Admas University

Meskel campus

Accounting and Finance Level IV

Learning guide
Unit of Competence: Maintain Inventory Records and valuation system
Module Title: Maintaining Inventory Records and valuation system
TTLM Code : LSA ACF4 M08 1221
Lo1:- . Process inventory purchase
Lo2:- . Record inventory flows
Lo3:- . Reconcile inventory records to general ledgers
Lo4:- Prepare inventory schedules and ad hoc reports
Occupational Standard: Accounting and Finance Level IV
Unit Title Maintain Inventory Records and valuation system
Unit Code LSA ACF4 08 1221
Unit Descriptor
This unit describes the performance outcomes, skills and knowledge
required to comply with organisational inventory procedures,
reconcile inventory records to general ledgers, record inventory
flows, prepare schedules and produce ad hoc reports.

Elements Performance Criteria

1. Process inventory 1.1 Purchase of inventory is recorded from appropriate
purchase documentation in subsidiary ledger
1.2 Periodic and perpetual records of inventory are maintained
2. Record inventory 2.1 Inventory flow assumptions are applied as appropriate
flows
2.2 Inventory is valued using appropriate valuation rules
3. Reconcile 3.1 All inventory records to the accounts are reconciled in
inventory records accordance with organization’s policies, procedures and
to general ledgers practices
3.2 Discrepancies are identified and adjusted according to
organization’s policies, procedures and practices
4. Prepare inventory 4.1 Schedules of inventory turnover and other procedures are
schedules and ad developed and documented
hoc reports
4.2 Spreadsheets and ad hoc reports reporting on inventory status
are prepared as required or requested

Variable Range
Documentation May include but not limited to :
 delivery reports
 invoices from suppliers
 purchase orders
 purchase requisitions
Inventory flow May include but not limited to :
assumptions  Perpetual and periodic procedure
 calculations based on gross margins
 cost
 net realisable value
Inventory valuation May include but not limited to :
rules  first in, first out
 Last in, first out
 specific identification
  weighted average
 Other than cost method
Gross profit method
Retail method
Net realizable Method
Organisation's May include but not limited to :
policies, procedures  inventory management
and practices  preparation of reconciliation reports
 stock take
Ad hoc reports May include but not limited to :
 inventory turnover analysis
 total purchases and inventory usage for a period
 Lo1:- . Process inventory purchase
Inventory: Cost Measurement and Flow Assumption
Inventories: is especially significant because the acquisition manufacture and sale
of products are important to the profitability of many companies the cost (carrying
value) of the inventory usually has a material impact on a company’s balance sheet
since the ending inventory of one period is the beginning inventory of the next
period the cost of the inventory on the balance sheet will have an impact on the
next periods cost of goods sold and net income. In this chapter we shall discuss.
The determinations of inventory quantities and costs and alternative inventory cost
flow assumptions.
Learning objectives
Having finished studying this chapter you must understand.
 How inventory quantities are determined.
 How to compute ending inventory and costs of goods sold under specific
identification, FIFO, average cost and LIFO.
 The alternative inventory cost flow assumption.
 The concepts of dollar value LIFO. Cost flow assumption.
Determination of inventory Costs
The cost of inventory is the price paid or consideration given to acquire it. Thus
inventory cost includes costs directly or indirectly incurred in bringing an item to
its existing condition and Location. To determine the cost of inventory, we must
understand the following cost flow assumptions.
Cost flow assumptions
A company typically starts an accounting period with units in the beginning
inventory and then purchases or process additional units during the period.
Together these constitute the goods available for sale, which are then either sold or
remain in the ending inventory.
We will discuss each cost flow assumption in the following sections and apply it to
both the perpetual and the periodic inventory systems using the information for
ABC Company.

A. Specific Identification Method

Under the specific identification inventory cost flow assumption, a company
identifies each unit sold and each unit remaining in the ending inventory and
includes the actual costs of those units in cost of goods sold and ending inventory,
respectively.
The specific identification method can be applied in either a perpetual or a periodic
inventory system but it is more reasonable to use it with a perpetual system in
which: - each unit is identifies as it is sold and the appropriate cost attached.

