Fundamentals of Accounting II (AcFn 2012)

Course Outline
Chapter 1: Inventories
Chapter 2: Plant, Intangible Assets and natural resources
Chapter 3: Current liabilities
Chapter 4: Accounting For Payroll In Ethiopia
Chapter 5: Accounting for Partnership
Chapter 6: Accounting for Corporation

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Chapter One

Inventories
Chapter Outline:
• Nature and definition of inventories
• The inventory cost flow methods/assumptions and their financial effects
• Inventory costing methods under the periodic and perpetual inventory systems
• Valuation of inventory at other than cost
• Estimating inventory costs
• The effects of inventory errors on the financial statements
• Presentation of inventory in the financial statements

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Nature and definition of inventories
 Inventories are asset items that a company holds for sale in the
ordinary course of business, or assets in the process of production
for such sale; or goods/materials that it will use or consume in the
production of goods to be sold. I.e.
 Inventories are assets:
• held for sale in the ordinary course of business
• in the process of production or
• in the form of materials or supplies to be consumed in the
production process or the rendering of services.

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 Merchandising Company Manufacturing Company

One Classification: Three Classifications:

• Merchandise Inventory: • Raw Materials(RMI): Item left unused
goods held for resale • Work in Process(WIPI): Item still in process
purpose
• Finished Goods(FGI): Item left unsold

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Inventories major issues

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Inventory Costing
 Steps
• Determine Inventory Quantities (Q)
• Determine Unit cost (UC)
• Determine Total cost (TC) = Q*UC
 Physical inventory taken for two reasons (Q) – inventory records:
• Perpetual System
1. Check accuracy of inventory records.
2. Determine amount of inventory lost due to wasted raw materials, shoplifting, or employee theft.
3. EI (solved for) = BI (known) + P (known) – CGS (known)
• Periodic System
1. Determine the inventory on hand.
2. Determine the cost of goods sold for the period.
3. CGS (solved for) = BI (known) + P (known) – EI (physical count)

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 Taking a Physical Inventory means:
Involves counting, weighing, or measuring each kind of inventory on hand.
 Companies often “take inventory”
• when the business is closed or business is slow
• at the end of the accounting period
 Determining Inventory Quantities
• IQ = Physical + Goods in + Goods on
Inventory transit consignment
Inventories recognized as an asset when the entity owns the asset and bear
all risks related to the item

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 Determining Ownership Control of Goods

• Goods In Transit

To determine goods included in inventory necessary to consider shipping term and

inventory costing system used by the company.

— Purchased goods not yet received (i.e. plus)

— Sold goods not yet delivered (i.e. minus)

• Goods in transit should be included in the inventory of the company that has legal
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title to the goods.

• Legal title is determined by the terms of sale.

There are two common shipping terms:

I. FOB (Free On Board) Shipping Point

This means that ownership of the goods passes from the seller to the
buyer at shipping point or right after the goods leave the store of the
seller.
Under this term the buyer owns the goods in transit and will cover all
freight costs.
Transportation costs are recorded by the buyer as a debit to an account
called
 Freight or Transportation In– under periodic inventory system

Freight-in (Transportation in) xx

Cash xx

 Inventory – under perpetual inventory system

Merchandise inventory xx

Cash xx
II. FOB Destination
This means that ownership of the goods will not pass from the seller to the buyer until
the goods reach their destination i.e. the buyer’s location or store.

Under this term the seller owns the goods in transit and covers all freight costs.

The seller, if responsible to cover for transportation costs, records transportation costs paid
as operating expenses by debiting an expense account called Delivery Expense or
Transportation/Freight Out as follows.

Freight-Out/Delivery Expense xx

Cash xx
Summary Terms of sale - Shipping
terms
Ownership of the goods
passes to the buyer when
the public carrier accepts
the goods from the seller.

