Valuation of Inventories.

A Cost Basis Approach

1. Inventory issues classification
Inventories are asset items that a company holds for sale in the ordinary course of
business, or goods that it will use or consume in the production of goods to be sold.

A merchandising concern. Purchases its merchandise in a form ready for sale, so

inventory appears under one account only as follows:
• Current assets (IFRs)
Cash and cash equivalents XXX
Receivables, net XXX
Inventories XXX
Prepaid expenses and others XXX
Total current assets XXX

A manufacturing concern. Produce goods to sell merchandising firms, so inventory

appears in three accounts as follows:
• Current assets (IFRs)
Cash and cash equivalents XXX
Accounts receivable, less allowance XXX
Inventories
Raw materials XXX
Work in process XXX
Finished goods XXX XXX
Other current assets XXX
Total current assets XXX
N.B Raw materials + labor + overhead Work in process

2. Inventory cost flow

Companies that sell or produce goods report inventory and cost of goods sold at the
end of each accounting period. The flow of costs for a company is as follows:

• Beginning inventory + the cost of goods purchased = cost of goods available

for sale – ending inventory = cost of goods sold
Companies use one of two types of systems for maintaining accurate inventory
records for these costs; "perpetual system or periodic system".
Perpetual system: a company records all purchases and sales of goods directly in
the inventory account as they occur.
1. Purchases of merchandise are debited to Inventory.
2. Freight-in is debited to Inventory. Purchase returns and allowances and purchase
discounts are credited to Inventory.
3. Cost of goods sold is debited and Inventory is credited for each sale.
4. Subsidiary records show quantity and cost of each type of inventory on hand.
5. The perpetual inventory system provides a continuous record of the balance in
both the Inventory and Cost of Goods Sold accounts.

Periodic system: a company determines the quantity of inventory on hand only

periodically. It records all acquisitions of inventory during the accounting period by
debiting the purchases account.
1. Purchases of merchandise are debited to Purchases.
2. Ending Inventory determined by physical count.
3. Calculation of Cost of Goods Sold:
Beginning inventory $ 100,000
Add: Purchases, net 800,000
Goods available for sale 900,000
Less: Ending inventory 125,000
Cost of goods sold $ 775,000

Note: Companies must allocate the cost of all the goods available for sale (or use)
between the goods that were sold or used and those that are still on hand.

Example on perpetual and periodic system

1- Beginning balance of inventory 100 units at $6.
2- Cash purchases 900 units at $6.
3- Purchase return as non-up to simple 100 units.
4- Sale of 600 units at $12 on account.
5- A physical count indicates inventory of $200 as shortages (deficit).

Required "By using both perpetual and periodic", prepare the journal entries.
 Solution
Journal entries
No. Perpetual system Dr. Cr. No. Periodic system Dr. Cr.

1 No entry 1 No entry
Inventory /c 5,400 Purchases a/c 5,400
2 Cash a/c 5,400 2 Cash a/c 5,400
900 units × $ 6
Cash a/c 600 Cash a/c 600
3 Inventory a/c 600 Purchases return
100 units × $ 6 and allowances a/c 600
4 A/R a/c 7,200 4 A/R a/c 7,200
(a) Sales rev. a/c 7,200 (a) Sales revenues a/c 7,200
Cost of goods sold 3,600 No entry
(b) Inventory a/c 3,600 (b)
600 units × $ 6
Inventory over No entry
5 and short a/c 200 5
Inventory a/c 200

Note: Inventory Over and Short adjusts Cost of Goods Sold. In practice, companies
sometimes report Inventory Over and Short in the “Other income and expense”
section of the income statement.

Inventory Control
All companies need periodic verification of the inventory records by actual count,
weight, or measurement, with counts compared with detailed inventory records.
Companies should take the physical inventory near the end of their fiscal year, and
to properly report inventory quantities in their annual accounting reports.

