Chapter 2 Inventories

Related standard: PAS 2 Inventories

 Learning Objectives

1. Define inventory and identify the timing of its recognition.

2. Differentiate between the periodic and the perpetual
inventory systems.
3. Measure inventories and apply the cost formulas.
4. Account for inventory write-down and the reversal thereof.
 Example of inventories:
• Merchandise purchased by a trading entity and held
for resale.
• Land and other property held for sale in the ordinary
course of business.
• Finished goods, goods undergoing production, and
raw materials and supplies awaiting use in
production process by a manufacturing entity.
Ordinary course of business means usual business activities of an entity
 Recognition and
Ownership over inventories
• Inventories are recognized when they meet the definition of inventory
and they qualify as assets, such as when legal title is obtained by the
buyer from the seller.
• Legal title normally passes when possession over of the goods is
transferred.
• However, there may be cases where the transfer of control (ownership)
does not coincide with the transfer of physical possession.
• All inventories over which it holds legal title to or has obtained control
must be reported in the entity’s financial statements regardless of its
location.
In this regard, proper consideration should be given to the following 👉next slide
 1. Goods in Transit
• Pertain to the goods already shipped by the seller but
are not yet received by the buyer.
• Depending on terms of sales contract, goods in transit
may form part of either buyer or sellers inventories.
Such terms are either
• FOB shipping point, ownership over the goods is
transferred upon shipment.
• FOB destination, ownership over the goods is
transferred only when the buyer receives the goods.
👉FOB stands for “free on board

👉Sale contracts may also contain terms for shipping costs

indicated by any of the following. Next slide👉
• Freight collect- Freight is not yet paid upon
shipment. The carrier collects shipping costs from
the buyer upon delivery.
• Freight prepaid- The seller pays the freight in
advance before shipment.
• FAS (free alongside)- The seller assumes all the
expenses in delivering the goods to the docks next to
the carrier. The buyer assumes loading and shipping
costs. Title passes upon shipment to the carrier.
• Ex-ship- the seller assumes all expenses
intil the goods are unloaded from the
carrier, at which time title passes to the
buyer.
• CIF (cost, insurance, freight)–the buyer
pays in lump sum the CIF.
• CF (cost and freight)- the buyer pay the
cost of the goods and the freight cost.
👉In either CIF or CF, the seller must deliver the goods to the carrier
and pay the costs of loading. Thus, title passes to the buyer upon
delivery of the goods to the carrier.
👉As a rule, the entity who owns the goods being shipped should
pay for the shipping costs.
 Term of Sales Contract

No special accounting is necessary Special accounting arises in either:

in either:

• FOB shipping point, Freight • FOB shipping point,

collect. Freight prepaid.
• FOB destination, Freight prepaid.
• FOB destination, Freight
• The owner pays freight charges
collect.
of the goods in transit.
• The owner doesn’t pay for
freight charges of the
2. Consigned Goods
• A consignment involves a consignor transferring the goods to
a consignee who acts as agent of the consignor in selling the
goods.
• Consigned goods are included in the consignor’s inventory
and are excluded from the consignee’s inventory.
• Ownership is not transferred to the consignee.
• Transfer of consigned goods are recorded through
memorandum entries.
• Freight and other incidental costs form part of cost of the
consigned goods.
• Commission based sale.
3. Inventory financing agreements
• Inventories may be acquired or sold under various
forms of financing agreements, which may include
the following:
A. Product financing agreement
• The seller sells inventory to a buyer but assumes an
obligation to repurchase it at a later date.
• This arrangement does not result to a transfer of
control over the asset.
• The seller retains the ownership over the inventory.
B. Pledge of inventory
•A borrower uses its inventory as a collateral security for a loan.
•It does not result to a transfer of control over the asset.
•The borrower retains ownership over the inventory.
👉 Warehouse financing – under this arrangement, a third party
(e.g., public warehouse) holds the inventory and acts as the
creditor’s agent. The public warehouse then furnishes the creditor
the warehouse receipts evidencing rights to the inventory.
C. Loan of Inventory
•An entity borrows inventory from another entity to be replaced
with the same kind of inventory.
•Results to a transfer of control over the asset.
•The borrower includes the loaned goods in its inventory.
4. Sale with unusual right of return
• The buyer normally recognizes goods purchased under a
sale with right of return at the time of sale. Unless the
goods purchased does not qualify for recognition as
asset. For example, the buyer does not recognize any
inventory when:
A. The buyer assesses that no economic benefits will be
derived from the goods because they are defective or
unsalable.
B. The buyer intends to return the goods to the seller
within the time limit allowed under the sale agreement.
5. Sale on trial (or approval)
• A seller allows a prospective buyer to use a good for a
given period of time.
• If the buyer is satisfied with the good, he purchases it.
If not, he returns it to the seller.
• The legal title over the goods does not pass to the
buyer until the buyer purchases it. The same as the
buyer does not include it to his inventory until he
purchases the good.
• The goods are considered as sold if it is not returned
within the given period of time.
6. Installment sale
• The possession of the goods is transferred
to the buyer but the seller retains legal
title solely to protect the collectability of
the amount due is considered as a regular
sale.
• Therefore, the goods are excluded from
the seller’s inventory and included in the
buyer’s inventory at the point of sale.
7. Bill and hold arrangememt
• Is a contract of sale under which a seller bills a customer
but retains physical possession of the goods until it is
transferred to the customer at a future date.
• The goods are excluded from the seller’s inventory and
included in the buyer’s inventory upon billing, provided:
👉The reason for the bill and hold arrangement is substantive.
👉The goods are available for immediate transfer to the
customer; and
👉The seller cannot use the goods or sell them to another
customer.
Lay away sale
• Is a type of sale in which goods are delivered only when the
buyer makes the final payment in a series of installments.
• It is different from a regular installment sale where in the
goods are delivered at the time of sale.
• The goods are included in the seller’s inventory until the
goods are delivered to the buyer.
• Delivery is made when the final installment payment is
paid.
• The buyer may include the good in his inventory when there
is significant payments that have been made, provided that
delivery is probable.
 Summary to remember:

