FINANCIAL ACCOUNTING AND REPORTING

INVENTORIES

Key Terms and Definitions

Inventories are assets:

(a) Held for sale in the ordinary course of business;

(b) In the process of production for such sale; or
(c) In the form of materials or supplies to be consumed in the production process or in the rendering
of services. (eg. Finished goods produced, goods in process and materials and supplies)

** Inventories encompass goods purchased and held for resale. Eg. Merchandise purchased by a retailer
held for resale or land and other property held for resale by a subdivision entity and real estate developer.
** Inventories of a trading concern- one that buys and sells goods. Merchandise Inventory is generally
applied to such goods.
** Inventories of a manufacturing concern- one that buys goods then convert or alter it into another form
before selling them. (Finished goods, goods in process, raw materials and factory or manufacturing supplies)
** factory or manufacturing supplies referred to as indirect materials and are not physically incorporated in the
products being manufactured, since the amounts involved are insignificant.

Net realizable value is the estimated selling price in the ordinary course of business less the estimated costs
of completion and the estimated costs necessary to make the sale.
Fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable,
willing parties in an arms length transaction.
Trade Discounts are deductions from the list or catalog price in order to arrive at the invoice price which is the
amount actually charged to the buyer. Not recorded. Purpose: to encourage trading or increase sales.
Cash Discounts are deductions from the invoice price when payment is made within the discount period.
Recorded as purchase discount by the buyer and sales discount by the seller. Purpose: to encourage prompt
payment.

Methods of Recording Purchases

Gross Method- Purchases and accounts payable are recorded at gross. Violates the Matching Principle but
more convenient.
Net Method- Purchases and accounts payable are recorded at net.
** Payment is made beyond the discount period.
Accounts Payable xx
Purchase Discount Lost (other expense) xx
Cash xx
** At the end of accounting period, no payment is made and discount period has expired.
Purchase Discount Lost xx
Accounts Payable xx

Inventories are initially measured at historical cost. Cost of Inventories includes:

Costs of purchase
Costs of conversion
Other costs incurred in bringing the inventories to their present location and condition.

Costs of Purchase

The costs of purchase of inventories comprise the purchase price, import duties and other non recoverable
taxes and transport, handling and other costs directly attributable to the acquisition of finished goods, materials
and services. Trade discounts, rebates and other similar items are deducted in determining the costs of
purchase.
** Inventories may be purchased on terms, whereby payment is deferred for a specified period; where such
terms constitute a financing arrangement, hence the cost of inventories represents the Present Value of all the
related payment.

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Costs of Conversion

Direct labor
Variable production overhead is indirect cost of production that varies directly with the volume of production
and allocated to each unit using the actual use of production facilities. (eg. Indirect labor and materials)
Fixed production overhead is an indirect cost of production that remains relatively constant regardless of
the volume of production and allocated using the normal operating capacity of production facilities.
(depreciation of factory building)

Other Costs

Other costs are included in the cost of inventories only to the extent that they are incurred in bringing the
inventories to their present location and condition. For example, it may be appropriate to include non-
production overheads or the costs of designing products for specific customers in the cost of inventories.

Inventory cost should exclude:

Abnormal waste
Storage costs unless such costs are necessary in the production process prior to a further production.
** Storage costs on goods in process are capitalized but storage costs on finished goods are expense.
Administrative overheads unrelated to production
Foreign exchange differences arising directly on the recent acquisition of inventories invoiced in a foreign
currency
Interest cost when inventories are purchased with deferred settlement terms.
Selling costs

** Inventory acquired with a forward contract, the cost of the inventory should be the Forward Price adjusted for the
derivative asset or liability (Forward price + derivative asset/liability (FV of forward contract) to be offset upon settlement
of the forward contract.)