Physical goods included in inventory

a. Goods in transit. Purchased merchandise but still in transit (not yet received) at
the end of the fiscal period. The accounting for these shipped goods depends on
who owns them. For example, the company determines ownership by applying the
"passage of title" rule:
1. If the supplier (seller) ships goods to the company (buyer) f.o.b. shipping point,
title passes to the company (buyer) when the supplier delivers the goods to a
common carrier.

Seller places goods Free On Board

the carrier, and buyer pays freight
costs, and it's added to net
purchases.

2. If the supplier ships goods to the company f.o.b. destination, title passes to the
company only it receives the goods from common carrier.

Seller places goods Free On Board

to the buyer’s place of business,
and seller pays freight costs, so it
considered in accounts "Operating
expense".

b. Consigned goods. Goods sold out to another party but still existing in the stores
of the company as a consignment goods, so it remains the property of the consignor
and the consignee:
1. Should be careful not to include any of the goods consigned as a part of inventory.
2. Agrees to accept the goods without any liability, except to exercise due care and
reasonable protection from loss or damage, until it sells the goods to a third party.
3. Sells the goods, it remits the revenue, less a selling commission and expenses
incurred, to the consignee.

Example R. Company completed its inventory count. It arrived at a total inventory

value of $200,000. You have been given the information listed below. Discuss how
this information affects the reported cost of inventory.
1. R. included in the inventory goods held on consignment for Falls Co., costing
$15,000.
2. The company did not include in the count purchased goods of $10,000, which
were in transit (terms: FOB shipping point).
3. The company did not include in the count inventory that had been sold with a
cost of $12,000, which was in transit (terms: FOB shipping point).

Solution
1. Goods of $15,000 held on consignment should be deducted from the inventory
count.
2. The goods of $10,000 purchased FOB shipping point should be added to the
inventory count.
3. Item 3 was treated correctly.

Costs included in inventory

Product costs. Costs directly connected with bringing the goods to the buyer’s place
of business and converting such goods to a salable condition.

Cost of purchase includes all of:

1. The purchase price.
2. Import duties and other taxes.
3. Transportation costs.
4. Handling costs directly related to the acquisition of the goods.
Period costs. Are the costs that are indirectly related to the production of goods,
such as, selling expenses, general and administrative expenses are not included as
part of inventory cost.
Purchase discounts. Purchase or trade discounts are reductions in the selling prices
granted to customers.
There are two methods to record the purchase discounts;
1-Gross method 2- Net method

Example on gross and net method

1- Purchases cost $10,000, terms 2/10, net 30.
2- Invoices of $4,000 are paid within discount period.
3- Invoices of $6,000 are paid after discount period.
 Required Journal entries by the two methods.
Journal entries
No. Gross method Dr. Cr. No. Net method Dr. Cr.
Purchases a/c 10,000 Purchases a/c 9,800
1 1
A/P a/c 10,000 A/P /c 9,800
A/P a/c 4,000 A/P a/c 3,920
Purchases Cash a/c 3,920
2 2
discount a/c 80
Cash a/c 3,920
A/P a/c 6,000 A/P a/c 5,880
Cash a/c 6,000 Purchases
3 3
dis. Lost a/c 120
Cash a/c 6,000

Note The term of a Purchase Discounts Lost account considered as financial expenses and
recorded in the income statement under "other expenses and losses".

Special sales agreements. As we indicated earlier, transfer of legal title is the general
guideline used to determine whether a company should include an item in inventory.
Unfortunately, transfer of legal title and the underlying substance of the transaction
sometimes do not match. For example, legal title may have passed to the purchaser, but
the seller of the goods retains control of the inventory.

Two special sales situations to indicate the types of problems companies encounter:
1- Sales with repurchase agreement.
Sometimes a company finances its inventory without reporting either a liability or the
inventory on its balance sheet. This approach, often referred to as a repurchase (or
product financing) agreement, usually involves a transfer (sale) with either an implicit or
explicit repurchase agreement.

