6 PAS 2 - INVENTORIES

• Objectives, Scope and Definition – Q&A #1-5

• Recognition – Q&A #6-11
• Measurement – Q&A #12-30
• Presentation and Disclosure – Q&A #31-32
• PFRS for SMEs

OBJECTIVES, SCOPE AND DEFINITION
1. What are the objectives of PAS 2?
The objectives of PAS2 are:
a. To prescribe the accounting treatment for inventories, primarily the amount of cost to
recognized as an asset and carried forward until the related revenues are recognized;
b. To provide guidance on the determination of cost and its subsequent recognition as an
expense, including any write-down to net realizable value; and
c. To provide guidance on the cost formulas that are used to assign costs to inventories.

2. What are those inventories which is not totally within PAS 2?
a. Financial Instruments (PAS 32 and PAS 9 Financial Instruments); and
b. Biological assets related to agricultural activity and agricultural produce at the point of
harvest (PAS 41 Agriculture)

3. What are those inventories which is not within PAS 2 – Measurement?
a. Inventories held by producers of agricultural and forest products, agricultural produce
after harvest, and minerals and mineral products.
b. Inventories held by commodity brokers who measure their inventories at fair value less
costs to sell.
However, the requirement of PAS2 with respect to recognition, disclosure and
presentation continues to apply.

4. What are Inventories:
Inventories are assets:
a. Held for sale in the ordinary course of business (Finished Goods Inventory)
b. In the process of production for such sale (Work in Process Inventory)
c. In the form of materials or supplies to be consumed in the production process or in the
rendering of services (Raw Materials Inventory)

5. What are different entities that considers accounting for inventories?
a. Merchandising Entity – it has a single inventory account usually entitled merchandise
inventory. These are goods on hand that are purchased for resale.
b. Manufacturing Entity – it has three inventory accounts Raw Materials inventory, Work
in Process Inventory and Finished Goods Inventory.

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RECOGNITION

As an asset
6. When to recognize inventory as an asset?
An inventory can only be an asset to the entity if the present economic resource is
controlled by the entity at the date of the statement of financial position. In other words, all
goods to which an entity has title shall be included as part of an asset, therefore an inventory,
regardless of location.

Determination of legal title or ownership of inventory will not matter on day to day
transactions but critical on cut-off date (at the end of an accounting period) to properly
determine the inventory value.

As an expense
7. When to recognize inventories as expense?
a. When inventories are sold
b. When the inventories are written down to net realizable value and all losses of
inventories.
c. Inventories that are allocated to other asset accounts wherein the expense are
recognize during the useful life of the asset.

Ownership of Goods
8. Who is the owner of goods when items are in transit?
Items that are in transit are owned by entities dependent on the shipping terms used in
overland shipping contracts (ex. FOB) or maritime transport contract (ex. FAS, CIF, Ex-ship)

FOB stands for Free on Board. If the goods are shipped FOB Destination, the ownership
title will transfer to the buyer upon receipt of the item. Therefore, when the items are still in
transit, the goods are part of the inventory of the seller and at the same time the seller is
responsible for the payment of shipment.

If the goods are shipped FOB shipping point, the ownership title will transfer to the buyer
upon shipment or when the carrier takes possession. Therefore, when the items are still in
transit, the goods are already part of the inventory of the buyer and at the same time the
buyer is responsible for the payment of shipment.

FAS stands for Free Alongside. The seller who ships the goods FAS must bear all the
expenses and risk in delivering the items alongside the vessel and the buyer bears the cost of
loading and shipment. Thus, title generally passes when the carrier takes possession of the
goods.

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CIF stands for Cost, Insurance, Freight. This generally means that the buyer agrees to pay
the cost, insurance and freight charges in lump sum. Thus, the title and risk of loss will
generally pass to the buyer upon delivery of the goods to the carrier.

Lastly, if the seller delivers the goods under ex-ship, the seller will normally bears the
expenses and risk until the goods are unloaded, after which the legal title will transfer to the
buyer.

9. Who is the owner of goods under consignment?
Consignment is an arrangement in which goods are left in possession of an authorized
third party to sell. There are two parties involved in the consignment, the consignor (owner
of the goods) and the consignee (who has the actual possession of the goods but acts only as
an agent to sell the items).

The consigned items should form part of the inventory of the consignor not of the
consignee. This is aligned to the basic concept that inventories are owned by entities who has
the legal title regardless of location.

10. Who is the owner of goods when the sale agreement contains an unusual right of return?
When a buyer is granted an exceptional right to return the merchandise acquired, the
seller must continue to include the goods in its measurement and valuation of inventory.
The unusual right of return does not pertain to the normal sales terms (ex. Buyer can
return the goods found to be defective or not within a short period of time) but it refers to
situations where the return privileges is beyond the normal standard, so as to place doubt to
the true nature of the sale.

