University of Kerbela

College of Administration & Economics

Department of Accounting
Accounting in English /2

Chapter 5

Valuation of Inventories:
A Cost-Basis Approach

Learning Objectives
After studying this chapter, you should be able to:
1. Identify inventory classifications and different inventory systems.
2. Describe and compare the cost flow assumptions used to accounting
for inventories.

Lecturers: MSc. Alaa R. & MSc. Hayder S.

Classification
Inventories are:
• asset items held for sale in ordinary course of business, or
• goods to be used in production of goods to be sold

Inventory is considered a current asset because a company normally sells

it within a year or within its operating cycle.
Valuation of inventories affects the amount of inventories on the balance
sheet and the cost of goods sold on the income statement.
Inventory Cost Flow

Inventory Methods
There are two basic methods used to accounting for inventory: Periodic
and Perpetual.
 Perpetual Inventory:
1. Purchases of merchandise are debited to Inventory.
2. Freight-in is debited to Inventory. Purchase returns,
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.

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 Periodic Inventory:
1. Purchases of merchandise are debited to Purchases.
2. Ending Inventory determined by physical count.
3. Calculation of Cost of Goods Sold:
Beginning inventory ×××
Purchases, net + ×××
Goods available for sale ××××
Ending inventory − ×××
Cost of goods sold ××××

Comparing Perpetual and Periodic System

Illustration: ABC Company had the following transactions during the
current year.
Beginning inventory 100 units at $6 = $600
Purchases 900 units at $6 = $5,400
Sales 600 units at $12 = $7,200
Ending inventory 400 units at $6 = $2,400

Record these transactions using the Perpetual and Periodic systems.

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Inventory Cost Flow Assumptions: FIFO, LIFO and Average Cost
Under these three inventory methods, inventory items or units do not retain
their unit purchase cost after the purchase has been recorded. Instead, units
sold during the accounting period and units remaining in inventory at the
end of the accounting period are assigned a cost according to the rules of
FIFO, LIFO or Average Cost.
How costs are assigned the units in ending inventory and units sold is
controlled by two factors:
1. Whether the Periodic or Perpetual inventory method is used.
2. Whether FIFO, LIFO or Average Cost assumption is used for the
flow of costs assigned to inventory and cost of goods sold.
Illustration
XYZ Inc. had the following transactions in its first month of operations.
Date Purchased Sold or Issued Balance
March 2 2,000 @ $4.00 2,000 units
March 15 6,000 @ $4.40 8,000 units
March 19 4,000 units 4,000 units
March 30 2,000 @ $4.75 6,000 units

Calculate Goods Available for Sale.

Beginning inventory (2,000 × $4) $ 8,000

Purchases :
6,000 × $4.40 26,400
2,000 × 4.75 9,500
Goods available for sale $43,900

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 Weighted-Average Method
Date of invoice No. Units Unit Cost Total Cost
March 2 2,000 $4.00 $ 8,000
March 15 6,000 4.40 26,400
March 30 2,000 4.75 9,500
Total goods available 10,000 $43,900
Cost of Goods Available for Sale ÷ Units Available for Sale = Average Unit Cost

$ 4 3 ,9 0 0
W e ig h t e d - a v e r a g e c o s t p e r u n it = $ 4 .3 9
1 0 ,0 0 0

Inventory in units 6,000 units

Ending inventory 6,000 × $4.39 = $26,340

Moving-Average Method
Date Purchased Sold or Issued Balance
March 2 (2,000 @ $4.00) $ 8,000 (2,000 @ $4.00) $ 8,000
March 15 (6,000 @ 4.40) 26,400 (8,000 @ 4.30) 34,400
March 19 (4,000 @ $4.30) $17,200 (4,000 @ 4.30) 17,200
March 30 (2,000 @ 4.75) 9,500 (6,000 @ 4.45) 26,700

In this method, XYZ computes a new average unit cost each time it makes
a purchase.

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First-In, First-Out (F I F O)
• Assumes goods are used in order in which they are purchased
• Approximates physical flow of goods
• Ending inventory is close to current cost
• Fails to match current costs against current revenues
Periodic Inventory System
Date No. Units Unit Cost Total Cost
March 30 2,000 $4.75 $ 9,500
March 15 4,000 4.40 17,600
Ending inventory 6,000 $27,100
Cost of goods available for sale $43,900
Deduct: Ending inventory 27,100
Cost of goods sold $16,800
Determine cost of ending inventory by taking the cost of the most recent
purchase and working back until it accounts for all units in the inventory.

Perpetual Inventory System

In all cases where F I F O 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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Last-In, First-Out (L I F O)
Periodic Inventory System
Date of Invoice No. Units Unit Cost Total Cost
March 2 2,000 $4.00 $ 8,000
March 15 4,000 4.40 17,600
Ending inventory 6,000 $25,600
Goods available for sale $43,900
Deduct: Ending inventory 25,600
Cost of goods sold $18,300
The cost of the total quantity sold or issued during the month comes from
the most recent purchases.

Perpetual Inventory System

The L I F O method results in different ending inventory and cost of

goods sold amounts than the amounts calculated under the periodic
method.