Establishment of the Year-End Inventory

Periodic System physical counting of goods on hand at the end of the accounting period. It gives actual or
physical inventories. And generally used when items have small peso investment (such as groceries and auto
parts)
Perpetual System requires stock cards to maintain the inflow and outflow of goods. It is usually used when a
relatively large peso investment is involved (such as jewelry and cars)
** A physical count of the units on hand should be made at least once a year or at frequent interval to determine
the accuracy of the records.
** If the physical count indicates a different amount, an adjustment is necessary to recognize;
Inventory Shortage is closed to Cost of Goods Sold since it is often a normal shrinkage and breakage
in inventory.
Inventory Shortage xx
Merchandise Inventory xx
However, Abnormal and material Shortage shall be classified and presented as other expense.
PERIODIC PERPETUAL
Purchase of merchandise on Purchases xx Merchandise inventory Xx
account Account Payable xx Account Payable Xx
Payment of Freight on the Freight in xx Merchandise inventory Xx
purchase Cash xx Cash Xx
Return of Merchandise on Account Payable xx Account Payable Xx
account Purchase return xx Merchandise inventory Xx
Accounts Receivable xx Accounts Receivable Xx
Sales xx Sales Xx
Sale of merchandise on account
Cost of Goods Sold Xx
No Entry
Merchandise inventory Xx
Sales Return xx Sales Return Xx
Return of Merchandise sold Accounts Receivable xx Accounts Receivable Xx
from customer Merchandise inventory Xx
No Entry
Cost of Goods Sold Xx

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Merchandise xx No adjustment, the balance of the
Adjustment of Ending Inventory inventory-end merchandise inventory account
Income Summary xx represents the ending inventory.

Year-end Inventories includes all items of inventories owned and controlled by the enterprise that are in good, usable
and salable condition within or outside the enterprises premises, such as:

1. Merchandise in Transit
a. FOB Destination, the goods in transit are still property of the seller, therefore included in the inventory of the
seller.
b. FOB Shipping point, the goods in transit are property of the buyer, therefore included in the inventory of the
buyer.
c. If the term of the contract is Cost of Insurance and Freight (CIF), goods should be included as inventory of
the buyer once merchandise is delivered to the carrier. It stipulates that buyer agreed to pay lump sum cost of
the merchandise, insurance as well as the freight cost.
d. If the term of the contract is Free Alongside (FAS) the vessel, the seller is required to bring the goods along
side of the vessel/carrier is borne by the seller. Once the carrier takes possession of the merchandise, title to
the goods passes to the buyer.
2. Goods on Consignment- include as inventory of the consignor and excluded from the consignees inventory.
Consignment method of marketing goods in which the owner (consignor) transfer physical possession of
certain goods to an agent (consignee) who sells them on the owners behalf.
** Goods out on consignment- are owned by the consignor hence included in the inventory at cost plus cost of
transferring the inventory to the consignee.
** Freight (borne by the consignor and must be allocated over the units sold and unsold) and other handling
charges on goods out on consignment are part of the COG consigned.
** To record the cash remittance from consignee:
Cash xx
Commission xx
Expenses xx
Sales xx
** Sales payable to consignor
Sales xx
Less: Expenses paid by the
consignee xx
Commission xx (xx)
Payable to Consignor xx

3. Sales on Approval- Goods sent on approval to a potential buyer should remain as inventory of the seller until
payment is received for items kept by the buyer.
4. Special Sales Contract
a. Product Financing/ park sale, The seller parks (transfers) its inventory in the buyers premises thru sales
contract that specifies to purchase back the same inventory over a specified period of time at a specified
amount. Include as inventory of the seller.
b. Sale but buyer given the right to return, Revenue from sales transaction shall be recognized at the point
of sales only if such conditions are met, otherwise the seller should continue to recognize the inventory
(1) The sellers price to the buyer is substantially fixed or determinable at the date of sales,
(2) The buyer has paid the seller, or the buyer is obligated to pay the seller and the obligation is not
contingent on resale of the product,
(3) The buyers obligation to the seller wouldnt be changed in the event of theft or physical destruction or
damage of the product,
(4) The buyer acquiring the goods for resale has economic substance apart from that provided by the
seller,
(5) The seller doesnt have significant obligation for future performance directly about the resale of the
product by the buyer,
(6) And the amount of future returns can be reasonably estimated.
c. Installment Sales- Goods sold on installment are included in the inventory of the buyer and excluded from
the inventory of the seller. (Application of substance prevail over legal form)
d. Segregated Goods- mere segregation doesnt exclude such inventory; however, if segregation is due to
sales contract such as special order, such inventory is excluded in the inventory of the seller.

