Inventories

Unit 1: Inventories

1.1 Introduction

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

i. Inventories of merchandising businesses are merchandise purchased for resale in the normal course of business. These types of inventories are called merchandise inventories.

ii. Inventories of manufacturing businesses 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

 

1. 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.

2. 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.

3. Finished goods inventory- is the cost identified with the completed but unsold units on hand at the end of each period.

In this unit only the determination of the inventory of merchandise purchased for resale commonly called merchandise inventory will be discussed.

 

1.2 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.

 

1.3 The Effects of inventories on current and following period’s financial statements.

   1.3.1 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

a. Cost of goods (merchandise) sold =Beginning inventory + Net purchase – Ending inventory

As you see, ending inventory is a deduction in calculation cost of merchandise sold. So, it has an indirect (negative) relationship to cost of merchandise sold, i.e. if ending inventory is understated, the cost of merchandise sold will be overstated, and if ending inventory is overstated, the cost of merchandise sold will be understated.

b. Gross Profit = Net sales – Cost of merchandise sold

Here, the cost of merchandise sold had indirect relationship to gross profit. So, the effect of ending inventory on gross profit is the opposite of the effect on cost of merchandise sold. That is, if ending inventory is understated, the gross profit will be understated and if ending inventory is overstated, the gross profit will be overstated. This is a direct (positive) relationship.

c. Operating income = Gross Profit – Operating Expenses

Gross profit and operating income have direct relationships. Thus, the effect of ending inventory on net income is the same as its effect on gross profit, i.e. direct (positive) effect (relationship).

Balance Sheet

  1. Current assets - Ending inventory is part of current assets, even the largest. So, it has a direct (positive) relationship to current assets. If ending inventory balance is understated (overstated), the total current assets will be understated (overstated). Since current assets are part of total assets, ending inventory has direct relationship to total assets.
  2. Liabilities- No effect on liabilities. Inventory misstatement has no effect on liabilities.
  3. Owners’ equity – The net income will be transferred to the owners’ equity at the end of accounting period. Closing income summary account does this. So, net income has direct relationship with owners’ equity at the end of accounting period. The effect-ending inventory on owners’ equity is the same as its effect on net income, i.e. if ending inventory is understated (Overstated), the owners’ equity will be understated (Overstated).
     

   1.3.2 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

  1. Cost of merchandise sold= Beginning inventory + Net Purchases – Ending inventory
    As you see, beginning inventory is an addition in determining cost of goods sold. It has direct effect on cost of merchandise sold. That is, if the beginning inventory is understated (Overstated), the cost of merchandise sold will be understated (Overstated)
  2. Gross Profit= Net Sales – Cost of merchandise sold
    The effect of beginning inventory on gross profit is the opposite of the effect on cost of merchandise sold, i.e. indirect (negative) relationship. If the beginning inventory is understated, the gross profit will be overstated and if it is overstated, the gross profit will be understated.
  3. Net income = Gross Profit – Operating expenses
    The effect of beginning inventory on net income is the same as its effect on gross profit.

Balance sheet

  1. Current assets – The inventory included in current assets is the ending inventory. So, beginning inventory has no effect on current assets.
  2. Owners’ equity- If the effect comes from the previous year, the beginning inventory will not have an effect on ending owners’ equity since the positive or negative effect of the previous year will be netted off by the negative or positive effect of the current year. But if the error is made in the current period, it will have indirect effect on ending owners’ equity.

 

   1.3.3 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.

Illustration - 1

The following amounts were reported in Belay Company’s financial statements for three consecutive fiscal year ended December 31.

                                                                 2000                             2001                          2002

a) Cost of merchandise sold               Br. 130,000                 Br. 154,000                 Br. 140,000

b) Net income                                        40,000                         50,000                         42,000

c) Total Current assets                           210,000                       230,000                       200,000

d) Owner’s equity                                  234,000                       260,000                       224,000

In making the physical counts of inventory, the following errors were made:

            m Inventory on December 31,2000, under stated by Br. 12,000

            m Inventory on December 31, 2001, overstated by Br. 6000

Required:

Determine the correct amount of the items listed above.