Type of arrangement Included in the inventory of

• FOB shipping point 👉Buyer
• FOB destination 👉Seller
• Consigned goods 👉Consignor
• Inventory financing 👉Borrower
• Sale with unusual right of return 👉Buyer, except when unsalable
• Sale on trial (or approval) 👉Seller
• Installment 👉Buyer
• Bill and hold 👉Buyer
• Lay away 👉Seller
 Financial Statement
Presentation

• All items that meet the definition of inventory are

presented on the statement of financial position as
one line item under the caption “Inventories”.
• The breakdown is disclosed in the notes.
• Inventories are classified as current assets.
 Accounting for inventories
The major objectives of inventory accounting are:
• Proper determination of periodic income through the
recognition of appropriate costs which are matched with
revenue.
• Proper representation of inventories recognized as asset in
the financial statements.
👉Inventories are accounted for either through:
a. Perpetual Inventory System
b. Periodic Inventory System
Perpetual inventory system
• The “inventory“ account is updated each time a
purchase or sale is made.
• The “inventory” account shows continuing or running
balance of the goods on hand.
• Maintenance of stock cards and stock ledgers.
• Without the need of physical count.
• All increases and decreases in inventory are recorded in
the “Inventory” account.
• Commonly used for specifically identifiable and relatively
high valued inventories.
Periodic inventory system
• Increases and decreasen in inventory during the period are recorded in
the purchases, freight-in, purchase returns, and purchase discounts.
• Cost of Goods Sold is not recorded
• Physical count is necessary to determine the balances of inventory on
hand and cost of goods sold.
• Requires the use of the following formula when determining the cost
of goods sold.
Beginning Inventory P xx
Add: Net Purchases xx .
Total Goods Available for Sale xx
Less: Ending inventory (physical count) (xx) .
Cost of Goods Sold P xx
 Inventory Shortages/Overages
• When an entity uses a perpetual inventory system and a difference exist between
the perpetual inventory balance and the physical inventory count, there is
inventory shortage or overage.
Illustration:
Assume that at the end of the reporting period, the perpetual inventory account
reported an inventory balance of P3,800. However, the physical count only shows
P3,600 is actually on hand. Prepare necessary journal entries to adjust the balances.
• Loss on inventory shortage P 200
(or Inventory shortage or overage)
Inventory 200

• Inventory shortage is charged to cost of goods sold if it is considered normal

spoilage, if abnormal (theft) it is charged as loss.
• Periodic inventory system does not report the account Inventory shortage/overage
because it subsumes them in the cost of goods sold.
Inventory errors under the periodic system
• The cost of goods sold as the residual amount is affected by errors in
ending inventory as well as beginning inventory and net purchases.
• When the cost of goods sold is misstated, so is the profit for the
period.
• The following relationship between accounts can provide guidance in
determining the effects of inventory errors on profit or loss under a
periodic system.
👉Ending inventory : Profit – Direct relationship
👉Beginning inventory & Purchases : Profit – Inverse Relationship
👉Ending inventory : Cost of goods sold – Inverse relationship
👉Beginning inventory & Purchases : Cost of goods sold – Direct
relationship
Measurement
• Inventories are measured at lower of
cost and net realizable value. (LCNRV)
Cost of inventories comprises the following :