Under PAS 18 “Revenue” if the buyer has right to rescind or cancel the transaction under
defined conditions and the seller cannot, with reasonable confidence, estimate the likelihood
of this occurrence, the retention of significant risks of ownership makes the transaction as
not a sale. Although the legal title has passed to the buyer, the sale is only to be recorded by
the seller if the future amount of the returns can reasonably be estimated.

MEASUREMENT

Accounting System
11. What are the two systems used in accounting for inventory?
The accounting systems for inventories are periodic and perpetual inventory system.
Periodic inventory system calls for a periodic physical count of goods. In quantifying the cost
of ending inventories, a cost formula (please refer to Question#20) is applied. The cost of
goods sold is computed by adding beginning inventory and net purchases less ending
inventory.

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Perpetual inventory system requires the maintenance of record (stock cards) and
monitors the balance of inventory on hand by recording all sales and purchases as they occur.
Physical count is only necessary to verify the perpetual records and to satisfy the tax
regulations.

General measurement
12. How to measure inventories?
Inventories shall be measured at the lower of cost and net realizable value. Inventories
are not remeasured to its fair value or current replacement cost like the property, plant and
equipment or investment property because these assets are held over a short period of time.

Inventories at cost
13. What comprises the COST of inventories?
The costs of inventories shall comprise the following:
a. Cost of purchase - It includes the purchase price, import duties and irrecoverable taxes,
transport, handling and other costs directly attributable to the acquisition of finished
goods, materials and services. Trade discount, rebates and other similar items are
deducted in the costs of purchase.

b. Costs of Conversion - These are costs associated in converting the raw materials into
finished goods. It includes costs directly related to the units of production (direct labor)
and the those indirectly related (factory overhead).

c. Other costs incurred in bringing the inventories to their present location and condition

14. What are the two kinds of factory overhead and how to account them as cost of
conversion?
a. Fixed production overhead - These are indirect costs of production that remain
relatively constant regardless of the volume of production such as depreciation,
maintenance of factory building and equipment and cost of factory management and
administration. The fixed production overhead is allocated based on the normal
capacity of the production facilities. If there is a low production or idle plant, the fixed
cost per unit of production will not be adjusted however, if there is abnormally high
production, the fixed cost per unit is decreased so that inventories are measured above
cost.

b. Variable production overhead - These are indirect costs of production that vary directly,
or nearly directly, with the volume of production, such as indirect materials and
indirect labor. The variable production overhead is allocated based on the actual use
of the production facilities.

15. What is normal capacity?
In manufacturing industry, there are four capacity levels to allocate the cost. These are
theoretical capacity, practical capacity, expected actual capacity and normal capacity. Normal

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capacity is the production expected to achieve on average over a number of periods or

seasons under normal circumstances, taking into account the loss of capacity resulting from
planned maintenance.

16. How to account the costs of conversion under Joint process?
Joint process is a type of production process that may result in more than one product
that is being produced simultaneously. The products may be joint products/main products
and by product. If the conversion costs are not separately identifiable among joint products
or between joint and by products, the cost will be allocated on a rational and consistent basis.

The allocation may be based on the relative sales value of the joint products either at the
split off point of production (at the point of various product separation) or at the completion
of production.
The byproduct is measured at net realizable value and such amount will be deducted to
the joint/main product.

17. How to measure the cost of agricultural produce harvested from biological asset?
According to PAS 41, inventories comprising agricultural produce that an entity has
harvested from its biological assets are measured on initial recognition at their fair value less
costs to sell at the point of harvest.

18. What are the costs excluded from the costs of inventories and must be expense in the
period in which they are incurred?
• Abnormal amounts of wasted materials, labor or other production costs.
• Storage costs, unless those costs are necessary in the production process before a
further production stage.
• Administrative overheads that do not contribute to bringing inventories to their
present location and condition
• Selling costs

Additional:
• Difference between the purchase price for normal credit terms and the amount paid -
interest expense.
• Foreign currency difference.

19. What are the different techniques for the measurement of cost?
a. Standard Cost Method – A costing method that takes into account the normal levels of
materials and supplies, labor, efficiency and capacity utilization.

b. Retail Method – A costing method used in the retail industry for measuring inventories
of large numbers of rapidly changing items with similar margins for which it is
impracticable to use other costing methods.

