INTERMEDIATE ACCOUNTING

I. 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 the rendering of
services. These encompass goods purchased and held for resale such as:

a. Merchandise purchased by a retailer and held for resale

b. Land and other property held for resale by a subdivision entity and real estate developer.

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

Classes of Inventories
Inventories are broadly classified into two:
a. inventories of a trading concern – buys and sells goods in the same form purchased; the term
merchandise inventory is generally applied to goods held by a trading concern
b. inventories of a manufacturing concern – one that buys goods which are altered or converted into
another form before they are made available for sale.
i. Finished goods – completed products which are ready for sale
ii. Goods in process/Work in process (WIP) – partially completed products which require further
process or work before they can be sold
iii. Raw Materials – goods that are to be used in the production process; no work process has been
done on them yet
iv. Factory or manufacturing supplies (used in production; not to be confused with office supplies
account) – similar to raw materials but their relationship to the end product is indirect

Goods includible in the inventory

As a rule, all goods to which the entity has title shall be included in the inventory, regardless of location.
The phrase “passing of title” is a legal language which means the point of time at which ownership changes

Legal Test: Is the entity the owner of the goods to be inventories? If yes, include in inventory. If no, exclude.

Applying the legal test, the following are included:

a. Goods owned and on hand
b. Goods in transit and sold FOB destination
c. Goods in transit and purchased FOB shipping point
d. Goods out on consignment to consignee
e. Goods in the hands of salesmen or agents
f. Goods held by customers on approval or in trial

Exception to the legal test

Installment contracts may provide for retention of title by the seller until the selling price is fully
collected. However, in such a case, it is an accepted accounting procedure to record the installment sale as a
regular sale on the part of the seller and as a regular purchase on the part of the buyer. Thus, the goods sold on
installment basis are excluded in the inventory of the seller, the legal test notwithstanding. This is a clear
example of economic substance prevailing over legal form.

Who is the owner of goods in transit?

The ownership goods in transit depends on the terms, whether FOB destination or FOB shipping point.
FOB means free on board. If FOB destination, ownership is transferred to the buyer upon receipt of goods. If
FOB shipping point, ownership is transferred upon shipment of goods.

*Recall the discussion on freight terms discussed in your Reading 2

Consigned goods
Consignment is a method of marketing goods in which the owner called the consignor transfers physical
possession of certain goods to an agent called the consignee who sells them on the owner’s behalf.
Consigned goods should be included in the consignor’s inventory and excluded from consignee’s
inventory.
Freight and other handling charges on goods out on consignment are part of the cost of goods
consigned. When consigned goods are sold by the consignee, a report is made to the consignor together with a
cash remittance for the amount of sales minus commission and other expenses chargeable to the consignor.

Example: Consignee sells consigned goods for P100,000. This amount is remitted to the consignor less
commission of P15,000 and advertising of P2,000.
POV of Consignor
Cash 83,000
Commission Expense 15,000
Advertising Expense 2,000
Sales 100,000

Accounting for Inventories

1. Periodic system – calls for the physical counting of goods on hand at the end of the accounting period to
determine quantities. The quantities are then multiplied to the corresponding unit costs to get the inventory
value for balance sheet purposes. This approach gives actual or physical inventories. This is normally used
when the items have small peso investment such as groceries, hardware and auto parts.

Illustration
a. Purchase of merchandise on account, P300,000
Purchases 300,000
Accounts Payable 300,000

b. Payment of freight on the purchase, P20,000

Freight in 20,000
Cash 20,000

c. Return of merchandise purchased to supplier, P30,000

Accounts Payable 30,000
Purchase return 30,000

d. Sale of merchandise on account, P400,000 at 40% gross profit

Accounts Receivable 400,000
Sales 400,000
e. Return of merchandise sold from customer, P25,000
Sales return 25,000
Accounts Receivable 25,000

f. Adjustment of ending inventory, P65,000

Merchandise inventory-end 65,000
Income summary 65,000

2. Perpetual system – requires the maintenance of records called stock cards that usually offer a running
summary of the inventory inflow and outflow. Inventory increases and decreases are reflected in the stock
cards and the resulting balance represents the inventory. This approach gives book or perpetual inventories.
This is commonly used where inventory items individually represent a relatively large peso investment such
as jewelry and cars. In an ideal scenario, stock cards are kept to reflect and control both unit and costs. Thus,
the entity would be able to know the inventory on hand at a particular moment in time.
- When this system is used, a physical count of the units on hand should at least be made once a year to
confirm the balances appearing on the stock cards.