Cost Formulas

The cost of inventories of items that are not ordinarily interchangeable and goods or services produced and
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segregated for specific projects shall be assigned by using specific identification of their individual costs.
The cost of inventories that are ordinarily interchangeable shall be assigned by using the first-in, first-out
(FIFO) or weighted average cost formula. An entity shall use the same cost formula for all inventories having
a similar nature and use to the entity. For inventories with a different nature or use, different cost formulas may
be justified.

FIFO Perpetual and Periodic Illustrated

Units Unit Cost Total Cost
Jan. 1 Beginning balance 8,000 70.00 560,000
6 Purchase 3,000 81.00 243,000
Feb. 5 Sale 10,000
Mar. 5 Purchase 11,000 73.50 808,500
Mar. 8 Purchase return 800 73.50 58,800
Apr. 10 Sale 7,000
Apr. 30 Sale return 300
If periodic FIFO is used, the ending inventory will be unit cost from the March 8 purchase and will be
deducted from the accumulation of the beginning inventory and net purchase, known as the total goods
available for sale.
Beginning balance (8,000 x 70) 560,000
Feb. 5 Purchase (3,000 x 81) 243,000
Mar. 5 Net Purchase (10,200 x 73.50) 749,700
Total goods available for sale 1,552,700
Less: Ending Inventory* (4,500 x 73.50) 330,750
Cost of goods sold 1,221,950

*Ending inventory in units (21,200 16,700) 4,500

COGS computation under perpetual

Feb. 5 Costs of goods sold:

Jan. 1 Inventory (8,000 x 70) 560,000

Jan. 6 Inventory (2,000 x 81) 162,000
Total 722,000

April 10 Net Costs of goods sold:

Jan.6 Inventory (1,000 x 81) 81,000

Mar. 5 Inventory (5,700 x 73.50) 418,950
Total 499,950

Jan. 1 Inventory 560,000

6 Purchase 243,000
Total 803,000
Feb. 5 COGS (722,000)
Balance 81,000
Mar. 5 Net Purchase 749,700
Total 830,700
Apr. 10 Net COGS (499,950)
Apr. 30 Inventory balance 330,750

Periodic Average or Weighted Average

Beginning balance (8,000 x 70) 560,000
Feb. 5 Purchase (3,000 x 81) 243,000
Mar. 5 Net Purchase (10,200 x 73.50) 749,700
Total goods available for sale 1,552,700
Less: Ending Inventory* (4,500 x 73.24**) 329,580
Cost of goods sold 1,223,120

Total cost 1,552,700

Divide: by total number of units 21,200
**Weighted average cost per unit 73.24
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Perpetual Average or Moving Average
Jan. 1 Inventory 560,000
6 Purchase 243,000
Total 803,000
Feb. 5 COGS (10,000 x 73.00***) (730,000)
Balance 73,000
Mar. 5 Net Purchase 749,700
Total 822,700
Apr. 10 Net COGS (6,700 * 73.46****) (492,182)
Apr. 30 Inventory balance 330,518

*** Feb 5. Average cost (803,000 / 11,000) 73.00

**** April 10 Average cost (822,700 / 11,200) 73.46
~The average cost will be used to get the remaining
cost of the inventories.~

Change in Cost Flow Method

Change in inventory in prior years doesnt affect the combined income.

Measurement of Inventories
Inventories are required to be stated at the lower of cost and net realizable value (NRV). Inventories are
usually written down to net realizable value item by item. In some circumstances, however, it may be
appropriate to group similar or related items.

