which is its net
realizable value.

4.2 ESTIMATING INVENTORIES

We have assumed throughout the unit that a company would be able to do a physical
count of its inventory. But what if it cannot, as in the example of the lumber inventory
destroyed by fire? In that case, we would use an estimate.
 Two circumstances explain the reasons for estimating rather than
counting inventories:
i. First, management may want monthly or quarterly financial statements
but a physical inventory is taken only annually.
ii. Second, a casualty such as fire, flood, or earthquake may make it
impossible to take a physical inventory. The need for estimating
inventories is associated primarily with a periodic inventory system
because of the absence of detailed inventory records.

 There are two widely used methods of estimating inventories:

(1) The Gross Profit Method and
(2) The Retail Inventory Method.
4.2.1 Gross Profit Method
The gross profit method estimates the cost of ending inventory by applying a gross
profit rate to net sales. It is used in preparing monthly financial statements when
physical inventories are not taken. This method is a relatively simple but effective
estimation technique.
 To use this method, a company needs to know:
o Its Net Sales,
o Cost of Goods Available for Sale, and
o Gross Profit Rate.
The company then uses the gross profit rate to estimate its gross profit for the
accounting period.
 The formulas for using the gross profit method are given below:

Estimated Estimated
Net Sales Gross Cost of
Step - 1 - Profit = Goods Sold

Step - 2 Cost of Goods Estimated Estimated

Available for Sale - Cost of
GoodsSold = Cost of
Ending Inventory

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 To illustrate, assume that Wesen Company wishes to prepare an income statement for the
month of January, when its records show net sales Br200,000; beginning inventory Br40,000;
and cost of goods purchased Br120,000. In the preceding year, the company realized a 30%
gross profit rate, and it expects to earn the same rate this year. Given these facts and
assumptions, the estimated cost of the ending inventory at January 31, under the gross profit
method is Br 20,000, computed as follows:
Step 1:
Net Sales Br200, 000
Less: Estimated gross profit (30% X Br 200,000) 60,000
Estimated cost of goods sold Br140, 000

Step 2:
Beginning Inventory Br 40,000
Cost of Goods Purchased 120,000
Cost of Goods Available for Sale 160,000
Less: Estimated Cost of Goods Sold 140,000
Estimated Cost of Ending Inventory Br 20,000
4.2.2 Retail Inventory Method
A retail store has thousands of different types of inventory at low unit costs. In such cases the
application of units cost to inventory quantities is difficult and time-consuming. An alternative
is to use the retail inventory method to estimate the cost of inventory. In most retail concerns, a
relationship between cost and sales price can be established. Under the retail inventory
method, the cost to retail percentage is then applied to the ending inventory at retail prices to
determine inventory at cost.

To use the retail inventory method, a company must maintain records that show both the cost
and retail value of the goods available for sale. Under the retail inventory method, the
estimated cost of the ending inventory is derived from the formulas presented below:

Ending
Goods Net Sales Inventory
Step - 1 Available for
Sale at Retail
- = at Retail

Cost of Goods Goods Cost to

Step - 2
Available for
Sale at Cost
÷ Available for
Sales at Retail
= Retail
Ratio

Step- 3 Ending Cost to Estimated

Inventory Retail Cost of
At Retail x Ratio = Ending Inventory

-  The logic of the retail method can be demonstrated by using unit cost data.

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 Illustration, the accounting recodes of Lucy company disclosed the following
information’s: Beginning inventory at cost Br.14,000, at retail Br.21,500; Cost of
goods purchased at cost Br.61,000, at retail Br.78,500; and Net sales Br.70,000.
At Cost At Retail
Beginning inventory Br14, 000 Br 21, 500
Goods purchased 61,000 78, 500
Goods available for sale Br 75, 000 100,000
Net sales 70,000
(1) Ending inventory at retail -------- Br 30,000

(2) Cost to retail ratio = (Br75, 000 ÷ Br100, 000) = 75%

(3) Estimated cost of ending inventory = (Br30, 000 x 75%) Br22, 500

4.3 COMPARISON OF INVENTORY COSTING METHOD

 Financial Statement Effects of Cost Flow Methods

 Income Statement Effects

To understand why companies might choose a particular cost flow method, let’s
examine the effects of the different flow assumptions on the financial statements of
RIFT Valley Electronics. The condensed income statements in illustration bellow
assume that RIFT Valley sold its 550 units for Br11,500, its operating expenses were
Br2,000, and its income tax rate is 30%.

RIFT VALLEY ELECTRONICS

Condensed Income Statements
FIFO LIFO Average cost
Sales Br 11,500 Br 11,500 Br 11,500
Beginning Inventory 1,000 1,000 1,000
Purchases 11,000 11,000 11,000
Cost of Goods Available for Sale 12,000 12,000 12,000
Ending Inventory 5,800 5,000 5,400
Cost of Goods Sold 6,200 7,000 6,600
Gross Profit 5,300 4,500 4,900
Operating Expenses 2,000 2,000 2,000
Income Before Income Taxes 3,300 2,500 2,900
Income Tax Expense (30%) 990 750 870
Net Income Br 2,310 Br 1,750 Br 2,030

 In a period of rising prices (inflation), FIFO reports the highest net income
(&2,310) and LIFO the lowest (Br1,750); average cost falls in the middle
(Br2,030).
 If prices are falling, FIFO will report the lowest net income and LIFO the
highest.

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 Balance Sheet Effects
A major advantage of the FIFO method is that in a period of inflation, the costs
allocated to ending inventory will approximate their current cost. Conversely, a major
shortcoming of the LIFO method is that in a period of inflation, the costs allocated to
ending inventory may be significantly understated in terms of current cost.
The understatement becomes greater over prolonged periods of inflation if the
inventory includes goods purchased in one or more prior accounting periods.

 Tax Effects
We have seen that both inventory on the balance sheet and net income on the income
statement are higher when FIFO is used in a period of inflation. Yet, many companies
have switched to LIFO. The reason is that LIFO results in the lowest income taxed
(because of lower net income). For example, at RIFT Valley Electronics, income taxes
are Br750 under LIFO, compared to Br990 under FIFO. The tax saving of Br240
makes more cash available for use in the business.

EFFECT OF THE MISSTATEMENTS/ERROR OF INVENTORY ON THE

FINANCIAL STATEMENT
It is true that the inventory at the end of one period becomes the beginning inventory for the
succeeding period.
 Thus, if the inventory is incorrectly stated at the end of a period;

a) Income Statement
i) Net income of the same period will be misstated by an equal amount in the
same direction, (For example in the above illustration, Ending Inventory is
5,800/more than the others and NI is 2,310 still more than the others)

ii) Net income of the next period will be misstated by an equal amount but in an
opposite direction.(Because, if for example the Ending Inventory is overstated
in the first year, it understate the next year NI)

b) Balance Sheet
Asset (Inventory) Accounts are misstated only in the period of the misstatement
if there are no other errors.(Since the misstatement is corrected in the next year
by physical count)

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