CHAPTER 2

MERCHANDISE INVENTORY
Introduction
- Definition. Inventories are those assets which are held for sale in the normal course of
business, are in the process of being produced for such purpose, or are to be used in the
production of such items.
- Thus, a manufacturing firm has three types of inventories: Raw material, Work-in-Process, and
Finished goods. Merchandising entity (generally a retailer or wholesaler) has a single inventory
account which is usually titled merchandise inventory.
- Inventories are typically classified as current assets on the balance sheet. The accounting
problems associated with inventory are complex; this chapter discusses the basic issues
involved in recording, valuing, and reporting merchandise inventory.
- But why do we need to have proper accounting for inventories? The description and
measurement of inventories demand careful attention because
a) they take substantial investment of money
b) the frequency of transactions involving inventory are high
c) they are principal source of revenue for trading firms
d) Cost of inventories sold is the largest deduction from revenue in the form of COGS.
Two Inventory Systems
- Inventory records may be maintained on a perpetual or periodic inventory system. The
essential difference between these two systems from an accounting point of view is the
frequency with which the physical flows are assigned a value. Here are the major differences
between the two:
Periodic Perpetual
• The inventory value and COGS are • Continuous record of both the physical flow
determined only at important point in and the cost of inventories and COGS.
time .e.g. end of reporting period Every point in time you determine the level
of inventory
• Only revenue is recorded at time of sale • Both revenue and COGS are recorded
• Purchase & purchase related accounts • No purchase and purchase related accounts
are used • For high unit cost items (not economical for
• More appropriate for low unit cost low unit cost items)
items • Physical inventory should be undertaken to
• Physical inventory is undertaken to test accuracy, to discover any shortage or
determine EI cost. Units sold are overage b/c of waste, breakage , theft,
determined indirectly by subtracting the improper entry, failure to record
units on hand from the sum of the units acquisitions etc
available for sale during the period.
• This makes preparation of interim f/sts • Facilitates the preparation of interim f/sts
more costly unless inventory estimation
technique is used.
• Weaker for internal control • Stronger for internal control

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 Example:
Sep.1 Goods were purchased for $10,000 terms 2/10,n/30
Periodic Perpetual
Sep.1 Purchases -------------- 10,000 Sep.1 Merchandise inventory ------ 10,000
Accounts Payable ---- 10,000 Accounts Payable --------- 10,000

Sep.2 Paid freight charge of $250 on merchandise purchased

Sep.2 Freight in ----------- 250 Sep.2 Merchandise Inventory------- 250
Cash --------------------- 250 Cash ------------------------------ 250

Sept.5 Returned $1000 of merchandise previously bought.

Sep.5 Accounts Payable -------1000 Sep.5 Accounts Payable ----------- 1000
Purch. ret & allow. ----- 1000 Merchandise Inventory ---- 1000

Sept. 6 Goods costing $6000 were sold for $10,000 terms 2/10,n/30
Sep.6 Accounts receivable -- 10,000 Sep.6 Accounts receivable ------ 10,000
Sales ----------------- 10,000 Sales ----------------- 10,000
COGS ----------------- 6,000
Merchandise inventory ---- 6,000
Sept. 11 Paid for the September 1 purchases
Sep.11 Accounts payable ---- 9,000 Sep.11 Accounts payable ------ 9,000
Cash --------------------- 8,820 Cash ------------------------ 8,820
PD(2%*$9000)---------- 180 Merchandise inventory ------ 180
Sept. 13 Issued a credit memo. for merchandise returned $2,000 with a cost of $1,200.
Sep.13 Sales ret.& allow ----- 2,000 Sep.13 Sales ret.& allow --------- 2,000
Accounts Receivable --- 2,000 Accounts Receivable ----- 2,000
Merchandise inventory --- 1,200
COGS --------------------- 1,200

Determining Inventory
- The two most important functions/objectives of accounting for inventories are to determine:
i) the quantities of goods to be included in inventory
ii) the cost of inventories on hand

i) Determining Which Goods to Include In Inventory

- Companies take physical inventories to count how many (or measure how much) of each item
the company owns. Inventory is easier to count when sales and deliveries are not occurring, so
many companies take inventory when the business is closed.
- But which item should be included in inventory during the physical count? The general rule is
that all goods the company OWNS at the inventory date should be included, regardless of their
location.

