1.1 Introduction

In the last ar of values of accounting I, you have actually learned around the principles and also practices of bookkeeping for receivables – one of the current asset items in the balance sheet of a retail business. In this unit you will certainly learn and discuss the ideas in bookkeeping for inventories.

You are watching: The inventory system that uses the merchandise inventory account as an active account is called

Inventories space asset items hosted for revenue in the ordinary course of service or products that will certainly be offered or consumed in the manufacturing of items to be sold. They room mainly separated into 2 major:

Inventories that merchandising businessesInventories of production businesses

i. Inventories the merchandising businesses are merchandise purchased because that resale in the common course the business. These types of inventories are called merchandise inventories.

ii. Inventories of production businesses production businesses are businesses that create physical output. They generally have three varieties of inventories. This are:


Raw material inventoryWork in procedure inventoryFinished products inventory


1. Raw product inventory -is the price assigned come goods and materials on hand yet not yet inserted into production. Life materials encompass the lumber to do a chair or other office furniture’s, the steel to make a automobile etc.

2. Work in process inventory- is the price of raw product on which production has been started however not completed, to add the direct labor cost used specifically to this material and allocated manufacturing overhead costs.

3. Finished items inventory- is the expense identified with the completed however unsold devices on hand at the finish of each period.

In this unit only the determination of the list of goods purchased for resale typically called merchandise inventory will be discussed.


1.2 prestige of Inventories

Merchandise purchased and also sold is the most energetic elements in merchandising business, i.e. In wholesale and retail kind of businesses. This is due to the complying with reasons:

The revenue of was is the principal source of revenue because that them.The expense of merchandise offered is the biggest deductions indigenous sales.Inventories (ending inventories) room the biggest of the current assets or those firms.

Because that the over reasons inventories, have effects on the current and the adhering to period’s financial statements. If inventories room misstated (understated that overstated), the gaue won statements will be distorted.


1.3 The impacts of inventories on current and also following period’s jae won statements.

1.3.1 result of finishing inventory on present period’s financial statements

Ending inventory is the expense of merchandise on hand in ~ the finish of accountancy period. Let us see its result on present period’s gaue won statements.

Income statement

a. Cost of products (merchandise) sold =Beginning list + Net purchase – ending inventory

As girlfriend see, ending inventory is a remove in calculation price of merchandise sold. So, it has actually an indirect (negative) partnership to price of was sold, i.e. If finishing inventory is understated, the price of merchandise marketed will be overstated, and also if ending inventory is overstated, the price of merchandise marketed will it is in understated.

b. Gross profit = network sales – cost of merchandise offered

Here, the expense of was sold had indirect relationship to gun profit. So, the effect of ending inventory on gross profit is the contrary of the effect on expense of was sold. That is, if ending inventory is understated, the gun profit will certainly be understated and if ending inventory is overstated, the pistol profit will be overstated. This is a direct (positive) relationship.

c. Operating revenue = Gross profit – operation Expenses

Gross profit and operating income have straight relationships. Thus, the impact of ending inventory on net income is the same as its effect on gross profit, i.e. Direct (positive) impact (relationship).

Balance Sheet

Current assets - finishing inventory is component of current assets, even the largest. So, it has actually a direct (positive) relationship to existing assets. If finishing inventory balance is understated (overstated), the total current assets will certainly be understated (overstated). Due to the fact that current heritage are part of complete assets, finishing inventory has straight relationship to total assets.Liabilities- No impact on liabilities. Perform misstatement has actually no effect on liabilities.Owners’ equity – The net revenue will be moved to the owners’ same at the end of audit period. Closing income review account walk this. So, net earnings has direct relationship v owners’ equity at the end of accountancy period. The effect-ending list on owners’ equity is the same as its impact on net income, i.e. If finishing inventory is understated (Overstated), the owners’ equity will certainly be understated (Overstated). 