Example. Rashedy sells inventory to Marwan and agrees to repurchase this merchandise
at a specified price over a specified period. Marwan then uses the inventory as collateral
and borrows against it. Marwan uses the loan to pay Rashedy, which repurchases the
inventory in the future; it's called "Parking transaction”.

Parking transaction means. Parks the inventory on the balance sheet for a short period
of time.
2- Sales with High Rates of Return
In industries such as publishing, music, toys, and sporting goods, formal or informal
agreements often exist that permit purchasers to return inventory for a full or partial
refund.

Example. Rashedy sells bubbles balloons to Marwan with an agreement that Marwan may
return for full credit any bubbles balloons not sold. Marwan returned 25% of the quantity
bought. How this transaction will be recorded?
1) Record the sales transactions and estimate an amount of sales return and allowances.
2) Not to record any transactions until the return period expires, then record all the actual
events happened.

Which Cost Flow Assumption to Adopt?

1. Specific Identification. Used when handling a relatively small number of costly, easily
distinguishable items. Matches actual costs against actual revenue. May allow a company
to manipulate net income.
2. First- in, first – out (FIFO). Means that the first goods purchased are the first sold, so the
value of ending inventory must represent the recent prices or cost. Companies use FIFO
to increase their earning cash through decreasing the cost of goods sold and increase the
value of ending inventory, but it makes the company more exposable to income tax.
3. Last – in, first – out (LIFO). Means that the last goods purchased are the first sold, so the
value of ending inventory must represent the oldest prices or cost. Companies use LIFO
to decrease their earning cash through increasing the cost of goods sold and decrease
the value of ending inventory, so it makes the company less exposable to income tax.
4. Moving (Weighted) average method (WAM). Companies use moderate prices by
calculating the average costs of all production and dividing then on the average units for
all production in order to get an average price for missing the inventory, so the value of
ending will be a fair price around all the production, income tax will be a moderate
amount.

Example.
Assume that Call-Mart Inc. had the following transactions in its first month of operations:
Calculate Goods Available for Sale
1) Beginning inventory 2,000 units × 4
Add: purchases 6,000 units × 4.40
2,000 units × 4.75
Cost of goods available for sale $43,900

Specific Identification
Call-Mart Inc.’s 6,000 units of inventory consists of 1,000 units from the March 2 purchase,
3,000 from the March 15 purchase, and 2,000 from the March 30 purchase. Compute the
amount of ending inventory and cost of goods sold.

First- in, first – out (FIFO) Periodic

First- in, first – out (FIFO) Perpetual

Last – in, first – out (LIFO) Periodic

Last – in, first – out (LIFO) Perpetual

Moving (Weighted) average method (WAM) Periodic

 Moving (Weighted) average method (WAM) Perpetual

Income statement under the three methods using periodic, sales revenues
100,000, operating expenses 10,000, tax rate 40%, & retained earnings 5,000.

Income statement WAM FIFO LIFO

Sale revenues 100,000 100,000 100,000
Less: cost of goods sold 17,560 16,800 18,300
Gross profit 82,440 83,200 81,700
Less: operating expenses 10,000 10,000 10,000
Income before tax 72,440 73,200 71,700
Less: income tax (40%) 28,976 29,280 28,680
Net income 43,464 43,920 43,020
Add: beginning retained earnings 5,000 5,000 5,000
Retained earnings at end 48,464 48,920 48,020

LIFO reserve entry for ending inventory

LIFO Reserve is the difference between the inventory method used for internal reporting
purposes (FIFO) and LIFO.

LIFO Reserve = ending inventory FIFO - ending inventory LIFO

= 27,100 – 25,600 = 1500

Journal entry to reduce inventory to LIFO

Cost of goods sold 1,500
Allowance to reduce inventory to LIFO 1,500
Inventory adjustment
Ending inventory LIFO + LIFO reserve = 25,600 + 1,500 = 27,100 FIFO

End of the Chapter