- Some areas which create a question as to proper ownership are:

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 o Goods in transit- When merchandise is shipped FOB shipping point, the merchandise
must be included in the purchaser's inventory even if the purchaser has not yet received
it. When merchandise is shipped FOB destination, the merchandise must be included in
the seller's inventory until the purchaser receives it.
o Consignment is a marketing arrangement whereby the consignor (the owner of the
goods) ships merchandise to another party, known as a consignee, who acts a sales
agent only. Goods out on consignment, because they are owned by the consignor until
sold, should be excluded from the inventory of the consignee and included in the
inventory of the consignor. If we have goods in on consignment, we should exclude
them from our inventory.
- So the physical units to be included (counted) are:
Number of units + Units out on + Goods in transit purchased + Goods in transit - Goods in on
in warehouse consignment FOB shipping point sold FOB dest. consignment
ii) Cost Determination
- Remember that cost of ending inventory is a critical factor in determining income as it is
deducted from the cost of goods available for sale to determine cost of goods sold, a major
income statement item. In earlier chapters, the dollar amount for inventory was simply given. 
Not much attention was given to the specific details about how that cost was determined.  In
this part, we will see which costs are included in inventory (inventoriable costs) and how cost
of inventory is determined (costing methods).

Inventoriable costs:
- What costs should be included in inventory?
- After the quantity of goods owned has been determined, the starting point in inventory
valuation process is to ascertain the costs to be included in inventory.
- Generally, inventory should include all costs incurred to bring them to a condition and place
ready for sale or converting such goods to a salable condition.
- Thus, inventory (inventoriable) cost would include the invoice price, less discounts that are
taken, plus any duties and transportation costs paid by the purchaser.
- Technically, inventory costs include warehousing and insurance expenses associated with
storing unsold merchandise. However, the cost of tracking this information often outweighs the
benefits of allocating these costs to each unit of inventory, so many companies expense these
costs as incurred.
Costing Methods:
- Inventory cost is determined by multiplying number of units on hand and unit cost. We face
here a major accounting problem: which unit costs to use. This arises when identical units of a
single inventory item, because of inflation or deflation, are acquired at different price at
different time.
Example: Five units of inventory type HH have been acquired at different time at a price of
$4, $5, $6, $7, and $8. If only two units remain unsold, what should be the cost of
the inventory and the cost of goods sold?
- The answer would be easy if purchase prices and other inventory costs never changed. But the
price fluctuations may force a company to make certain assumptions about which items have
been sold and which items remain in inventory. There are four generally accepted methods for
assigning costs to ending inventory and cost of goods sold: specific identification; average

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 cost; first-in, first-out (FIFO); and last-in, first-out (LIFO) all of which can be used under either
the periodic or the perpetual system.
- Each of these methods, except the specific identification, entails certain cost-flow assumptions. 
Importantly, the assumptions bear no relation to the physical flow of goods; they are merely
used to assign costs to units on hand (and to units sold).
We will use the following data for inventory item X to illustrate the above inventory
costing methods.
Units Unit cost Total cost
Jan. 1 Inventory 6 $10 $60
10 Purchase 10 12 120
30 Purchase 8 15 120
24 $300
Units SP per unit
Jan. 3 Sale 5 $15
20 Sale 4 18
28 Sale 2 22
11
Additional information:
1) The physical count shows only one unit in the warhouse
2) One unit is placed on a display shelf in the firm's own shop
3) Three units are held by an agent(consignee)
4) Two of the units from the above items belong to the beg. Inventory and
three are from Jan.10 purchase
5) Eight units purchased on Jan. 30 being shipped FOB shipping point are in transit
Required: Determine Ending inventory and COGS under each of the costing methods.

Inventory Costing Methods under Periodic Inventory System

Specific Identification
- It does not depend on a cost flow assumption.
- Instead it requires that each item of inventory is marked, tagged, or coded so that the actual
(specific) unit cost of each item sold and remaining on hand can be identified at any time
easily. This method tracks the actual physical flow of the goods.
Solution
Ending Inventory Cost(13 units):
2 units @ $10 ----------------- $20
3 units @ $12 ----------------- 36
8 units @ $15 ----------------- 120
$176

Cost of Goods Sold:

Cost of Goods Available for Sale ---------- $300

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 Less: Ending Inventory Cost(above) ------------- 176
$124
Advantage
o Gives the accurate cost information. The method is consistent with the physical flow of
goods
Disadvantage
o It is costly and requires tedious recordkeeping and is typically only used for small
inventories of uniquely identifiable goods (e.g., automobiles, fine jewelry, works of art, and
so forth).
o Income manipulation is possible as the seller has the flexibility of selectively choosing
specific items of higher/lower-costing inventory depending on particular income goals at
the time of sale.