1.3.2 results of start inventory on present period’s financial statements

Beginning inventory is list balance that was left on hand in the previous duration and transferred to the current period. Its impact is summarized below:

Income Statement

Cost of merchandise sold= start inventory + net Purchases – finishing inventory As you see, beginning inventory is an addition in determining expense of products sold. It has direct effect on expense of was sold. The is, if the beginning inventory is understated (Overstated), the cost of merchandise marketed will be understated (Overstated)Gross Profit= net Sales – expense of goods soldThe result of start inventory top top gross benefit is opposing of the result on expense of goods sold, i.e. Indirect (negative) relationship. If the beginning inventory is understated, the gross profit will be overstated and also if the is overstated, the gun profit will be understated.Net income = Gross benefit – operation expensesThe result of start inventory on net revenue is the exact same as its impact on gross profit.

Balance sheet

Current assets – The inventory contained in present assets is the finishing inventory. So, start inventory has no result on current assets.Owners’ equity- If the effect comes from the ahead year, the start inventory will not have actually an effect on finishing owners’ equity due to the fact that the positive or negative effect of the previous year will certainly be netted turn off by the an adverse or positive result of the present year. However if the error is make in the present period, the will have actually indirect effect on finishing owners’ equity.


1.3.3 result of ending inventory ~ above the following period’s jae won statements

The ending inventory the the current duration will come to be the start inventory because that the adhering to period. So, that will have the same result as start inventory of the present period. Let us summarize it.

Income declare of the following period

price of merchandise marketed ---> direct relationship

Gross benefit ---> indirect relationship

Net income ---> indirect relationship

Balance paper of the complying with period

The ending inventory that the current period will not have actually an effect on the complying with period’s balance sheet items.

Illustration - 1

The following quantities were reported in Belay Company’s gaue won statements for three consecutive fiscal year finished December 31.

2000 2001 2002

a) cost of merchandise sold Br. 130,000 Br. 154,000 Br. 140,000

b) Net earnings 40,000 50,000 42,000

c) full Current legacy 210,000 230,000 200,000

d) Owner’s equity 234,000 260,000 224,000

In do the physical counts the inventory, the complying with errors to be made:

m perform on December 31,2000, under stated by Br. 12,000

m list on December 31, 2001, exaggeration by Br. 6000


Determine the correct amount the the items noted above.


2000 2001 2002

Cost of goods sold:

report Br. 130,000 Br. 154,000 Br. 140,000

adjustment of

2000 error (12,000) 12,000 _

2001 error _ 6,000 (6,000)

repair Br. 118,000 Br. 172,000 Br. 136,000

Net income:

reported Br. 40,000 Br. 50,000 Br. 42,000

convey of

2000 error 12,000 (12,000) _

2001 error _ (6,000) 6,000

corrected Br. 52,000 Br. 32,000 Br. 48,000


Total present assets:

Reported Br. 210,000 Br. 230,000 Br. 200,000

Adjustment of

2000 error 12,000 _ _

2001 error _ (6,000) _

repair Br. 222,000 Br. 224,000 Br. 200,000


Owner’s equity:


reported Br. 234,000 Br. 260,000 Br. 224,000

adjustment of

2000 error 12,000 _ _

2001 error _ (6,000) _

corrected Br. 246,000 Br. 254,000 Br. 224,000


1.4 list Systems: routine Vs perpetual

There room two primary systems that inventory audit periodic and perpetual.

1.4.1 routine inventory system

Under this device there is no consistent record that merchandise inventory account. The list balance stays the exact same through out the audit period, i.e. The start inventory balance. This is because when items are purchased, they room debited come the purchase account quite than merchandise list account.

The revenue from sales is recorded each time a sale is made. No entrance is created the cost of items sold. So, physics inventory must be take away periodically to identify the expense of inventory on hand and also goods sold.

The regular inventory mechanism is much less costly to keep than the perpetual inventory system, yet it offers management less information about the existing status of merchandise.

This mechanism is often used by sleeve enterprises the sell numerous kinds of low unit cost merchandise such as groceries, drugstores, hardware etc.