Ownership of the goods

remains with the seller
until the goods reach the
buyer.
 • Goods on consignment (Consigned Goods)
To hold the goods of other parties and try to sell the goods for them for a
fee, but without taking ownership of the goods.
The two parties on consignment sale:
1. Consignor: The party that owns the goods and sends them to another
party for sale.
2. Consignee: The party that receives the goods and sells them on behalf
of the consignor but does not take ownership
• Goods damaged or obsolete:
not counted in inventory if unsalable, if salable at reduced price,
included at their net realizable value (NRV) which is the sales price
minus the cost of making the sale.
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Question 1: Rules of Ownership
ABC Imports completed its inventory count. It arrived at a total inventory value of
Br200,000. You have been given the information listed below. Discuss how this
information affects the reported cost of inventory.
1. ABC included in the inventory goods held on consignment for Falls Co.,
costing Br15,000.
2. The company did not include in the count purchased goods of Br10,000, which
were in transit (terms: F O B shipping point).
3. The company did not include in the count inventory that had been sold with a
cost of Br12,000, which was in transit (terms: F O B shipping point).
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What is the correct balance of inventory?

Solution
1. Goods of Br15,000 held on consignment should be deducted
from the inventory count.

2. The goods of Br10,000 purchased F O B shipping point should

be added to the inventory count.

3. Item 3 was treated correctly, so no adjustment is needed

Inventory should be= 16

Br195,000 (Br200,000 − Br15,000 + Br10,000)

Ex. 1
A master carver of wooden birds operates her business out of a garage. At the
end of the current period, the carver has 17 units (carvings) in her garage, 3 of
which were damaged by water and cannot be sold. She also has another 5 units
in her truck, ready to deliver per a customer order, terms FOB destination, and
another 11 units out on consignment at retail stores. How many units does she
include in the business’s period-end inventory?

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EX. 2
Inventory costing Methods and Financial Effects
 After the quantity of inventory on hand is determined, the cost of the inventory is
assigned for reporting in the financial statements.
All costs directly connected with bringing the inventories to their present(buyer)
location and converting such goods to a salable condition. i.e. Inventory Cost
includes all expenditures necessary to acquire goods and place them in a condition
ready for sale.
The cost of inventory includes:
1. all costs of purchase less trade discounts and rebates
2. costs of conversion(Direct labor, and manufacturing overhead costs) and
3. other costs incurred in bringing the inventories to to the point of sale and in
salable condition.
 Initially considered as an asset and expensed as cost of goods sold, only when
products are sold. 19
Freight costs are added to the inventory account in a perpetual

system.

In a periodic system, freight costs generally are recorded in a

temporary account called freight-in or transportation-in, which is

added to total purchases in determining net purchases for inclusion

in cost of goods sold.

Costs excluded from inventory cost
1. Period cost
 Those costs that are indirectly related to the acquisition or production of goods.

 Period costs such as selling expenses and, under ordinary circumstances, general and
administrative expenses are therefore not included as part of inventory cost.

2. Purchase discount
 Reductions in the selling prices granted to customers

 These discounts may be used to provide an incentive for a first-time purchase or as a reward for a
large order

 In some cases, incentives are provided to encourage early payment.

Net purchase = Gross purchase- purchase discount- PRA

Inventory Methods and Financial Effects
—Unit costs are applied to quantities to determine the total cost of
inventory and cost of goods sold using the following costing methods:
 Specific identification (per actual flow)
 Cost flow assumptions
• First-in first-out and
• Average-cost
— Cost flow does not need be consistent with the physical movement of
the goods.

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 Cost Flow Assumption
There are 4 cost flow assumptions under GAAP
1. Specific Identification

2. Average Cost

3. FIFO

4. LIFO

There are 3 cost flow assumptions under IFRS

1. Specific Identification

2. Average Cost

3. FIFO
1. Specific identification (SI)
• The specific identification method tracks the actual physical flow of the
goods.
• Each item of inventory is marked, tagged, or coded with its specific unit cost,
so Cost of goods sold includes costs of the specific items sold.
• It is most frequently used when the company sells a limited variety of high
unit-cost items.
• Matches actual costs against actual revenue.
• Cost flow matches the physical flow of the goods.
• May allow a company to manipulate net income.
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Example 1. The cost flow methods, assume that X-Mart had the following
transactions in its first month of operations.
Date Purchase Sold Balance
Beginning Balance 2000 @ 4.00 2000 units
March 15 6000 @ 4.4 8000 units
March 19 4000 units 4000 units
March 30 2000 @ 4.75 6000