- The SI method gives the same result for ending inventory and COGS under both a periodic and
perpetual system. The only difference between the systems is that the value of inventory and
the cost of goods sold is determined every time a sale occurs under the perpetual system, and
these amounts are calculated at the end of the accounting period under the periodic system.
- Companies that sell a large number of inexpensive items generally do not track the specific
cost of each unit in inventory. Instead, they use one of the other three methods to allocate
inventoriable costs (FIFO, LIFO, and AC).

First-in, First-out(FIFO)
- This method assumes that goods are sold in the order in which they are purchased. Therefore,
the goods that were bought first (first-in) are the first goods to be sold (first-out), and the goods
that remain on hand (ending inventory) are assumed to be made up of the latest costs.
Solution
Under FIFO, the 13 units on hand on January31 would be costed as follows:

Ending Inventory Cost(13 units):

Most recent purchase(Jan. 30) 8 units @$15 = $120
Next most recent purchase(Jan.10) 5 units @$12 = 60
13 units $180
The cost of goods sold would be calculated as follows:
Cost of Goods Available for Sale ---------- $300
Less: Ending Inventory Cost(above) ------------- 180
$120
Advantages
o Tends to be consistent with the actual flow of costs, since merchandisers attempt to sell
their old stock first.(perishable items and high fashion items are examples).
o FIFO best approximates the current replacement value of ending inventory in the balance sheet
o No manipulation of income is possible because the cost attached to units sold is always the
oldest cost
Disadvantage

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 o For income determination, earlier costs are matched with current revenue resulting poor
matching in the income statement.
o Does not exclude inventory profit - a major criticism cited by opponents of this method.
Inventory profit arises as a result of holding inventories during periods of rising inventory
costs and are measured by the difference between the historical cost of goods sold and their
current cost at the time the goods are sold.
Last-in, First-out(FIFO)
- The LIFO method of inventory measurement assumes that the most recently purchased items
are to be the first ones sold and that the remaining inventory will consist of the earliest items
purchased.
- In other words, the order in which the goods are sold is the reverse of the order in which they
are bought. This is the opposite of the FIFO system. Remember that FIFO assumes that costs
flow in the order in which they are incurred.
Solution
Under LIFO, the 13 units on hand on January31 would be costed as follows:

Ending Inventory Cost(13 units):

Beginning inventory (Jan.1) 6 units @$10 = $60
Earliest purchase (Jan.10) 7 units @$12 = 84
13 units $144
The cost of goods sold would be calculated as follows:
Cost of Goods Available for Sale ---------- $300
Less: Ending Inventory Cost(above) ------------- 144
$156
Advantages
o It is best at matching the most recent costs against the current revenue, thereby keeping
earnings from being greatly distorted by any fluctuating increases or decreases in prices.
o Tends to excludes inventory/paper profit.
Disadvantage
o Does not approximate the physical flow of goods except in special situations such as for
items to be sold out of a stockpile. eg packages of nails or screws
o The oldest purchase costs are assigned to inventory, which may result in inventory
becoming grossly understated in terms of current replacement costs.
o Income manipulation is possible. This may cause poor buying habits
Weighted-average Method
- Some merchandise is nearly identical (homogenous) and is carried in large quantities, like
lumber, nails, nuts and bolts or gasoline. Companies use the average cost method to account
for things like this.
- No assumption is made about the sale of specific units. Rather, all sales are assumed to be of
the “average” unit at the average cost per unit.
- Weighed-average is a periodic inventory costing method where ending inventory and COGS
are priced at a single weighted-average cost of all items available for sale.
Weighted Average unit cost = COGSAFS

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 Total units available for sale

Solution
Under WA method, the 13 units on hand on January31 would be costed as follows:

Weighted Average unit cost = $300 = $12.50

24 units

Ending Inventory Cost = 13 units @$12.50 ----------- $162.50

The cost of goods sold would be calculated as follows:

Cost of Goods Available for Sale ---------- $300
Less: Ending Inventory Cost(above) ------------- 162.50
$137.50
Advantages
o Relatively simple to implement
o It can be supported as realistic and as paralleling the physical flow of goods, particularly
where there is an intermingling of identical inventory units(e.g gasoline)
o Income manipulation is possible by buying or failing to buy goods near year end but its
effect is lessened because of the averaging process.
Disadvantage
o Inventory values may lag significantly behind current prices in periods of rapidly rising or
falling prices.