B. First in first out (FIFO)

Under the FIFO cost flow assumption, a company includes the earliest cost
incurred in the cost of goods sold, and includes the most recent cost in the ending
inventory.
Earliest Costs cost of goods sold Income statement
FIFO
Latest costs ending inventory Balance sheet
In other words the first costs incurred are the first transferred to cost of goods sold
(in a merchandising company) or goods in process and then to finished goods and
costs of goods sold (in a manufacturers company).
Consequently the ending inventory consists of the most recent costs incurred.
There fore in periods of rising costs, FIFO produces a lower costs of goods sold
figure in dollar (Birr), whereas ending inventory is based on the most recent and
higher costs.
Illustration 7-4 Inventory inflows and out flows for ABC Company
Inventory, April 1 --------------------- 100 units at $10 per unit---------------$ 1,000
Purchases, April 10 ------------------- 80 units at $11 per unit-------------------$ 880
Purchases, April 20 ------------------- 70 units at $12 per unit-------------------$ 840
Goods available for sale --------------250 units----------------------------------$ 2,720
Sales, April 18-----------------------------(90) units
140 units
Sales, April 27-----------------------------(50) units
Inventory, April 30--------------------110 units
FIFO cost flow assumption
(Periodic inventory system)
Ending inventory (110 units)
40 units at $ 11 $440
70 units at $ 12 $840
Total $1,280 Cost
of goods sold (140 units)
 Beginning inventory +Purchases - ending inventory = Cost of goods sold
$ 1000 +$1,720 - $1,280 =$1440
If ABC Company uses perpetual inventory system (for cost as well as physical
quantities) it calculates the cost of goods sold of $1,440 and the end inventory of
$1,280 as shown below:

FIFO cost flow assumption

(Periodic inventory system)
Cost of goods sold (140 units):
April 18:90 units at $10 $900
April 27: 50 units: 10 units at $10----------------------------------100
: 40 units at $ 11 440
Total
$1,440
Ending inventory (110 units)
40 units at $11=$440
70 units at $12= 840
Total $1,280
Note that the ending inventory and the cost of goods sold under both the perpetual
and the periodic systems are equal this always is true for the FIFO cost flow
assumption because the most recent costs incurred are included in the ending
inventory.
C. Last-in first-out method (LIFO)
In this method of costing is based on the assumption that the most recent cost incurred
should be charged against revenue. Hence the inventory remaining is assumed to be
composed of the earliest costs.
LIFO cost flow assumption
(Periodic inventory system)
Cost of goods sold (140 units):
April 20:70 units at $12 $ 840
20 units at $ 11 220
April 27: 50 units at $11 550
Total $ 1,610
Ending inventory (110 units)
100 units at $10=$1000
10 units at $11 = 110
Total---------------------$1,110
 D. Average cost Flow Assumption
Under the average cost flow assumption, a company considers all the costs and
units to be commingled so that no individual units or costs are identified. When the
periodic inventory system is used the average cost method is known as the
weighted average method. The cost of the units for the period is calculated on the
basis of the cost of the beginning inventory and the average cost of the unit’s
purchased or manufactured, weighted accounting to the number of units at each
cost. In other words under the weighted average method, the average cost per unit
for the period is the cost of goods available for sale divided by the number of units
available. This average cost is used for both the ending inventory and the cost of
goods sold.
When a company uses the average cost method under a perpetual inventory system
(for costs as well as physical units) the same principle are applied, but it is known
as a moving average method because a new weighted average cost must be
calculated after each purchase. The new weighted average is computed in the same
way as in the weighted average method. That is under the moving average method,
the average cost per unit is the cost of the units available for sale after the purchase
divided by the number of units available for sale at that time.
This available cost is used to determine the cost each sale made until the next
purchase, at which time a new average cost must be calculated. The illustration for
both systems as follows:
 Weighted Average cost flow Assumption
(Periodic Inventory system)
Cost of goods available for sale ($1000 + $1,720)------------------------$ 2,720
Units available for sale 250
Average cost (cost  number of units)---------------------------------------$ 10.88
Ending inventory (110 units at $10.88)---------------------------------------$ 1,197
Beginning + purchases - Ending = Cost of goods
Inventory Inventory Sold
$1000 + $ 1,720 - $1,297 = $1,423