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20. What are the formulas used in the computation of costs?

a. Specific Identification Method - This is used for costing of inventories that are not
ordinarily interchangeable and goods or services produced and segregated for specific
projects, whether they are bought or produced.
This method is inappropriate when there are large numbers of items of inventory
that are ordinarily interchangeable.

b. First In – First Out (FIFO) – This method assumes that that the inventory that were
purchased or produced first are sold first, thus the inventories are those most recently
purchased or produced.

c. Weighted Average – The cost of each item under this method is determined from the
weighted average cost of similar items at the beginning and during the period. Average
calculation can be done on a period basis or as each shipment is received.

21. Can the company use different cost formulas for their inventories?
Yes, if the inventories are different in nature or use. For example, inventories used in
one operating segment may have a different use to the entity as compared to the same type
of inventories used in another operating segment. However, difference in geographical
location of inventories, will not justify using different cost formulas.

Inventories at net realizable value (nrv)
22. What is Net Realizable Value?
It 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.

23. What is the difference between Net Realizable Value and Fair Value?
Net Realizable Value Fair Value
- It is the net amount that an entity expects - It is the price at which an orderly transaction to
to realize from the sale of inventory in the sell the same inventory in the principal market
ordinary course of business. for the inventory would take place between
market participants at the measurement date.

- It is an entity-specific value - It is not entity – specific value

24. What is the basis of estimating the net realizable value?
It is based on the most reliable evidence available at the time the estimates are made, of
the amount the inventories are expected to realize.

25. What are the possible considerations should be taken in estimating the NRV?
a. The fluctuations of price or cost directly relating to events occurring after the end of
the period to the extent that such events confirm conditions existing at the end of the
period.
b. The purpose for which the inventory is held.

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Inventory writedown
26. What is the meaning of inventory writedown?
Inventories are measured at lower of cost and net realizable value. If the cost is lower
than the net realizable value, there will be no adjustment as the inventory amount is usually
recorded at cost already. However, if the net realizable value is lower than the cost, an
adjustment must be made by reducing the cost to its net realizable value as assets should not
be carried in excess of amounts expected to be realized from their sale or use. The adjustment
made is known as inventory writedown

27. What are the instances when inventories are not recoverable and must be written down
from cost to net realizable value?
a. If inventories are damaged
b. If inventories have become wholly or partially obsolete
c. If the selling prices of inventories have decline.
d. If the estimated costs of completion or the estimated costs to be incurred to make the
sale have increased.

28. How are inventories usually written down to net realizable value?
Inventories are written down item by item or individual basis however in some
circumstances it is appropriate to group similar or related items before writing it down.

There are two accounting methods in inventory writedown – Direct Method and
Allowance Method. The main difference between the two is the recognition of loss on
inventory writedown (an addition to the cost of goods sold)

Under the Direct Method or Cost of Goods Sold method, there will be no recognition of
Loss on Inventory Writedown, which is the difference between Cost and NRV, thus the ending
inventory will automatically be recorded at NRV.

Under Allowance method or Loss method, the ending inventory will be recorded first at
cost and the amount will be reduced by recognizing a Loss on Inventory Writedown.

29. When will the materials and other supplies held for use in production of inventories are not
written down below cost?
If the finished product in which they will be incorporated are expected to be sold at or
above cost.

30. Can inventories previously written down below cost be reversed?
Yes, if the circumstance that cause the write down no longer exist or there is a clear
evidence that the NRV will increase. However, the reversal is limited only to the amount of
the original write down.

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PRESENTATION AND DISCLOSURES

31. How to present inventory in the financial statement?
Inventories are generally classified as current assets and presented as one line item in the
statement of financial position. The details of the inventories shall be disclosed in the notes
to financial statements.

32. What are the necessary disclosures for inventories?
a. The accounting policies adopted in measuring inventories, including the cost formula
used;
b. The total carrying amount of inventories and the carrying amount in classifications
appropriate to the entity
c. The carrying amount of inventories carried at fair value less cost to sell
d. The amount of inventories recognized as an expense during the period
e. The amount of any write down of inventories recognized as an expense in the period
f. The amount of any reversal of any write down that is recognized as a reduction in the
amount of inventories recognized as expense in the period
g. The circumstances or events that led to the reversal of a write down of inventories
h. The carrying amount of inventories pledged as security for liability.

PFRS FOR SMEs
The PFRS for SMEs and FULL PFRS are practically have the same provisions related to
definition, measurement, cost of purchase, cost of conversion, other costs and cost formulas for
inventories. The main difference is the recognition of the loss on inventory write-down.
Under the PFRS for SMEs, the excess of the carrying amount over the selling price less cost
to complete and dispose shall be recognized as impairment loss on the other hand, under Full
PFRS this is accounted for as loss on inventory write-down under cost of goods sold.