Inventory Costing Methods under Perpetual Inventory System

- All of the preceding examples were based on the periodic inventory system.  In other words,
the ending inventory was counted and costs were assigned only at the end of the period. 
- With a perpetual system, a running count of goods on hand is maintained at all times and a
continuous record of inventory and COGS is maintained as discussed earlier.
- All the costing methods: SI, FIFO, LIFO, AC can be used under the perpetual system.
- Let us compute ending inventory and COGS using our data.
Solution
FIFO – Perpetual Inventory Ledger account for Item X
Inventory Item X
Purchases COGS Inventory
Date Qty Unit Total Qua. Unit Total Qty Unit Total
Cost Cost Cost Cost Cost Cost
Jan. 1 6 $10 $60
3 5 $10 $50 1 10 10
10 10 $12 $120 1 10 10
10 12 120
20 1 10 10 7 12 84
3 12 36
28 2 12 24 5 12 60

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 30 8 15 120 5 12 60
8 15 120

COGS = $50 + $10 + $36 + $36 + $24 = $120

Ending Inventory = $60 + $120 = $180
NB. The FIFO method gives the same result whether the periodic or perpetual system is
used. This occurs because each withdrawal of goods is from the oldest stock.
- We can record the purchase and sale information as follows. 
Journal Entries:
Jan. 3 Accounts Receivable/Cash --------------
75
Sales -------------------------------- 75
COGS --------------------------------50
Merchandise Inventory --------- 50
10 Merchandise Inventory ----------------
120
A/P or Cash --------------------- 120
20 Accounts Receivable/Cash --------------
72
Sales -------------------------------- 72
COGS --------------------------------46
Merchandise Inventory --------- 46
28 Accounts Receivable/Cash --------------
44
Sales -------------------------------- 44
COGS --------------------------------24
Merchandise Inventory --------- 24
30 Merchandise Inventory ---------------
120
A/P or Cash --------------------- 120
- Realize that this type of data must be captured and maintained for each item of inventory if the
perpetual system is to be utilized; a task that was virtually impossible before cost effective
computer solutions became commonplace.  Today, the method is quite common, as it provides
better "real-time" data needed to run a successful business.
Solution
LIFO – Perpetual Inventory Ledger account for Item X
Inventory Item X
Purchases COGS Inventory
Date Qty Unit Total Qua. Unit Total Qty Unit Total
Cost Cost Cost Cost Cost Cost
Jan. 1 6 $10 $60
3 5 $10 $50 1 10 10
10 10 $12 $120 1 10 10
10 12 120
20 1 10 10
4 12 48 6 12 72
28 2 12 24 1 10 10
4 12 48

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 30 8 15 120 1 10 10
4 12 48
8 15 120

COGS = $50 + $48 + $24 = $122

Ending Inventory = $10 + $48 + $120 = $178
NB. When LIFO is used the periodic and perpetual systems do not have the same value for
inventory and COGS. This is because the "last-in" layers are constantly being peeled
away, rather than waiting until the end of the period. 
- The journal entries are not repeated here for the LIFO approach.  Do note, however, that the
accounts would be the same (as with FIFO); only the amounts would change. 
Average Method
- The average cost method in a perpetual inventory system is called the moving average method.
Under this method a new average unit cost for each type of commodity is computed each time
a purchase is made rather than at the end of the period. This unit cost is used to determine the
cost of each sale until another purchase is made and a new average is computed.
- Goods sold and remaining still on hand (in inventory) are costed at the most recent moving
average cost.
- Since the average cost method is rarely used in perpetual inventory system, we do not illustrate
it in this chapter. But if we do the computation you will have the following results:
COGS = $50 + $47.27 + $23.64 = $120.91
Ending Inventory = $179.09
- Note that the Average cost method gives different results under the periodic and the perpetual
system. This is because the perpetual system uses a continuously changing (moving) average
cost to determine inventory and COGS while the periodic system uses only a single average
cost at the end of the period. 
Comparison of Inventory Methods
- Although the cost of goods available for sale is the same under each cost flow method, each
method allocates costs to ending inventory and cost of goods sold differently. Compare the
values found for ending inventory and cost of goods sold under the various assumed cost flow
methods in the previous examples and their effect on income.
Periodic Perpetual
Income Statement Income Statement
FIFO LIFO AC FIFO LIFO AC
Sales $191 $191 $191 Sales $191 $191 $191
Cost of goods sold  120 156 137.5 Cost of goods sold  120  122 120.91
Gross profit $71 $35 $53.50 Gross profit $71 $69 $70.09