The journal entries to be ready are:

At the time of purchase of merchandise: to buy XX accounts payable or cash XX
At the moment of sale of merchandise: account receivable or cash XX Sales XXTo record purchase returns and allowance: account payable or cash XX purchase returns and allowance XXTo document adjusting entrance or closeup of the door entry because that merchandise inventory: Income review XX Merchandise perform (beginning) XX

To close beginning inventory

Merchandise inventory (ending) XX

Income an introduction XX

To record finishing inventory


1.4.2 Perpetual list system

Under this mechanism the accountancy record repetitively disclose the lot of inventory. So, the list balance will not remain the very same in the bookkeeping period. All increases are debited come merchandise list account and all decreases are credited to the exact same account.

There room no purchases and purchase returns and also allowances account in this system. At the time of sale, the price of goods sold is tape-recorded in enhancement to journal entry for the sale. So, we deserve to determine the expense of inventory and goods offered from the accounting record. No require of physics counting to determine their costs.

Companies that market items that high unit value, such as appliances or automobiles, tended to use the perpetual perform system.

Given the number and also diversity of items included in the merchandise inventory of most businesses, the perpetual inventory mechanism is usually much more effective for keeping track the quantities and also ensuring optimal customer service. Monitoring must pick the mechanism or combination of systems that is finest for afford the company"s goal.

Journal entries come be ready are:

1. At the moment of acquisition of merchandise

Merchandise inventory XX

accounts payable/cash XX

To record price of goods sold

2. At the time of sale of merchandise

account receivable or cash XX

Sales XX

To record cost of goods sold


To record the sales

cost of goods sold XX

Merchandise perform XX

To record the cost of merchandise sold

3. Come record purchase returns and allowances

accounts payable or cash XX

Merchandise list XX

4. No adjusting entry or closing entry for merchandise list is needed at the end of each audit period.

Illustration – 2

In its start inventory on jan 1, 2002, NINI company had 120 units of was that cost Br. 8 every unit. The adhering to transactions to be completed throughout 2002.

February 5 purchase on credit transaction 150 devices of merchandise at Br. 10 every unit.

reverted 20 detective systems from February 5 purchases to the supplier.

June 15 Purchased for cash 230 devices of merchandise in ~ Br 9 per unit.

September 6 offered 220 units of merchandise because that cash at a price that Br. 15 every unit. These

products are: 120 systems from the start inventory and 100 systems for February


December 31 260 units space left top top hand, 30 units from February 5 purchases.

See more: What Divides The Inner And Outer Planets In Our Solar System

Required: Prepare basic journal entries because that NINI agency to record the above transactions and adjusting or closeup of the door entry because that merchandise perform on December 31,

Periodic inventory systemPerpetual list system


a) February 5 purchase (150 x Br.10) 1,500

Account payable 1,500

9 account payable (20 x Br. 10) 200

purchase returns and also allowances 200

June 15 to buy (230 x Br. 9) 2,070

Cash 2,070

 September 6 Cash (220 x Br. 15) 3,300

Sales 3,300

December 31 To record or near the merchandise list account

Income an introduction (120 x Br. 8) 960

Merchandise list (beginning) 960

_To nearby the beginning inventory

goods inventor (ending) 2,370

Income summary <(30 x Br. 10) + (230 x Br. 9)> 2,370 

_ To document the finishing merchandise perform

b) February 5 Merchandise inventory 1,500

account payable 1,500

9 accounts payable 200

Merchandise perform 200

June 15 Merchandise inventory 2,070

Cash 2,070

September 6 i) To record the sales

Cash 3,300

Sales 3,300

ii) come record expense of was sold

= (120 x Br. 8) + (100 x Br. 10)

= Br. 960 + Br. 1,000 = Br. 1,960

cost of merchandise marketed 1,960

Merchandise inventory 1,960

December 31 No entry is necessary to document or near merchandise inventory account.