PAS 2 Inventories – Notes

Inventories – are assets held for sale in the ordinary course of business, in the process of production for such
sale or in the form of materials or supplies to be consumed in the production process or in rendering of
services.

Inventories – also encompass finished goods produced, goods in process and materials and supplies awaiting
use in the production process.

Classes of inventories

1. Trading concern – is one that buys and sells goods in the same form purchased.

“Merchandise inventory” is generally applied to goods held by a trading concern.

2. Manufacturing concern – is one that buys goods which are altered or converted into another form before
they are made available for sale.

Finished goods

Goods in process

Raw materials

Factory or manufacturing supplies

Cost of inventories:

1. Cost of purchase

2. Cost of conversion

3. Other cost incurred in bringing the inventories to their present location and condition

COST OF PURCHASE

Comprises the purchase price, import duties and irrecoverable taxes, freight 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 cost of purchase

COST OF CONVERSION

Includes cost directly related to the units of production such as direct labor

It also includes a systematic allocation of fixed and variable production overhead that is incurred in
converting materials into finished goods

Fixed production overhead is the indirect cost of production that remains relatively constant regardless
of the volume of production

Depreciation and maintenance of factory building and equipment and the cost of factory management
and administration

Variable production overhead – is the indirect cost of production that varies directly with the volume of
production

Indirect labor and indirect materials

Other cost – is included in the cost of inventories only to the extent that it is incurred in bringing

the inventories to their present location and condition

Excluded from the cost of inventories:

Abnormal amounts of wasted materials, labor and other production costs

Storage costs, unless necessary in the production process prior to a further production stage. Storage
cost goods in process are capitalized but storage costs on finished goods are expensed

Administrative overheads

Distribution or selling costs

Consist primarily of the labor and other costs of personnel directly engaged in providing the service,
including supervisory personnel and attributable overhead

Labor and other costs relating to sales and general administrative personnel are not included but are
recognized as expenses in the period in which they incurred.

Cost formulas
First in. first out Weighted average

First in, First out (FIFO)

The goods purchased are first sold and consequently the goods remaining in the inventory at the end
of the period are those most recently purchased or produced

Rule: First come, first sold

The inventory is thus expressed in terms of recent of new prices while the cost of goods sold is
representative of earlier or old prices

Favors the statement of financial position in that the inventory is stated at current replacement cost

The objection to the method is that there is improper matching of cost against revenue because the
goods sold are stated at earlier or older prices resulting in understatement of cost of goods sold

In a period of inflation or rising prices, the FIFO method would result to the highest net income

In a period of deflation or declining prices, the FIFO method would result to the lowest net income

Weighted average
The cost of the beginning inventory plus the total cost of purchases during the period is divided by the total
units purchased plus those in the beginning inventory to get a weighted average unit cost

Such weighted average unit cost is then multiplied by the units on hand to derive the inventory value

The average unit cost is computed by dividing the total cost of goods available for sale bythe total number of
units available for sale

The weighted average method produces inventory valuation that approximates current value if there is a
rapid turnover of inventory

The argument against the weighted average method is that there may be a considerable lag between the
current cost and inventory valuation since the average unit cost involves early purchases

Last in, first out (LIFO)

The inventory is thus expressed in terms of earlier or old prices and the cost of goods solds is
representative of recent or new prices

Favors the income statement

The objection of the LIFO is that the inventory is stated at earlier or older prices and therefore there
may be a significant lag between inventory valuation and current replacement cost

In a period of rising prices, the LIFO method would result to the lowest net income

In a period of declining prices, the LIFO method would result to the highest net income

Specific Identification
Means that specific costs are attributable to identified items of inventory

Cost of the inventory is determined by simply multiplying the units on hand by the actual unit cost
 Appropriate for inventories that are segregated for a specific project and inventories that are not
ordinarily interchangeable

Measurement of inventory

Inventories shall be measured at the lower of cost and net realizable value

The cost of inventory is determined using either FIFO cost or average cost

Net realizable value

Is the estimated selling price in the ordinary course of business less the estimated cost of completion
and the estimated cost of disposal

Inventories are usually written down to net realizable value on an item-by-item or individual basis

Accounting for inventory writedown

If the net realizable value is lower than the cost, the inventory is measured at NRV

The writedown of inventory to NRV is accounted for using the allowance method

Allowance method
The inventory is recorded at cost and any loss on inventory writedown is accounted for separately

Also known for loss method

If the required allowance increases, an additional loss is recognized

If the required allowance decreases, a gain on reversal of inventory writedown is recorded

The gain is limited only to the extent of the allowance balance