Balance Sheet Balance Sheet

Ending inventory $180 $144 $162.50 Ending inventory $180 $178 $179.09

- As shown above, the FIFO method yielded the lowest amount for the cost of merchandise sold
and the highest amount for gross profit (and net income). It also yielded the highest amount
for the ending inventory. On the other hand, the LIFO method yielded the highest amount for

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 the cost of merchandise sold, the lowest amount for gross profit (and net income), and the
lowest amount for ending in inventory. The average cost method yielded results that were
between those of FIFO and LIFO.

Inventory Costing Methods and Price Changes

Costing Method
FIFO LIFO Weighted Average
Economic Condition
− Higher inventory, − Lower inventory,
Inflation GP, NI, Tax GP, NI, Tax − The average
− Lower COGS − Higher COGS between the two
− Lower inventory, − Higher inventory,
Deflation GP, NI, Tax GP, NI, Tax − The average
− Higher COGS − Lower COGS between the two

- Note that in a period of inflation, LIFO will yield the highest amount of COGS resulting in
lower reported profits and a tax advantage (lower income taxes) than the other methods. With
reduced taxes, cash flow is improved.
- As you might have already noticed, the average cost method takes a “middle-of-the road
approach. This method also averages price fluctuation (up or down), in determining both gross
profit and inventory cost, and the results will be the same regardless of whether price trends are
rising or falling.
Valuation of Inventories at Other Than Cost
- Cost is the primary basis for the valuation of inventories like all assets. This is prescribed by
the cost principle the objective of which is to provide objectively verifiable information that is
free from bias. In spite of these efforts accountants do employ a degree of conservatism. 
Conservatism dictates that assets and income be understated, when in doubt (there is a decline
in utility) justifying departure from cost principle.
- Two such circumstances arise with regard to inventory when:
1) the cost of replacing items in inventory is below the recorded cost—LCM method and
2) the inventory is not salable at normal sales prices—NRV method. This latter case may
be due to imperfections, shop wear, style changes, or other causes.
1. Valuation at Lower of Cost or Market
- If inventory declines in value (loses its utility) below its original cost for whatever reason the
inventories should be written down to reflect this loss.
- The utility of the goods in question is generally considered to be their market value, thus the
term lower of cost or market.
- But what is market? Market value of an inventory is its replacement cost (not sales price!). RC
is the amount that it would cost for the company to acquire or reproduce the inventory (by
purchase or by reproduction based on current material prices, labor rate and current OH costs).
- How can RC show utility? Declines in RC usually indicate declines in sales values, though
such declines in sales values do not necessarily occur with the same immediacy or

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 proportionality. In general for a loss to be recognized under the LCM method, both a decline in
RC and in the final sales value must have occurred. In businesses where technology changes
rapidly (e.g.., microcomputers and televisions), market declines are common.
- When LCM is used inventories are valued either at cost or at market value; whichever is less.

- Applying the lower-of-cost-or-market method involves the following steps:

Step 1:  Determine Cost(SI, FIFO etc)
Step 2:  Determine Market -- which is replacement cost*
Step 3:  Compare the “market value” and the “historical cost” and report inventory at
the lower of its cost or market.
- * RC may not always be market (covered in advanced courses).
Example:
Suppose a retail computer store purchases ten computers for $3,000 each. After the store sells
eight of them each for $3,900, the manufacturer decreases the computer's price, enabling the
store-as well as the store's competitors-to purchase the same type of computer for $2,500.
Now the retailer has two unsold computers the selling price of which has been reduced to
$3,250 each.
Required: At what amount should the two remaining computers be reported (valued)?
Solution
Step 1:  Cost = $6,000
Step 2:  RC = $5,000
Step 3:  Inventory at LCM = $5,000
This $1,000 write-down is recorded by debiting the loss on inventory write-down account
and by crediting inventory. The loss may be reported as a separate item on the income
statement or included in the COGS the effect of both of which is to reduce net income.
- If market value is less than historical cost, the use of LCM provides two advantages:
1. The gross profit and net income are reduced for the period in which the decline
occurred, not in the period in which it is sold. So LCM is also supported by the
matching principle, and
2. An approximately normal gross profit is realized during the period in which the item
is sold.
- If a company has different types of inventories (e.g. computers, printers etc), how do we
determine total inventory value under the LCM method? We have three alternatives. LCM can
be applied: Item -by–item; To Major categories of inventories; or To Inventory as a whole
Example:
Based on data about four items included in the inventories of ABC Co., calculate the value of
the inventory assuming LCM is applied on an
i) item-by-item basis
ii) major categories(assume A & B are in one category and B & C in a second
category)
iii) Inventory as a whole

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 LCM Rule applied to
Commodity Qty Unit Cost Unit RC Cost Market Items Group As a whole
A 400 $10.25 $9.50 $4,100 $3,800 $3,800
B 120 22.55 24.1 2,700 2,892 2,700
Total 6,800 6,692 6,692
C 600 8 7.75 4,800 4,650 4,650
D 280 14 14.75 3,920 4,130 3,920
Total 8,720 8,780 8,720
Total Inv. $15,520 $15,472 $15,070 15,412 $15,472
- The item-by-item basis produces the most conservative (lowest) inventory value because units
whose market value exceeds cost are not allowed to offset items whose market value is less
than cost. Valuation of inventory as a whole produces the highest inventory amount. It results
in low COGS and high profit resulting in higher tax
- Note that regardless of which of the three methods is adopted, each inventory item should be
priced at cost and at market as a first step in the valuation process
Valuation at Net Realizable Value
- What if merchandise is out of date (obsolete), spoiled, or damaged and can be sold only at
prices below cost? Do we report it at cost? No!
- The inventory should not be reported above its maximum utility (NRV). Such inventories
should be written down to their NRV value as there is a decline in utility (profit generating
capacity). This is also application of the conservatism principle.
- Net realizable value is the estimated selling price less any direct cost of disposal, such as sales
commission, advertising, repairs etc.
- The valuation rule is cost or NRV whichever is lower.
Example:
Assume that damaged merchandise that had a cost of $1,500 can be sold for only $1200. Direct
costs of disposal are estimated as $150 for maintenance and $200 for sales commission.
Required: At what amount should the items be included in the inventory?
Solution:
NRV = $1200 - ($150 + $200) = $850

The inventory should be reported at its NRV ($850) because it is lower than cost ($1500).
The expected loss of $650 is recognized by recorded as follows:
Loss due to obsolescence -------- 650
Merchandise inv. --------------------- 650
To write down inventory to NRV
Estimating Inventory Costs
- The basic purpose in taking a physical inventory is to verify the accuracy of the perpetual
inventory records or, if no records exist, to arrive at an inventory amount. Some times, taking a
physical inventory is impractical or very costly or an independent check on the validity of
inventory figures is sought. Then, estimation methods are employed.

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- Reasons of estimation:
o To prepare interim financial statements when the periodic system is used without having
physical count. In a perpetual system there is no need to estimate inventory because we
have current information about inventory. In periodic system inventory is determined
only through physical count which is very costly to undertake for more often than
annually making estimation invaluable.
o To verify the reasonableness of the EIC reported in the body of the financial statements
as a result of the physical count- any significant discrepancy should be investigated.
o To know the amount inventory that has been lost, stolen, or destroyed. These are
conditions in which taking physical inventory is impossible. Even if perpetual inventory
records have been kept, if the documents which could be referred to have been destroyed
together with the inventory, estimation techniques are the only option to determine
inventory destroyed/lost.
- Two estimation techniques are commonly used: (1) the retail method or (2) the gross profit
method.
1. Retail Method
- This method is often used by retail stores, particularly department stores that sell a wide variety
of items. In such situation, perpetual inventory procedures may be impractical, and it is unusual
to take a complete physical inventory count for more often than annually.
- To use this method, dual records for goods available for sale should be maintained by the
company:
 One record at cost, and
 Another at retail (selling prices)  this is a supplementary record separate
from the accounting records kept for the purpose of estimating inventory.
- At time of sale the store records only the amount of the sale not the costs of the items sold. So
the company cannot compute directly the cost of ending inventory. However, the company can
estimate the cost of ending inventory by using the ratio of cost to retail price assuming
existence of an observable pattern between the two.
- It is appropriate when items sold within a department have essentially the same markup rate,
and articles purchased for resale are priced immediately.
- Three steps involved in the retail method are:
1. Determine the retail value of EI
BI at RP
+ Purchases at RP
= RP of goods available for sale
- Net sales at RP
EI at RP
The term at retail means the amount of inventory at the marked selling prices
2. Compute the cost-to-retail ratio
Cost ratio (%ge) = Cost of goods available for sale × 100%
RP of goods available for sale
= __[BI + NP] at cost__ × 100%
[BI + NP]at RP
3. Estimate EIC ( 1 × 2)
EIC = C%ge × EI at RP
i.e., EI at RP is converted into a cost value by applying the computed cost ratio