Illustration
a. Purchase of merchandise on account, P300,000
Merchandise inventory 300,000
Accounts Payable 300,000

b. Payment of freight on the purchase, P20,000

Merchandise inventory 20,000
Cash 20,000

c. Return of merchandise purchased to supplier, P30,000

Accounts Payable 30,000
Merchandise inventory 30,000

d. Sale of merchandise on account, P400,000 at 40% gross profit

Accounts Receivable 400,000
Sales 400,000

Cost of goods sold 240,000a

Merchandise inventory 240,000

a
400,000 x 60% = 240,000
 e. Return of merchandise sold from customer, P25,000. The cost of merchandise returned is 60%
Sales return 25,000
Accounts Receivable 25,000

Merchandise inventory 15,000a

Cost of goods sold 15,000

a
25,000 x 60% = 15,000

f. Adjustment of ending inventory, P65,000

As a rule, the ending merchandise inventory is not adjusted. The balance of the merchandise inventory
account represents the ending inventory

Inventory shortage or overage

In the illustration, merchandise inventory account has debit balance of P65,000. If at the end of
accounting period, a physical count indicates a different amount, an adjustment is necessary to recognize any
inventory shortage or overage.

If physical count showed inventory on hand of P55,000: shortage (count>records)

Inventory over/short 10,000

Merchandise inventory 10,000

If physical count showed inventory on hand of P75,000: overage (count<records)

Merchandise inventory 10,000

Inventory over/short 10,000

Trade discounts and cash discounts

- 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. Trade discounts are not recorded.
- Cash discounts are deductions from the invoice price when payment is made within the discount period.
Cash discounts are recorded as purchase discount by buyer and as sales discount by seller.

Illustration

The list price of a merchandise purchases is P500,000 less 20% and 10%, with credit terms of 5/10, n/30. This
means that trade discounts are 20% and 10%, and the cash discount is 5% if payment is made in 10 days. The full
amount of the invoice is paid if the payment is made after 10 days and within the credit period of 30 days.

List price 500,000

First trade discount (100,000) 500,000 x 20%
400,000
Second trade discount (40,000) 400,000 x 10%
Invoice price 360,000
Cash discount (18,000) 360,000 x 5%
Payment within the discount period 342,000

Journal entry:
Purchases 360,000
Accounts Payable 360,000

*Trade discounts are not recorded. They are only used to arrive at the invoice amount.

If payment is made within the discount period

Accounts Payable 360,000
Cash 342,000
Purchase discount 18,000

OR

If payment is made beyond the discount period

Accounts Payable 360,000
Cash 360,000
Methods of recording purchases

A. Gross method – purchases and accounts payable are recorded at gross amount of invoice

Illustration

1. Purchases on account P200,000, 2/10 n/30

Purchases 200,000
Accounts Payable 200,000
2. Assume payment is made within the discount period
Accounts Payable 200,000
Cash 196,000
Purchase discount 4,000
3. Assume payment is made beyond the discount period
Accounts payable 200,000
Cash 200,000

B. Net method - purchases and accounts payable are recorded at net amount of invoice

Illustration

1. Purchases on account P200,000, 2/10 n/30

Purchases 196,000
Accounts Payable 196,000
2. Assume payment is made within the discount period
Accounts Payable 196,000
Cash 196,000
3. Assume payment is made beyond the discount period
Accounts payable 196,000
Purchase discount lost 4,000
Cash 200,000

4. Assume it is the end of the accounting period, no payment is made and the discount period has expired.
Purchase discount lost 4,000
Accounts Payable 4,000
*Take note that JEs 2, 3 and 4 cannot happen simultaneously. Either 1 and 2, 1 and 3, or 1 and 4.

Cost of Inventories

The cost of inventories shall comprise:

a. Cost of purchase – comprises the purchase price, import duties and irrevocable 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.
The cost of purchase shall not include foreign exchange differences which arise directly from the recent
acquisition of inventories involving a foreign currency.
Moreover, when inventories are purchased with deferred settlement terms, the difference between the
purchase price for normal credit terms and the amount paid is recognized as interest expense over the period of
financing.

b. Cost of conversion – includes cost directly related to the units of production such as direct labor. (Related to
inventories of manufacturing entities) For example, your Nike shoes are produced in a factory, the costs of
conversion involve costs of operating the machines as well as the wages paid to factory workers.
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 costs of production that remains constant regardless of the volume of
production. (Ex: Depreciation and maintenance of factory)

*Variable production overhead is the indirect cost of production that varies directly with the volume of
production. (Ex: indirect labor and indirect materials)

Directly attributable costs

- The cost of inventories incurred in bringing the inventories to their present location and condition. For
For example, designing product for specific customers.

