CHAPTER IIAccounting for Inventories2.1 IntroductionIn the last section of Principles of Accounting I, you have learned about the principles and practices ofaccounting for receivables – one of the current asset items in the balance sheet of a retail business. In this unityou will learn and discuss the concepts in accounting for inventories.Inventories are asset items held for sale in the ordinary course of business or goods that will be used orconsumed in the production of goods to be sold. They are mainly divided into two major:Inventories of merchandising businessesInventories of manufacturing businessesI. Inventories of merchandising businesses are merchandise purchased for resale in the normal course ofbusiness. These types of inventories are called merchandise inventories.II. Inventories of manufacturing businesses manufacturing businesses are businesses that produce physicaloutput. They normally have three types of inventories. These are:Raw material inventoryWork in process inventoryFinished goods inventory1.Raw material inventory-is the cost assigned to goods and materials on hand but not yet placedintoproduction. Raw materials include the wood to make a chair or other office furniture’s, the steel to make a caretc.2.Work in process inventory-is the cost of raw material on which production has been started but notcompleted, plus the direct labor cost applied specifically to this material and allocated manufacturing overheadcosts.3.Finished goods inventory-is the cost identified with the completed but unsold units on hand at the end ofeach period.In this unit only the determination of the inventory of merchandise purchased for resale commonly calledmerchandise inventorywill be discussed.2.2 Importance of InventoriesMerchandise purchased and sold is the most active elements in merchandising business, i.e. in whole sale andretail type of businesses. This is due to the following reasons:1. The sale of merchandise is the principal source of revenue for them.2. The cost of merchandise sold is the largest deductions from sales.3. Inventories (ending inventories) are the largest of the current assets or those firms.Because of the above reasons inventories, have effects on the current and the following period’s financialstatements. If inventories are misstated (understated of overstated), the financial statements will be distorted.
2.3 The Effects of inventories on current and following period’s financial statements.2.3.1 Effect of ending inventory on current period’s financial statementsEnding inventory is the cost of merchandise on hand at the end of accounting period. Let us see its effect oncurrent period’s financial statements.Income statementa.Cost of goods (merchandise) sold =Beginning inventory + Net purchase –Ending inventoryAs you see, ending inventory is a deduction in calculation cost of merchandise sold. So, it has an indirect(negative) relationship to cost of merchandise sold, i.e. if ending inventory is understated, the cost ofmerchandise sold will be overstated, and if ending inventory is overstated, the cost of merchandise sold will beunderstated.