Moving Average cost flow assumption

(Perpetual inventory System)
April 1, Beginning Inventory --------------------- 100 units at $10------$1000
April 10, Purchases --------------------------------- 80 units at $11----------$880
April 10, Balance ---------------------------------- 180 units at $10.44-----$1,880
April 18, Sales --------------------------------- (90) units at $10.44---------$(940)
April 18, Balance ---------------------------------- 90 units at $10.44---------$940
April 20, Purchases --------------------------------- 70 units at $12.00-------$840
April 20, Purchases --------------------------------- 160 units at $11.125- -$1,780
April 27, Sales -------------------------------------- (50) units at $11.125----$(556)
April 30, Balance ------------------------------ ---- 110 units at $11.125----$1,224
Cost of goods sold (140 units at $11.125)------------------------------------$1,224
 Lo2:- . Record inventory flows

Accounting for and reporting inventory under a perpetual system

In perpetual inventory system, all merchandise increase and decrease are recorded
in manner similar to the recording of increase and decrease in cash. The
merchandise inventories account at the beginning of an accounting period
indicated the merchandise in stock on that date. Purchase is recorded by debiting
merchandise inventory and crediting cash or account payable, on the data of each
sale. The cost of merchandise sold is recorded by debiting cost of merchandise sold
and crediting merchandise inventory.
Example:-The following units of item K are available for sale
Item K units cost
Jan.1 Inventory 20 $ 20
4 Sale 14
10 Purchase 16 21
22 Sale 8
28 Sale 4
30 Purchase 20 22
The firm used a perpetual inventory system, and there are 30 units of one item on
hand at end of the year. What is the total cost of goods sold and ending inventory
according to:-
A.FIFO B.LIFO C. average cost method.
FIFO method

Using cost, costs are included in the merchandise sold in the order in which they
were incurred.

Purchase Cost of merchandise sold Inventory

Date Quant Unit Total Quanti Unit Total Quanti Unit Total
ity cost cost ty cost cost ty cost cost
1 20 20 400
4 14 20 280 6 20 120
10 16 21 336 6 20 120
16 21 336
22 6 20 120 14 21 294
2 21 42
28 4 21 84 10 21 210
30 20 22 440 10 21 210
20 22 440
Total 26 $526 30 $650