A. Purchase cost- this includes the purchase price(net of

trade discount and other rebates), import duties, non-
refundable or non-recoverable purchase taxes, and
trasport, handling and other cost directly attributable to
the acquisition of the inventory.
Value-Added Taxes are not included for in the purchase
cost of VAT payers because it is recoverable. But it is
included in the purchase costs of Non- VAT payer.
• Trade discounts, rebates and other similar items are
detucted in determining the purchase costs.
B. Conversion costs- these refer to the costs
necessary in converting raw materials into
finished goods. Conversion costs include
direct labor and production overhead costs.
C. Other costs necessary in bringing the
inventories to their present location and
condition.
The following are excluded from the cost of
inventories and expensed outright:
a. Abnormal amounts of wasted materials, labor or
other production cost.
b. Selling costs, advertising and promotion costs
and delivery expense or freight-out.
c. Administrative overheads that are not necessary.
d. Storage costs unless necessary.
Trade discounts and Cash discounts
Trade discounts
• Given to encourage orders in large quantities.
• They do not form part of the cost of inventory.
• They are deducted from the list price in order to determine the
invoice price.
• And are not recorded in the books of either the buyer and seller.
Cash discounts
• Given to encourage promt payment.
• They are deducted from the invoice price in order to determine
the amount of net payment required within the discount period.
Accounting for cash discounts
Two accounting methods for cash discounts :
A. Gross Method- The cost of inventory and
accounts payable are recorded gross of cash
discounts. Purchase discounts are recorded
under the “Purchase discounts” account only
when taken. Purchase discounts is deducted
from gross purchases when computing for
net purchases.
•B. Net Method- The cost of inventory and accounts
payable are initially recorded net of cash discounts,
regardless of whether such duscounts are taken or not.
•Purchase discounts not taken are recorded under the
“Purchase discounts lost” account and included as part
of “other expense” or as “finance cost” (interest
expense).
•Cash discounts not taken reflects penalties.
•Theoretically, the net method should be used. However,
the gross method is more commonly used.
 Conversion Costs
•Refer to or the sum of direct labor and manufacturing overhead costs, which
are necessary in converting raw materials into finished goods.
•On the other hand, prime costs refer to the sum of direct materials and direct
labor costs.
•Manufacturing overhead are costs of production that are not directly
traceable to finished goods.
•Manufacturing overhead are subclassified into:
[Link] production overheads – are indirect costs of production that vary
directly with the volume of production, such as indirect materials and
indirect labor.
[Link] production overhead- are indirect costs of production that remain
relatively constant regardless of the volume of production such as
depreciation, maintenance of the factory buildings and equipment and cost
of factory management and administration.
Absorption costing and Variable costing
• Absorption (full) costing- is a costing method in
which both fixed and variable production overheads
are included in cost of inventories.
• Variable costing- is a costing method in which only
variable production overhead is included in cost of
inventories. Fixed production overhead is expensed
immediately.
• PAS 2 requires the use of absorption costing. Variable
costing is used only for internal reporting purposes.
Joint and By-products
• A production process may result in more than one product being
produced simultaneously.
• Joint products are produced (i.e., main product and a by product)
• When the conversion costs of each product are not separately
identifiable, they are allocated between the products on a rational
and consistent basis.
• The allocation may be based, for stage in the production process
when the products become separately identifiable, or at the
completion of production.
• Most by-products, by nature, are immaterial. In this case, they are
often measured at net realizable value and this value is deducted
from the cost of the main product.
Standard cost system
• Standard costs are budgeted inventory unit costs
established to motivate optimal productivity and
efficiency. Standard costs take into account normal levels
of materials and supplies, labor, efficiency and capacity
utilization. They are regularly reviewed and, if necessary,
revised in the light of current conditions.
• A standard cost system is designed to alert management
when the actual costs of production differ significantly
from target or standard cost. The use of a standard cost
system is allowed under PAS 2 for convenience provided
the results approximate cost.
Borrowing costs
• Borrowing costs(interest expense) forms part
of the cost of inventory only if it is incurred on
borrowings taken to finance the acquisition or
production of inventory that meets the
definition of a qualifying asset. A qualifying
asset is an asset that necessarily takes a
substantial period of time to get ready for its
intended use or sale. All other interests are
charged as expenses.
Deffered settlement terms
• When payment for purchases is deferred
and the arrangement effectively contains
a financing element, the difference
between the purchase price for normal
credit terms and the amount paid is
recognized as interest expense over the
period of the financing.
👉see the book for more comprehensive illustrations.
Cost of agricultural produce harvested from biological
assets

• Inventories comprising agricultural

produce harvested from biological assets
are initially measured at fair value less
cost to sell at the point of harvest in
accordance with PAS 41 Agriculture. This
will be deemed cost for subsequent
measurement at the lower of cost and
net realizable value using PAS 2.
Cost of inventories purchased in lump sum

