Page 281 - Accounting Principles (A Business Perspective)

7. Measuring and reporting inventories

In Exhibit 44 the correctly stated ending inventory for the year 2009 is USD 35,000. As a result, Allen has a
gross margin of USD 135,000 and net income of USD 50,000. The statement of retained earnings shows a
beginning retained earnings of USD 120,000 and an ending retained earnings of USD 170,000. When the ending

inventory is overstated by USD 5,000, as shown on the right in Exhibit 44, the gross margin is USD 140,000, and
net income is USD 55,000. The statement of retained earnings then has an ending retained earnings of USD
175,000. The ending inventory overstatement of USD 5,000 causes a USD 5,000 overstatement of net income and a
USD 5,000 overstatement of retained earnings. The balance sheet would show both an overstated inventory and an
overstated retained earnings. Due to the error in ending inventory, both the stockholders and creditors may
overestimate the profitability of the business.
Exhibit 45 is a continuation of Exhibit 44 and contains Allen's operating results for the year ended 2010

December 31. Note that the ending inventory in Exhibit 44 now becomes the beginning inventory of Exhibit 45.
However, Allen's inventory at 2010 December 31, is now an accurate inventory of USD 45,000. As a result, the
gross margin in the income statement with the beginning inventory correctly stated is USD 145,000, and Allen
Company has net income of USD 91,500 and an ending retained earnings of USD 261,500. In the income statement
columns at the right, in which the beginning inventory is overstated by USD 5,000, the gross margin is USD
140,000 and net income is USD 86,500, with the ending retained earnings also at USD 261,500.
Thus, in contrast to an overstated ending inventory, resulting in an overstatement of net income, an overstated
beginning inventory results in an understatement of net income. If the beginning inventory is overstated, then cost
of goods available for sale and cost of goods sold also are overstated. Consequently, gross margin and net income

are understated. Note, however, that when net income in the second year is closed to retained earnings, the
retained earnings account is stated at its proper amount. The overstatement of net income in the first year is offset
by the understatement of net income in the second year. For the two years combined the net income is correct. At
the end of the second year, the balance sheet contains the correct amounts for both inventory and retained
earnings. Exhibit 46 summarizes the effects of errors of inventory valuation:

Ending Inventory Beginning Inventory
Understated Overstated Understated Overstated
Cost of good sold Overstated Understated Understated Overstated
Net income Understated Overstated Overstated Understated

Exhibit 46: Inventory errors
Determining inventory cost
To place the proper valuation on inventory, a business must answer the question: Which costs should be

included in inventory cost? Then, when the business purchases identical goods at different costs, it must answer the
question: Which cost should be assigned to the items sold? In this section, you learn how accountants answer these
questions.
The costs included in inventory depend on two variables: quantity and price. To arrive at a current inventory
figure, companies must begin with an accurate physical count of inventory items. They multiply the quantity of
inventory by the unit cost to compute the cost of ending inventory. This section discusses the taking of a physical
inventory and the methods of costing the physical inventory under both perpetual and periodic inventory

procedures. The remainder of the chapter discusses departures from the cost basis of inventory measurement.

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