UNIT ONEACCOUNTING FOR INVENTORIES1.1INTRODUCTIONIn the last section of Principles of Accounting I, you have learned about the principles andpractices of accounting for receivables – one of the current asset items in the balance sheet of aretail business. In this unit you 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 beused or consumed 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 thenormal course of business. These types of inventories are calledmerchandiseinventories.ii.Inventories of manufacturing businesses: -manufacturing businesses are businesses thatproduce physical output. 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 yetplacedinto production. Raw materials include the wood to make a chair or other officefurniture’s, the steel to make a car etc.2.Work in process inventory-is the cost of raw material on which production has been startedbut not completed, plus the direct labor cost applied specifically to this material and allocatedmanufacturing overhead costs.3.Finished goods inventory-is the cost identified with the completed but unsold units on handat the end of each period.In this unit only the determination of the inventory of merchandise purchased for resalecommonly calledmerchandise inventorywill be discussed.1 |P a g e
1.2 THE EFFECTS OF INVENTORIES ON CURRENT AND FOLLOWING PERIOD’SFINANCIAL STATEMENTS.1.2.1 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 seeits effect on current period’s financial statements.Income statementa.Cost of goods (merchandise) sold =Beginning inventory + Net purchase – EndinginventoryAs you see, ending inventory is a deduction in calculation cost of merchandise sold. So, it has anindirect (negative) relationship to cost of merchandise sold, i.e. if ending inventory isunderstated, the cost of merchandise sold will be overstated, and if ending inventory isoverstated, the cost of merchandise sold will be understated.b.Gross Profit = Net sales – Cost of merchandise soldHere, the cost of merchandise sold had indirect relationship to gross profit. So, the effect ofending inventory on gross profit is the opposite of the effect on cost of merchandise sold. That is,if ending inventory is understated, the gross profit will be understated and if ending inventory isoverstated, the gross profit will be overstated. This is a direct (positive) relationship.