• The cost of different inventories having

different values purchased on a lump
sum basis is allocated to the inventories
based on their relative sales prices.
👉see the book for more comprehensive illustrations.
 Cost Formulas
• One of the major objectives of inventory accounting is the
determination of costs of inventories recognized as expense
when the related revenues are recognized. This is important for
the proper determination of periodic income. Proper
determination of such costs may be obtained by selecting an
appropriate cost formula.
• The cost formulas only refer to “cost flow assumptions”, and not
necessarily the physical flow of the entity that may vary.
• PAS 2 does not permit the use of last-in, first-out (LIFO) cost
formula.
1. Specific Identification
• This shall be used for inventories that are not ordinarily
interchageable and those that are segregated for specific
projects.
• Under this formula, specific costs are attributed to
identified items of inventory. Accordingly, cost of sales
represents the actual costs of the specific items sold while
ending inventory represents the actual costs of the specific
items on hand.
• Specific identification, however, is not appropriate when
inventories consist of a large number of items that are
ordinarily interchageable.
2. First-In, First-Out (FIFO)
• Under this formula, it is assumed that inventories that were
purchased or produced first are sold first, and therefore
unsold inventories at the end of the period are those most
recently purchased or produced.
• Accordingly, cost of sales represents costs from earlier
purchases while the cost of ending inventory represents
costs from the most recent purchases.
• There are two ways or classifications of using FIFO formula
which are the FIFO periodic and FIFO perpetual.
Accordingly, both ways produced the same outcome.
👉Illustration will be discussed by the presenter.
Weighted Average
• Under this formula, cost of sales and ending inventory are determined
based on the weighted average cost of beginning inventory and all
inventories purchased or produced during the period. The average
may be calculated on a periodic basis or as each additional purchase is
made, depending upon the circumstances of the entity.
• There are also two classifications of using the Weighted Average
method which are the Weighted Average- periodic and Weighted
Average- perpetual (Moving Average) that produces different
outcomes of the costs of ending inventory and the cost of goods sold.

👉Illustration will be discussed by the presenter.

 Net realizable value (NRV)
• Inventories are measured at the lower of cost and net realizable value.
• Net realizable value is “the estimated selling price in the ordinary course of the
business less the estimated costs of completion and the estimated costs
necessary to make the sale.
• NRV is different from fair value.
• The former is an entity-specific value and the latter is not.
• Measuring inventories at LCNRV is in line with the basic accounting concept that
an asset shall not be carried at an amount that exceeds it recoverable amount.
• If the inventory exceed its recoverable amount, the cost of inventory is written
down to NRV on an item by item basis.
• The amount of write-down is recognized as expense.
Write-down of inventory
•Write-down of inventories are usually carried out on an item by item
basis, although in some circumstances, it may be appropriate to group
similar items.
•It is not appropriate to write down inventories on the basis of their
classification.
•If the cost of an inventory exceeds its NRV, the inventory is written down
to NRV, the lower amount. The excess of cost over NRV represents the
amount of write-down. If the cost of an inventory is lower than its NRV, no
write-down is necessary.
•Write-down of inventories are normally charged to cost of goods sold.
•Material write-downs and those that arise from abnormal losses are
charged as loss.
👉Illustration will be discussed by the presenter.
Write-down or raw materials
• Raw materials inventory is not written down
below cost if the finished goods in which
they will be incorporated are expected to be
sold at or above cost. If, however, this is not
the case, the raw materials are written
down to their NRV. The best evidence of
NRV for raw materials is replacement cost.
👉Illustration will be discussed by the presenter.
Reversal of write-downs
• If the NRV subsequently increases, the
previous write-down is reversed.
However, the amount of reversal shall
not exceed the original write-down.
This is so that the new carrying amount
amount is the lower of the cost and the
revised NRV.
👉Illustration will be discussed by the presenter.
 Purchase Commitments
•A firm purchase commitment is “an agreement with an unrelated party, binding
on both parties and usually legally enforceable, that
[Link] all significant terms, including the price and timing of the transactions.
[Link] a disincentive for non-performance that is sufficiently large to make
perfromance highly probable.
•A contracting party under a purchase commitment cannot cancel without
suffering penalty.
•The buyer must accept the goods even if it become impaired and charges it as
loss on purchase commitment.
•Loss on purchase commitment is recognized only in guaranteed future
purchases.
•When the prices subsequently increases, the buyer recognizes gain on purchase
commitment.
👉Illustration will be discussed by the presenter.
T-Account analysis
• Most accounting problems can be
solved much easier using T-account
analysis than formulas.
• Common accounting problems
regarding inventory can be solved using
T-accounts.
👉Illustration will be discussed by the presenter.
Thank You😊