Solution                                                                     

                                                               2000                         2001                          2002

  1. Cost of merchandise sold:                  

                      Reported                       Br. 130,000                 Br. 154,000                 Br. 140,000

                     Adjustment of               

                           2000 error                       (12,000)                         12,000                            _

                           2001 error                             _                                6,000                         (6,000)    

                        Corrected                    Br. 118,000                 Br. 172,000                 Br. 136,000

  1. Net income:

          Reported                       Br. 40,000                   Br. 50,000                   Br. 42,000

          Adjustment of

                  2000 error                    12,000                        (12,000)                              _

                  2001 error                          _                             (6,000)                          6,000

                Corrected                Br. 52,000                   Br. 32,000                   Br. 48,000

 

  1. Total current assets:

Reported                     Br. 210,000                 Br. 230,000                 Br. 200,000

Adjustment of

        2000 error                    12,000                             _                                  _

        2001 error                          _                            (6,000)                             _

     Corrected               Br. 222,000                 Br. 224,000                 Br. 200,000

 

  1. Owner’s equity:

 

                         Reported                    Br. 234,000                 Br. 260,000                 Br. 224,000

                         Adjustment of

                                 2000 error                   12,000                             _                                  _

                                 2001 error                       _                            (6,000)                              _

                              Corrected              Br. 246,000                 Br. 254,000                 Br. 224,000

 

1.4 Inventory Systems: periodic Vs perpetual

There are two principal systems of inventory accounting periodic and perpetual.

   1.4.1 Periodic inventory system

Under this system there is no continuous record of merchandise inventory account. The inventory balance remains the same through out 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:

  1. At the time of purchase of merchandise:
        Purchases                       XX                       
                Accounts payable or cash                   XX
  2. At the time of sale of merchandise:
         Accounts receivable or cash                XX           
                    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

      To record ending inventory

 

   1.4.2 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.

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:

1. At the time of purchase of merchandise

          Merchandise inventory                    XX                    

                        Accounts payable/cash              XX

      To record cost of goods sold

2. At the time of sale of merchandise

           Accounts receivable or cash              XX                     

                         Sales                                           XX

    To record cost of goods sold

 

   To record the sales

           Cost of goods sold                   XX

                      Merchandise inventory                XX      

     To record the cost of merchandise sold

3. To record purchase returns and allowances

           Accounts payable or cash             XX

                     Merchandise inventory                   XX

4. No adjusting entry or closing entry for merchandise inventory is needed at the end of each accounting period.

Illustration – 2

In its beginning inventory on Jan 1, 2002, NINI Company had 120 units of merchandise that cost Br. 8 Per unit. The following transactions were completed during 2002.

February 5          Purchased on credit 150 units of merchandise at Br. 10 per unit.

  1.      Returned 20 detective units from February 5 purchases to the supplier.

June 15               Purchased for cash 230 units of merchandise at Br 9 per unit.

September 6       Sold 220 units of merchandise for cash at a price of Br. 15 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 NINI Company to record the above transactions and adjusting or closing entry for merchandise inventory on December 31,

  1. Periodic inventory system
  2. Perpetual inventory system

Solution

a) February 5     Purchases (150 x Br.10)                    1,500

                                    Account payable                               1,500

                   9    Accounts payable (20 x Br. 10)              200

                                    Purchase returns and allowances           200

         June 15     Purchases (230 x Br. 9)               2,070

                                    Cash                                           2,070

 September 6   Cash (220 x Br. 15)                 3,300  

                                    Sales                                 3,300

December 31    To record or close the merchandise inventory account

                        Income summary (120 x Br. 8)                 960

                                    Merchandise inventory (beginning)             960

                          _To close the beginning inventory

                        Merchandise inventor (ending)                  2,370

                            Income summary [(30 x Br. 10) + (230 x Br. 9)]               2,370 

                          _ To record the ending merchandise inventory                                                                                      

b) February 5   Merchandise inventory                 1,500

                                Accounts payable                        1,500

                   9     Accounts payable                      200

                                Merchandise inventory                    200

        June 15    Merchandise inventory                  2,070

                                Cash                                               2,070

September 6     i) To record the sales

                                Cash         3,300

                                         Sales              3,300

                        ii) To record cost of merchandise sold

                                = (120 x Br. 8) + (100 x Br. 10)

                                = Br. 960 + Br. 1,000 = Br. 1,960

                        Cost of merchandise sold                1,960     

                                  Merchandise inventory                         1,960  

December 31    No entry is needed to record or close merchandise inventory account.

 

1.5 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 systems 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 (some times called “taking an inventory”) is used to adjust the inventory ac count 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:

  1. Counting the units of each product on hand
  2. Multiplying the count for each product by its cost per unit
  3. 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

  1. FOB shipping point- the ownership title passes too 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.
  2. 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 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 are also a problem with goods on consignment at the time of taking and 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.

 

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