Thus cost of merchandise sold= $526 cost of ending inventory=$650

LIFO method
When the LIFO method is used in a perpetual inventory system the cost of the
units sold is the cost of the most recent purchase
Purchase Cost of merchandise sold Inventory
Date Quant Unit Total Quanti Unit Total Quanti Unit Total
1 20 20 400
4 14 20 280 6 20 120
10 16 21 336 6 20 120
16 21 336
22 8 21 168 6 20 120
8 21 168
28 4 21 84 6 20 120
4 21 84
30 20 22 440 6 20 120
4 21 84
20 22 440
Total 26 $532 30 $644
Thus cost of merchandise sold= $532 cost of ending inventory=$644
Average cost method
When the average cost method used in a perpetual inventory system an average
unit cost for each type of item is computed each time a purchase is made. This unit
cost is then used to determine the cost of each sale until another purchase is made
and a new average is computed .these average techniques called a moving
average.
Purchase Cost of merchandise sold Inventory
Date Quant Unit Total Quanti Unit Total Quanti Unit Total
1 20 20 400
4 14 20 280 6 20 120
10 16 21 336 22 20.7 456
22 8 20.7 166 14 20.7 290
28 4 20.7 83 10 20.7 207
30 20 22 440 30 21.56 647
Total 26 $529 30 $647
Thus cost of merchandise sold= $529 cost of ending inventory=$647
 Lo3:- . Reconcile inventory records to general
ledgers
Estimating Inventory cost
In practical an inventory amount may be need in order to prepare an income
statement when it is impractical or impossible to take a physical inventory or to
maintain perpetual inventory records the amount of inventory on hand can be
estimated.
The two commonly used methods of estimating inventory cost are:-
1. The retail method
2. The gross profit method
1. Retail Methods
The retail method of estimating the cost of inventories is used primary by retailing
enterprises. Under the periodic inventory system, the cost of the ending inventory
is subtracted from the total cost of goods available for sale to compute the cost of
goods sold. Under the retail method, a record of goods available for sale at selling
prices is kept separate at selling prices. The ending inventories valued at selling
prices then are reduced to estimated cost by multiplying the inventories at selling
price by the cost percentage computed for the accounting period.
Illustration of Retail Method
The retail method of estimating inventories (at average cost) is illustrated by the
following simplified example for ABC Company.
 ABC Company
Estimate of Inventories by Retail Method
End of current year
Cost Retail
Beginning inventories-----------------------------$ 40,000 $50,000
Net Purchases---------------------------------------$ 150,000 200,000
Goods available for sale--------------------------$ 190,000 250,000
Cost percentage ($190,000  $250, 00)---------$ 76%
Less: Sales and normal shrinkage
220,000
Ending inventories at retail $30,000
Ending inventories at
Cost ($30,000x0.76)-----------------------------------$22,800
2. Gross profit method
The gross profit method is useful for several purposes.
a. To control and verify the validity of inventories cost.
b. To estimate interim inventory valuations between physical counts, and
c. To estimate the inventory cost when necessary information normally used is
lost or unavailable.
The procedure involved is one of reducing sales to a cost basis; that is cost of
goods sold is estimate. The estimated cost of goods sold then is subtracted from the
cost goods available for sale to compute the estimated cost of the ending
inventories.
In the events that both merchandise and inventory records are destroyed by fire.
The inventory cost may be estimated by use of gross profit method. The gross
profit and cost of good sold percentage are obtained from prior year’s financial
statements, which presumably are available.
 Lo4:- Prepare inventory schedules and ad hoc reports

Gross profit Method is really a “Cost percentage” Method

The key step in the application of the gross profit method is the development of an
accurate cost percentage, obtained by deduction of the gross profit rate from 100%.
Frequently the best available measure is an average of the cost percentages for
recent years adjusted for any changes in costs and selling prices that have been
taken place in the current year.
Illustration
The following data are given for ABC Company for the year ended Dec 31, year 3.
Beginning inventories $ 40,000
Net Purchases 200,000
Net sales 225,000
Average cost percentage for the past two years ----------- 80%
Then by assuming that the cost percentage for year 4 remained at 80% the cost of
the inventories on Dec 31, year 3 is estimated as follows
ABC Corporation
Estimate of cost of inventories by gross profit method
December 31, year 3
Beginning inventories, at cost-------------------------------------$ 40,000
Add: Net purchases 200,000
Cost of goods available for sale-----------------------------------$240,000
Less: Estimated cost of goods sold:
 Net sales
$225,000
 Cost percentage 0.80 180.000
Estimated ending inventories at cost --------------------- $60,000
Some times the gross profit percentage is stated as a percentage of cost. In such
situations the gross profit percentage must be restated to a percentage of net sales
to compute the cost percentage (based on sales).
Illustration
The gross profit is stated as 25% of cost, and then computes the cost percentage in
terms of sales.
Solution
 25% =1/4 gross profit based on cost.
 Add: Numerator of fraction to denominator to make 1/5
 1/5 = 20% of gross profit based on net sales.
Or
Let x=cost as percentage of net sales 0.25x=gross profit percentage (based
on co