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 Example:
Data for the month of January is given below:
BI at cost, $18,000
BI at retail, 27,000
Purchases: at cost, $122,000
at retail, 173,000
Sales revenue $165,000

Required: Estimate EIC using the retail method

Solution
At Cost At Retail
Goods available for sale:
BI ---------------------------- $18,000 $27,000
+ Purchases --------------------- 122,000 173,000
Total goods available for sale ------ $140,000 $200,000

Cost ratio = $140,000 = 70%

$200,000
Deduct January sales at retail ---------------------------- 165,000
EI at retail --------------------------------------------------- $35,000
Estimated EI at cost ($7500×0.7) = $24,500

How much is COGS?

COGS = COGAFS - EIC = $140,000 - $24,500 = $115,500

OR Net Sale x Cost ratio = $165,000 x 70% = $115,500

- The above is an estimate of the amount of goods that should be on hand and does not reveal
any shortage due to breakage, loss, or theft. However, we can estimate the amount of such
shortage by comparing the amount of inventory that should be available on hand at retail with
the actual result of the physical count. For example, if actual count of goods showed EI at retail
of $30,000, the company must have had an inventory shortage at retail of $5,000 ($35,000 –
$30,000). Stated in terms of cost, the shortage is $5,000 × 70% = $3,500.
- The retail method has also the advantage of expediting the physical inventory count at the end
of the year. The physical inventory taking crew need only record the retail prices of each item
and convert the total value to cost using the retail method without the need for reference to
specific purchase invoices, thereby saving time and expenses
2. Gross Profit Method
- This method is used in place of the retail method when records of the retail prices of beginning
inventory and purchases are not kept
- It is an inventory estimation technique, based on a relationship between Sales, COGS and
Gross Profit that is assumed to be fairly stable from year to year.

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- Four steps are involved in the GP method:
1. Determine the GP %ge― based on past experience adjusted as appropriate to reflect
current conditions. GP can be expressed as a %ge of sale or cost. But it is common to
quote it based on sales.
2. Compute the estimated COGS during the current year:
o If GP is expressed as a %ge of sales:
Estimated COGS = current year's sale to date × (1 - GP %ge)
o If GP is expressed as a %ge of cost, it is necessary to restate it as a %ge of
sales before using the GP method. We can convert a markup percentage from
one based upon cost to one based on sales price, or vise-versa.
1 GP %ge on the basis selling price = __GP %ge on the basis of cost_____
(100% + GP %ge on the basis of cost)
2 GP %ge on the basis of cost = GP %ge on the basis of selling price____
(100% – GP %ge on the basis of cost)
3. Compute the COGAFS in the current year:
COGAFS = BI + Purchases to date
4. Compute the estimated cost of EI:
Estimated EI = COGAFS - Estimated COGS
- Note that very often different products have different markups, in these situations, a blanket
ratio should not be applied across the board. The accuracy of the estimate can be improved by
grouping inventory into pools of products that have similar gross profit relationships rather
than using one gross profit ratio for the entire inventory.

Example:
Given BIC ------------------------ $9,000
NP ------------------------- 30,000
Freight-in ----------------- 2,000
Net sales ------------------ 48,000
GP%ge on sales ---------- 25%

Required: Compute EIC using GP method

Solution:
BIC ----------------------------- $9,000
NP ----------------------------- 30,000
Freight-in ---------------------- 2,000
COGAFS ---------------------- $41,000
Less: Estimated COGS
(75%× $48,000) -------------- 36,000
Estimated EIC -------------- $5,000

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 Exercise
On December 31, a fire at ABC Co's store caused serious damage to its inventories. Only
$84,000 worth of inventories was saved. Given the following information compute the
total cost of inventories destroyed by fire. And ending inventory cost to be reported.