Below are excluded from costs of inventories and recognized as expenses in the period when incurred.
a. Abnormal amounts of wasted materials, labor and other production costs
 b. Storage costs, unless unnecessary in the production process prior to a further production stage. Thus,
storage costs on finished goods are expensed.
c. Administrative overheads that do not contribute to bringing inventories to their present location and
condition.
d. Distribution or selling costs.

Exercises:
1. Aman Company provided the following the data:

Items counted in the bodega 4,000,000

Items included in the count specifically
segregated per sales contract 100,000
Items in receiving department, returned by customer,
in good condition 50,000
Items ordered and in the receiving department 400,000
Items ordered; invoice received but goods not received.
Freight is on account of seller 300,000
Items shipped today, invoice mailed, FOB shipping point 250,000
Items shipped today, invoice mailed, FOB destination 150,000
Items currently being used for window display 200,000
Items on counter for sale 800,000
Items in receiving department, refused because of damage 180,000
Items included in count, damaged and unsalable 50,000
Items in the shipping department 250,000

What is the correct amount of inventory?

My tips for you are: first is to be visual in inventory problems, imagine the scenarios given (where are the goods
located etc.), second is understand the POV are you seller or buyer of inventory, lastly take note of shipment
terms and know them by heart.

For this type of problem, what you should do is go over the given items and list only those to be included. If
excluded do not put them in your list!

Solution:
Items counted in the bodega 4,000,000 counted in storage room so include
Items included in count but specifically segregated (100,00) even if this should be excluded, we
are putting it in the list because this
amount is included in 4M but
already segregated for a customer so
subtract them from your inventory, as
if already sold
Items returned by customer 50,000 returned and in good condition
Items ordered and in receiving department 400,000
Items shipped today, FOB destination 150,000 seller POV, and you are responsible
for freight so ownership is with you
Items for display 200,000 items for display can still be sold, so
include
Items on counter for sale 800,000 same as above
Damaged and unsalable items included in count (50,000) included in 4M count but cannot be
sold so same as item 2, put in list but
subtract
Items in the shipping department 250,000
Answer: 5,700,000

*for items that are not on the list

Items ordered; invoice received but goods not received.
Freight is on account of seller 300,000
*you are buyer POV, Freight is on account of seller and you have not received them yet so seller still owns the
product, you are not the owner of this, exclude it from the list
Items shipped today, invoice mailed, FOB shipping point 250,000
*you are seller POV, FOB shipping point, meaning buyer owned the goods once they were shipped so exclude.
Items in receiving department, refused because of damage 180,000
*you are buyer POV, you refused the goods because of damage, meaning you will return them to the seller,
exclude.
2. Corolla Company incurred the following costs:

Materials 700,000
Storage costs of finished goods 180,000
Delivery to customers 40,000
Irrecoverable purchase taxes 60,000

At what amount should the inventory be measured?

Go back to the notes on what should be included as inventory cost

Solution:

Materials 700,000
Irrecoverable purchase taxes 60,000
Answer: 760,000

3. On August 1 of the current year, Stella Company recorded purchases of inventory of P800,000 and P1,000,000
under credit terms of 2/15, n/30.

The payment due on the P800,000 purchase was remitted on August 16. The payment due on the P1,000,000
purchase was remitted on August 31.

Under the net method and the gross method, the purchases should be included at what respective amounts in
the determination of cost of goods available for sale?

Solution:

Net method

Aug 1 Purchases 1,764,000 (1,800,000*.98)

Accounts Payable 1,764,000
Aug 16 Accounts Payable 784,000 (800,000*.98)
Cash 784,000
Aug 31 Accounts Payable 980,000 (1,000,000*.98)
Purchase discount lost 20,000
Cash 1,000,000

*Purchase discount lost is expense account

Purchases: 1,764,000

Gross method

Aug 1 Purchases 1,800,000

Accounts Payable 1,800,000
Aug 16 Accounts Payable 800,000
Cash 784,000 (800,000*.98)
Purchase discount 16,000 (800,000*.02)
Aug 31 Accounts Payable 1,000,000 (1,000,000*.98)
Cash 1,000,000

*Purchase discount is contra purchase account

Purchases: 1,800,000
Less Purchase discount (16,000)
Net purchases 1,784,000

Answer: Net method 1,764,000 Gross method 1,784,000