1. Calculate Goods Available for Sale

2. Compute the amount of ending inventory and cost of goods sold. X-Mart’s 6,000 units of
inventory consists of 1,000 units from the March beginning balance, 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.
(Beginning Inventory + Purchases) - Ending Inventory = Cost of Goods Sold
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 Beginning inventory (2,000 x br4) Br 8,000
Purchases:
6,000 x br4.40 26,400
2,000 x br4.75 9,500
Goods available for sale Br 43,900

Date Number of units Unit cost Total

Beginning Balance 1000 4.00 4,000
March 15 3000 4.4 13,200
March 30 2000 4.75 9,500
Total 6,000 26,700

Cost of goods available for sale………………. 43,900

Less: cost of ending inventory …………………(26,700)
Cost of goods sold ……………………………… 17,200 26
2. Average Cost:
• Assumes that cost of goods sold and ending inventory consist of a mixture of all the
goods available for sale. Prices items in the inventory on the basis of the average cost of
all similar goods available during the period.
• Not as subject to income manipulation.
• Measuring a specific physical flow of inventory is often impossible.
 Allocates cost of goods available for sale on basis of weighted-average unit cost incurred.
 Applies weighted-average unit cost to units on hand to determine cost of ending inventory.
•Weighted-Average Method — Periodic Inventory
• Moving-Average Method — Perpetual Inventory: in this method, a new average
unit cost is computed each time it makes a purchase.
Calculate Goods Available for Sale, cost of ending inventory and CGS
under periodic and perpetual inventory system based (4000 units sold)
Weighted-Average Method — Periodic Inventory

Beginning balance

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 Moving-Average Method — Perpetual Inventory
— In this method, a new average unit cost is computed each time it makes a
purchase.

Beginning balance

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3. First-In, First-Out (FIFO)
• Assumes goods are used in the order in which they are purchased. (This often
reflects the actual physical flow of merchandise).
• Costs of earliest goods purchased are first to be recognized in determining cost
of goods sold
• Companies determine cost of ending inventory by taking unit cost of most recent
purchase and working backward until all units of inventory have been costed.
• In summary, under FIFO, the first goods purchased in the period are assumed to
be the first sold • The ending inventory consists of the most recently purchased.
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FIFO Method—Periodic Inventory

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 FIFO Method—Perpetual Inventory

Beginning balance

In all cases where FIFO is used, the inventory and cost of goods sold would be the same at the
end of the month whether a perpetual or periodic system is used.

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Financial Statement Effects of Cost Flow Methods
Income statement effects:
 In periods of rising prices (inflation):
FIFO reports the lower cost of goods sold, higher net income, higher tax
LIFO reports the higher cost of goods sold, lower Net income, lower tax
 In periods of falling prices(deflation):
FIFO reports higher cost of goods sold, lower Net income, Lower taxes
LIFO reports Lower cost of Goods sold, higher net income higher taxes

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Balance sheet effects:
 FIFO reports higher inventory value (it produces the best balance sheet
valuation. This is because the inventory costs are closer to their current, or
replacement costs (since what’s left is the most recently purchased).
 LIFO reports lower inventory value, making financial health appear
weaker.
Average Cost smooths out fluctuations, balancing the effects of FIFO and
LIFO. The value reported under average cost method lays in between FIFO
and LIFO
When prices are constant, all cost flow methods will yield the same results.
 The Need for Consistency
 A company needs to use its chosen cost flow method consistently

from one accounting period to another. Such consistent

application enhances the comparability of financial statements
over successive fiscal periods.

 When a company adopts a different cost flow method, the change

and its effects on net income should be disclosed in the financial

statements
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Exercise 1
The accounting records of Shumway Implements show the following data.

Beginning inventory 4,000 units at € 3

Purchases 6,000 units at € 4
Sales 7,000 units at €12

Determine the cost of goods sold during the period under a periodic inventory
system using (a) the FIFO method, and (b) the average-cost method.

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Exercise 2
Exercise 3

2.
Exercise 4
Effects of Inventory Errors
 Common Cause:
 Failure to count or price inventory correctly
 Not properly recognizing the transfer of legal title to goods
in transit, goods on consignment
 Errors affect both the income statement and the statement of
financial position/balance sheet.