SUMMARY KEY POINTS
• Inventories are assets held for sale in the ordinary course of business, in the production for
such sale and in the form of materials or supplies to be consumed in the production process
or in the rendering of services.
• Inventories are measured at lower of cost or net realizable value.
• Cost comprises the cost of purchase, conversion cost and other cost necessary in bringing
the inventories in their present location and condition.
• Net realizable value is the estimated selling price less the estimated cost of completion
and the estimated costs necessary to make the sale.
• If the net realizable value is lower than the cost, the cost of inventory must be written
down to net realizable value either using the direct method or allowance method.
• Periodic and perpetual inventory system are the two accounting system in recording
inventory.

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Exercise 6-1 Identification.

Read the statement carefully and identify the proper principle or terms .

1. This is a method of recording inventory where it requires physical count in determining
the cost of ending inventory.
2. It is a type measurement bases that is not entity specific value.
3. This method assumes that the inventory that were purchased or produced first are sold
first, thus the inventory are those most recently purchased or produced.
4. Meaning of FOB.
5. It is a privilege given to customers granting an exceptional right of return beyond the
normal standard, so as to place doubt to the true nature of the sale.
6. Meaning of CIF.
7. The owner of the consigned goods.
8. A type of entity who has only one type of inventory.
9. The difference between the purchase price of inventory under normal credit terms and
the cash price equivalent.
10. A costing method that takes into account the normal levels of materials and supplies,
labor, efficiency and capacity utilization.


Exercise 6-2. Multiple Choice. Choose the best answer

1. 1st statement: The total carrying amount of inventories and the carrying amount in
classifications appropriate to the entity shall be disclosed to the notes of financial
statements.
2nd statement: 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.
a. Only the 1st statement is true c. Both statements are false
nd
b. Only the 2 statement is true d. Both statements are true

2. It 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.
a. Historical cost c. Current Cost
b. Fair value d. Net Realizable Value

3. Inventories shall be measured at
a. Lower of cost and fair value c. Higher of cost and fair value
b. Cost d. Lower of cost and NRV
4. The weighted average inventory costing method is particularly suitable to inventory
where

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a. Homogenous products are mixed together

b. The entity carries stock of raw materials, work in process and finished goods
c. Dissimilar products are stored in separate locations
d. Goods have distinct use by dates and the goods produced first must be sold
earliest

5. The cost of conversion is
a. Direct materials plus direct labor
b. Direct labor and factory overhead
c. Direct materials plus factory overhead
d. Direct materials, direct labor and factory overhead

6. 1st statement: Net realizable value is the price that would be received to sell an asset or
paid to transfer a liability in an orderly transaction between market participants at the
measurement date.
2nd statement: Net realizable value is an entity-specific value.
a. Only the 1st statement is true c. Both statements are false
nd
b. Only the 2 statement is true d. Both statements are true

7. This is a technique for the measurement of costs which is determined by reducing the
sales value of the inventory by the appropriate percentage
a. Retail method c. FIFO Method
b. Standard cost method d. Weighted Average Method

8. Which of the following is not a basic assumption of the gross profit method?
a. Goods not sold must be on hand
b. The beginning inventory plus purchases equal to total goods to be accounted for.
c. The sales reduced to cost basis when deduction form the sum of beginning
inventory and purchases would result to inventory on hand
d. The amount of purchases and the amount of sales remain relatively unchanged
from the comparable previous period.

9. With regards the initial measurement of inventory, which of the following is incorrect?
a. The cost of purchase comprise the purchase price, import duties and other
recoverable taxes, transport, handling and other cost directly attributable to the
acquisition of finished goods, materials and services.

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b. Other costs that may be appropriate to include as part of the inventory are non-
production overheads or the cost of designing products for specific customers in
the cost of inventories.
c. The cost of inventories of a service provider does not include profit margins or
non-attributable overheads that are often factored into prices charged by service
providers.
d. The cost of conversion of inventories include cost directly related to the units of
production, such as direct labor and the systematic allocation and variable
production overheads that are incurred in converting materials into finished
goods.

10. In the period of rising prices, the inventory method which tends to give the highest
reported net income is
a. FIFO c. Base Stock
b. Weighted average d. LIFO

st
11. 1 statement: Materials and other supplies held for use in the production of inventories
are written down below cost if the finished products in which they will be incorporated
are expected to be sold below cost.
2nd statement: The amount of any write-down of inventories to net realizable value and
all losses of inventories shall not be recognized as an expense in the period the write-
down or loss occurs.
a. Only the 1st statement is true c. Both statements are false
nd
b. Only the 2 statement is true d. Both statements are true

12. The financial statement shall disclose the following, except:
a. The amount of inventories recognized as an expense during the period
b. The fair value amount of inventories pledged as security for liabilities
c. The total carrying amount of inventories and the carrying amount in classifications
appropriate to the entity.
d. The carrying amount of inventories recognized as an expense during the period.