Given BIC ---------------------------------------- $20,000

Goods purchased during the period and
received as of the date of fire ------------ 950,000
Goods purchased FOB ship. point but
in transit to date of fire -------------------- 35,500
Net sales for the period ------------------- 700,000
GP on the basis of cost ------------------------ 25%
Solution
BIC ---------------------------------------------------- $20,000
Goods purchased and received -------------------- 950,000
COGAFS -------------------------------------------- $970,000
Less: Estimated COGS
(80%× $700,000) ----------------------------------- 560,000
Estimated inv. that should be available before fire --- 410,000
Less: Inventories saved ------------------------------------- 84,000
Inventory destroyed ------------------------- $326,000

EIC = $84,000 + 35,500 = $119,500

Effect of Inventory Errors
- In the process of maintaining inventory records and the physical count of goods on hand, errors
may occur.  It is quite easy to overlook goods on hand, count goods twice, or simply make
mathematical mistakes.  Therefore, it is vital that accountants and business owners fully
understand the effects of inventory errors and grasp the need to be careful to get these numbers
as correct as possible.
- Inventory determination plays an important role in matching expired costs with revenues of the
period
Beginning inventory
+ Merchandise purchased
Merchandise available
- Ending inventory
Cost of goods sold
- If ending inventory is understated, the merchandiser assumes the items not included in the
ending inventory were sold; this overstates COGS. If ending inventory is overstated, the
merchandiser will assume that the extra items included in the inventory count were not sold;
this understates COGS. Error in the COGS amount causes an error in the amount of net income
reported on the income statement. An error in net income causes owner’s equity on the balance
sheet to be incorrect. Therefore, an error in inventory if not corrected will cause misstatements
in current and next period financial statements.

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 Example:
Relevant information for year is as follows:
Net Sales- $40,000; Ending Merchandise Inventory (Correct) - $10,000; Cost of goods
available for sale- $35,000. Let us see the effect of inventory error on the financial
statement of year 1.
Inventory Corr- Inventory Und- Inventory Over-
ectly stated stated by $5,000 stated by $4,000
Income Statement(Year 1):
Net Sales $40,000 $40,000 $40,000
COGS 25,000 30,000 21,000
Gross profit $15,000 $10,000 $19,000
Expenses 6,000 6,000 6,000
Net Income $9,000 $4,000 $13,000
Balance Sheet(Year 1):
Merchandise Inventory $10,000 $5,000 $14,000
Other assets 60,000 60,000 60,000
Total assets $70,000 $65,000 $74,000
Liabilities $22,000 $22,000 $22,000
Owner's Equity 48,000 43,000 52,000
Total Liab.& OE $70,000 $65,000 $74,000

Summary (taking understatement of inventory by $5000):

Effects on Year 1 Year 2*

Income statement COGS overstated 5000 understated 5000
GP understated 5000 overstated 5000
NI understated 5000 overstated 5000
Balance sheet Assets understated 5000 no effect
Capital understated 5000 no effect
* If no correction is made for the year 1 error and no additional error is made in year 2.
Eg Assume that EIC for year 2 was overstated by $1500, what would be its effect on the
income statement of year 2?
Year 1 Year 2 COGS
BIC Correct understated 5000 understated 5000
EIC understated 5000 overstated 1500 understated 1500
6500
Therefore, net income for Year 2 is overstated by $6500
Generalization:
- Beginning inventory errors have a direct relationship to COGS and an indirect to NI
- Ending inventory errors have an indirect relationship to COGS and a direct relationship to NI

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- Inventory errors are counterbalancing errors, meaning, an error in one period will reverse itself
in the next period. But the fact that the errors may be self-correcting does not remove the need
for correct presentation of financial position and results of operations for each period.

Balance Sheet Presentation

- Merchandise inventory is usually presented on the balance sheet immediately following

receivables. Both the method of determining inventory cost (SI, FIFO, LIFO, or AC) and the
method of valuing inventory (cost or LCM) should be shown either in parenthesis or footnote.

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