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Income Statement Effects
 Inventory errors affect the computation of cost of goods sold and net income in
two periods. Over two years, total net income is correct because errors offset
each other.
Cost of
Beginning Ending Cost of
+ Goods - =
Inventory Inventory Goods Sold
Purchased

Cost of
When Inventory Error: Goods Sold Is: Net Income Is:
Understates beginning inventory Understated Overstated
Overstates beginning inventory Overstated Understated
Understates ending inventory Overstated Understated
Overstates ending inventory Understated Overstated

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Statement of Financial Position Effects
 Effect of inventory errors on the statement of financial position is determined by
using the basic accounting equation:

Assets = Liabilities + Equity.

 Errors in the ending inventory have the following balance sheet effects:

Ending
Inventory Error Assets Liabilities Equity
Overstated Overstated No effect Overstated
Understated Understated No effect Understated

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Example:
Visual Designs overstated its 2019 ending inventory by Br. 22,000. Determine the
impact on ending inventory, cost of goods sold, net income and owner’s equity in
2019 and 2020.
2019 2020
EI is overstated BI is overstated but EI is un affected(no effect)
CGS is understated CGS is overstated
NI is overstated NI is understated
Owner’s equity overstated Owner’s equity is no effect

Note: Ending inventory in 2020 depends entirely on accuracy of taking and

costing inventory
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Note:
 In 2020, Owner’s equity corrects itself after two years, but net income
is distorted for both years.
 The total impact on net income across both years is zero, but each
year's earnings are distorted.
 The balance sheet is incorrect for 2019 (assets & equity overstated).
 The error self-corrects in 2020, but financial statements remain
misleading unless corrected

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 Example of Effects of Inventory Errors
2019 2020
Incorrect Correct Incorrect Correct
Sales € 80,000 € 80,000 € 90,000 € 90,000
Beginning inventory 20,000 20,000 12,000 15,000
Cost of goods purchased 40,000 40,000 68,000 68,000
Cost of goods available 60,000 60,000 80,000 83,000
Ending inventory 12,000 15,000 23,000 23,000
Cost of good sold 48,000 45,000 57,000 60,000
Gross profit 32,000 35,000 33,000 30,000
Operating expenses 10,000 10,000 20,000 20,000
Net income € 22,000 € 25,000 € 13,000 € 10,000
Combined income
for 2-year period is (€3,000) €3,000
correct. Understated 45
Overstated
Exercise 1
Exercise 2
 Special inventory valuation methods
Lower-of-Cost-or-Net Realizable Value(LCNRV)
 The Lower of Cost or Net Realizable Value (LCNRV) rule is a
principle in inventory valuation that ensures inventory is reported at
the lower of its historical cost or its estimated net realizable value
(NRV).
 This approach aligns with the conservatism principle in
accounting, ensuring that potential losses are recognized in
financial statements as soon as they become apparent.
 When the value of inventory is lower than its cost Companies must
“write down” inventory to its net realizable value.
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 LCNRV is applied when valuing inventory at the end of an
accounting period. It requires comparing:
• Cost: The original price paid to acquire or produce the
inventory.
• Net Realizable Value (NRV): The estimated selling price in
the ordinary course of business, minus any costs necessary to
complete the sale (such as selling and distribution expenses).
i.e. Amount that company expects to realize (receive from the
sale of inventory)

 If NRV is lower than the cost, the inventory is written down to its
NRV. If NRV is higher, the inventory remains at cost.
Example: Assume that Gao TVs has the following lines of merchandise with costs
and net realizable values as indicated. Determine the value of the company’s
inventory under the lower-of-cost-or-net realizable value approach.
Iteme unit Cost per unit Total value Value per unit
Flat-screen TVs 100 Br. 600 60,000 Br. 550
Satellite radios 500 90 45,000 104
DVD recorders 850 50 42,500 48
DVDs 3000 5 15,000 6
Total 162,500
Item LCNRV
Flat-screen TVs
Br. 55,000(Br. 550 x 100)
Satellite radios 45,000(90 x 500)
DVD recorders 40,800(48 x 850)
DVDs 15,000(5 x 3,000)
Total Br. 155,800 50
Exercise: 1
Poon Heaters sells three different types of home heating stoves (gas, wood, and pellet). The cost
and net realizable value of its inventory of stoves are as follows.
Cost Net Realizable Value
Gas NT$ 84,000 NT$ 79,000
Wood 250,000 280,000
Pellet 112,000 101,000
Determine the value of the company’s inventory under the lower-of-cost-or-net realizable value
approach.
Exercise: 2