13. FIFO
a. It permits the income manipulation, by making the year end purchases designed
to preserve existing inventory layers.
b. When prices are rising, the inventory valuation will be less than the current cost
and when prices are declining, the inventory valuation will be more than the
current cost.

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c. Favors the financial position in that the inventory is stated at current replacement
cost
d. Favors the income statement because there is matching of current cost against
current revenue.

14. The allocation of fixed factory overhead is based on what capacity level?
a. Theoretical capacity level c. Practical capacity level
b. Expected Actual capacity level d. Normal capacity level

st
15. 1 statement: The cost of purchase inventory includes the trade discounts, rebates and
other similar items.
2nd statement: Cost of designing products for specific customers should be capitalized as
part of inventory cost.
a. Only the 1st statement is true c. Both statements are false
nd
b. Only the 2 statement is true d. Both statements are true

16. When inventory declines in value below original cost what is the maximum amount that
the inventory can be valued at?
a. Net realizable value
b. Historical cost
c. Sales price reduced by estimated cost of disposal
d. Sales price

st
17. 1 statement: Under cost of conversion, only variable production overhead is included as
part of the cost.
2nd statement:Variable production cost are those indirect costs of production that remain
relatively constant in per unit basis regardless of the volume of production.
a. Only the 1st statement is true c. Both statements are false
nd
b. Only the 2 statement is true d. Both statements are true

18. Which of the following items should be included in a company’s inventory at the balance
sheet date?
a. Goods sold to a customer which are being held for the customer to call for at the
customer’s convenience.
b. Goods in transit which were purchased FOB destination.
c. Goods received from another company for sale on consignment.
d. Goods in transit which were purchased FOB shipping point.

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19. Which is not a mandated disclosure in relation to inventory?

a. The amount of any reversal of inventory write-down
b. The circumstances that led to reversal of inventory write-down
c. The amount of inventory write-down recognized as an expense
d. The fair value less cost of disposal of inventory pledged as security.

20. Net realizable value is
a. Estimated selling price
b. Current replacement cost
c. Estimated selling price less estimated cost to complete
d. Estimated selling price less estimated cost to complete and estimated cost of
disposal

21. PAS 2 (Inventories) applies to all inventories except:
a. Biological assets related to agricultural activity and agricultural produce at the
point of harvest
b. Financial instrument
c. Work in progress arising under construction contracts, including directly related
service contracts
d. All of the above

22. The following may be included in the cost of inventories, except
a. Administrative overheads
b. Wasted materials, labor and other production cost
c. Selling costs
d. Storage cost

23. The use of the gross profit method assumes
a. The relationship between selling price and cost of goods sold is similar to prior
years.
b. Sales and cost of goods sold have not changed from previous years
c. The amount of gross profit is the same as in prior years.
d. Inventory value has not increased from previous years.

24. Which is not a mandated disclosure in relation to inventory
a. The carrying amount of each item of inventory
b. The amount of inventory recognized as expense during the period
c. The carrying amount of inventory carried at fair value less cost of disposal

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d. Accounting policy adopted in measuring inventory

st
25. 1 statement: The retail method takes into account normal levels of materials and
supplies, labor, efficiency and capacity utilization.
2nd statement: The cost of inventories of items that are not ordinarily interchangeable
and goods or services produced and segregated for specific projects shall be assigned by
using specific identification of their individual costs only.
a. Only the 1st statement is true c. Both statements are false
nd
b. Only the 2 statement is true d. Both statements are true


Exercise 6- 3. Identify which of the following is part of the cost of inventory. Put a check mark
beside the number.

Unsaun Ni Sporting Goods Company is in manufacturing of sport equipment and had the
following costs incurred:
1. Sandpaper
2. Materials Handling
3. Wood, plastics and other materials for sport equipment
4. Indirect Manufacturing Labor
5. Direct Manufacturing Labor
6. Direct Materials
7. Finished Goods Inventory
8. Work in Process Inventory
9. Leasing Cost – Plant
10. Depreciation – Marketing Office
11. Property Taxes – Plant
12. Fire Insurance – Plant
13. Direct Material Purchases
14. Sales Commission
15. Advertising Costs
16. Administration Cost
17. Storage Costs for Raw Materials
18. Storage Costs for Finished Items
19. Salary Expense – Accountant
20. Abnormal spoilage

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