EXAMPLE:
Cost NRV LCNRV
Product A 200,000 180,000 180,000
Product B 300,000 250,000 250,000
Product C 100,000 130,000 100,000
Total 600,000 560,000 530,000

The total carrying amount of inventories shall be 530,000, which is the most conservative amount by applying
the LCNRV approach.

Write-Down to Net Realizable Value

If the ending inventory is recorded outright at 530,000, the write-down shall be immediately recognized in cost
of goods sold. This is the direct or cost of sales method.
If the ending inventory is recorded first at the cost of 600,000, a loss of 70,000 with a corresponding credit to an
allowance account shall be recognized. This is the loss/allowance method.
Any write-down to NRV should be recognized as an expense in the period in which the write-down occurs.
Any reversal should be recognized in the income statement in the period in which the reversal occurs.

Recognition as an Expense
When inventories are sold, the carrying amount of those inventories shall be recognized as an expense in the
period in which the related revenue is recognized.
The amount of any write-down of inventories to net realizable value and all losses of inventories shall be
recognized as an expense in the period the write-down or loss occurs.
The amount of any reversal of any write-down of inventories, arising from an increase in net realizable value,
shall be recognized as a reduction in the amount of inventories recognized as an expense in the period in which
the reversal occurs.
Some inventories may be allocated to other asset accounts, for example, inventory used as a component of
self-constructed property, plant or equipment. Inventories allocated to another asset in this way are recognized
as an expense during the useful life of that asset.

Required disclosures:

Accounting policy for inventories.

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Carrying amount, generally classified as merchandise, supplies, materials, work in progress, and finished
goods. The classifications depend on what is appropriate for the enterprise.
Carrying amount of any inventories carried at fair value less costs to sell.
Amount of any write-down of inventories recognized as an expense in the period.
Amount of any reversal of a write-down to NRV and the circumstances that led to such reversal.
Carrying amount of inventories pledged as security for liabilities.
Cost of inventories recognized as expense (cost of goods sold).

Inventory Estimation Techniques

Gross Method Based on the assumption that the gross profit applied by an entity to its products remains
approximately the same from period to period and therefore the relationship between cost of goods sold and
sales is constant.
Goods available for sale X
Less: Estimated cost of goods sold
Net sales* X
Less: Gross profit X X
Estimated ending inventory X

The cost of goods sold can also be computed if the net sale is multiplied by 1 less the GP rate if the gross profit
rate based on sales or net sales divided by 1 plus the gross profit rate if the gross profit rate is based on cost.

*Net sales shall be gross sales less sales returns and allowance or sales returns only in order for the estimate
in ending inventory not to be overstated.

Retail Method Employed by retailers dealing with numerous different items for sale with varying mark up
percentages to keep track unit cost.
Goods available for sale at retail/selling price X
Less: Net sales (Gross sales sales return only) X
Employee discounts X
Normal losses X X
Estimated ending inventory X
Multiplied by the cost ratio %
Estimated ending inventory at cost X

Conservative Cost Ratio = GAS at cost divided by GAS at retail before net markdown
Average Cost Ratio = GAS at cost divided by GAS at retail (after net markdown)
FIFO Cost Ratio = Purchases at cost divided by Purchases at retail after net markdown
A net sale similar to the gross profit method of estimation is computed by ignoring the sales
discount and sales allowance if it is separated from sales returns.

Items related to retail method:

1. Initial Markup- original markup on the Cost of Goods.
2. Original Retail- sales price at which goods are first offered for sale.
3. Additional markup- increase in sales price above the original sales price.
4. Markup Cancelation- decrease in sales price that doesnt decrease the sales price below the original sales price.
5. Net additional markup or net markup= markup markup cancellation
6. Markdown- decrease in sales price below the original sales price.
7. Markdown Cancelation- increase in sales price that doesnt increase the sales price above the original sales
price.
8. Net Markdown= markdown markdown cancelation
9. Maintained Markup/Mark on= Cost Sales price after adjustment for all the above items.

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