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Rationale for LCNRV
1. Ensures Accurate Financial Reporting:
LCNRV prevents overstatement of inventory value in financial statements. If
inventory is valued too high, assets and profits would be inflated, misleading
investors and stakeholders.
2. Prevents Future Losses(loss recognition):
Writing down inventory at the first sign of a decline in value allows companies to
recognize losses immediately, rather than delaying them to future periods. This
improves financial transparency.
3. Complies with Accounting Standards:
The Generally Accepted Accounting Principles (GAAP) and International
Financial Reporting Standards (IFRS) require companies to report inventory at the
lower of cost or NRV to reflect economic reality.
 Inventories Estimating Methods
 Businesses often need to estimate inventory levels when physical counts are
not feasible.
 Two circumstances explain why companies sometimes estimate inventories.
First, a casualty such as fire, flood, or earthquake may make it impossible
to take a physical inventory.
Second, managers may want monthly or quarterly financial
statements(interim reports), but a physical inventory is taken only annually.
 The need for estimating inventories occurs primarily with a periodic inventory
system because of the absence of perpetual inventory records.
 Two widely used methods for estimating inventories are:
1. The Gross Profit Method
2. The Retail Inventory Method
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1. The Gross Profit Method
 The Gross Profit Method estimates inventory by applying the historical
gross profit percentage to net sales. This helps determine cost of goods
sold (COGS) and estimate ending inventory.
 The gross profit method is useful for several purposes:
• Used for interim financial reporting when physical inventory counts
are impractical.
• Helps in estimating losses due to theft, fire, or natural disasters.
• Assists in budgeting and forecasting inventory levels.
 Accuracy depends on a consistent gross profit margin.
 Cannot be used for precise year-end reporting
.
Gross Profit Method…
Estimated Estimated
Step 1: Net Sales - Gross = Cost of
Profit Goods Sold

Cost of Goods Estimated Estimated

Step 2: - Cost of = Cost of
Available
for Sale Goods Sold Ending Inventory

Or
Estimated COGS} = Net Sales (1 - Gross Profit %)
Estimated Ending Inventory = Beginning Inventory +Purchases −estimated COGS

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Example:

ABC Company records show net sales of $200,000, beginning inventory

$40,000, and cost of goods purchased $120,000. In the preceding year, the
company realized a 30% gross profit rate. It expects to earn the same rate this
year. Compute the estimated cost of the ending inventory at January 31 under
the gross profit method.

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Solution: Compute the estimated cost of the ending inventory at January 31 under
the gross profit method.
Step 1:
Net sales $200,000
Less: Estimated gross profit (30% × $200,000) 60,000
Estimated cost of goods sold $140,000
Step 2:
Beginning inventory $ 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 $ 20,000

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Exercise
Retail Inventory Method
 The Retail Inventory Method estimates ending inventory by applying the cost-to-retail
percentage to the ending retail value of inventory.
 This method is widely used in retail businesses.
Purpose
• Used by retailers to quickly estimate inventory without a physical count.
• Useful for insurance claims and interim reporting.
• To permit the valuation of inventories when selling prices are the only available data
with out determining cost of goods sold
•Requires retailers to keep a record of:
1) Total cost and retail value of goods purchased.
2) Total cost and retail value of the goods available for sale.
3) Sales for the period
Retail Inventory Method…
Goods Available for Ending Inventory
Step 1: - Net Sales =
Sale at Retail at Retail

Step 2: Goods Available for Goods Available Cost-to-

÷ =
Sale at Cost for Sale at Retail Retail Ratio

Step 3: Ending Cost-to- Estimated Cost of

x =
Inventory at Retail Retail Ratio Ending Inventory

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Example
Determine the estimated cost of goods on hand using Retail Inventory Method
@ cost @ retail
Beginning inventory 14,000 21,500
Goods purchased 61,000 78,500
Net sales 70,000

Ending inventory at retail =GAFSAR – NS = 100,000 – 70,000 = 30,000

Cost-to-retail ratio = $75,000 ÷ $100,000 = 75%
Estimated cost of ending inventory = $30,000 x 75% = $22,500

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Exercise