B.C.

Villaluz
INTEGRATED REVIEW IN FINANCIAL ACCOUNTING AND REPORTING THEORIES
HANDOUT NO. 4: Inventories
Brian Christian S. Villaluz, CPA, MBA

NATURE OF INVENTORIES
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.

Therefore, inventories include the following:

1. Raw materials inventory
2. Factory or manufacturing supplies
3. Work in process inventory
4. Finished goods inventory

COST OF INVENTORIES
The cost of inventories comprises the following:
1. Purchase cost – this includes the purchase price (net of trade discounts and other rebates), import duties, non-refundable
or non-recoverable purchase taxes, and transport, handling and other costs directly attributable to the acquisition of the
inventory.
2. Conversion costs – these refer to the costs necessary in converting raw materials into finished goods. Conversion costs
include direct labor and production overhead costs.
3. Other costs necessary in bringing the inventories to their present location and condition.

The following are excluded from the cost of inventories and are expensed in the period in which they are incurred:
1. Abnormal amounts of wasted materials, labor or other production costs;
2. Selling costs, e.g., advertising and promotion costs and delivery expense or freight out;
3. Administrative overheads that do not contribute to bringing inventories to their present location and condition; and
4. Storage costs, unless those costs are necessary in the production process before a further production stage.

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.

SPECIAL CONSIDERATIONS
The following may require special attention in determining the proper inventory items at the end of the period:
1. Goods in transit
2. Consigned goods
3. Bill and hold sales
4. Segregated goods
5. Installment sales
6. Goods sold with buyback agreement
7. Goods sold with refund offers

GOODS IN TRANSIT
The owner of the goods in transit depends on the following FOB terms:
1. FOB Destination – ownership of goods purchased is transferred only upon receipt of the goods by the buyer at the
point of destination. Accordingly, the seller shall legally be responsible for freight charges and other expenses up to the
point of destination.
2. FOB Shipping point – ownership of goods purchased is transferred upon shipment of goods. Accordingly, the buyer
shall legally be responsible for freight charges and other expenses from the point of shipment to the point of destination.

Freight payment terms

1. Freight collect – The freight charge on the goods shipped is not yet paid. The carrier shall collect from the buyer. The
freight charge is actually paid by the buyer.
2. Freight prepaid – The freight charge on the goods shipped is already paid by the seller.

NOTE:
1. The FOB terms determine the ownership of the goods in transit and the party who is supposed to pay the freight charge
and other expenses from the point of shipment to the point of destination.
2. The freight payment terms determine the party who actually paid the freight charge but not the party who is supposed to
legally pay the freight charge.

Maritime shipping terms

1. Free alongside (FAS) – A seller who ships FAS must bear all expenses and risk involved in delivering the goods to the dock
next to or alongside the vessel on which the goods are to be shipped. The title to the goods passes to the buyer when the
carrier takes possession of the goods.
2. Cost, insurance and freight (CIF) – the title to the goods passes to the buyer upon delivery of the goods to the
carrier.
3. Ex-ship – a seller who delivers the goods ex-ship bears all expenses and risk of loss until the goods are unloaded at which
time title to the goods pass on to the buyer.
• This shipping term is similar to FOB Destination.

CONSIGNED GOODS
A consignment is a method in which the owner called the consignor transfers physical possession of goods to an agent called the
consignee who sells them on the owner’s behalf.

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Consigned goods shall be included in the consignor’s inventory and excluded from the consignee’s inventory. Freight and
other handling charges on goods out on consignment are part of the cost of goods consigned.

Note:
(a) Goods out on consignment – included in the inventory of the consignor
(b) Goods held on consignment – excluded from the inventory of the consignee

BILL AND HOLD ARRANGEMENT

A bill and hold arrangement is a contract 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:
a. The reason for the bill and hold arrangement is substantive (e.g., the customer has requested for the arrangement);
b. The goods are identified separately as belonging to the customer;
c. The goods are available for immediate transfer to the customer; and
d. The seller cannot use the goods or sell them to another customer.

SEGREGATED GOODS
➢ Special order goods manufactured according to customer specifications should be considered sold when completed, even
if it is still in the possession of the seller. Therefore, these are excluded from the seller’s inventory.
➢ Goods that are customarily manufactured and constitute stock items of the entity, even if physically segregated, are still
included in the inventory of the seller until delivered to the customer.

INSTALLMENT SALES
Goods sold under installment basis are included in the inventory of the buyer despite retention of the title by the seller until fully
paid. The substance is that control over the goods has already passed to the buyer at the time of sale.

GOODS SOLD WITH BUYBACK ARRANGEMENTS

A buyback arrangement is a form of product financing arrangement. The owner of the goods sells the inventory to another party and
agrees to repurchase the goods at a specified price. In effect, the inventory is used as collateral for a loan obtained from the buyer.

Goods sold under this case is included in the inventory of the transferor.

GOODS SOLD WITH REFUND OFFERS

In some instances, buyers are given the right to rescind the purchase of goods for a reason specified in the sales contract. Goods sold
with refund orders shall be excluded from the inventory of the seller.

INVENTORY ACCOUNTING SYSTEMS

Inventories are accounted for either through:
(a) Periodic inventory system, or
(b) Perpetual inventory system

Periodic inventory system

➢ Under this system, the entity does not maintain records that show the running balances of inventory on hand and cost of
goods sold as at any given point of time. A physical count of inventories is required to determine the year-end inventories.
➢ This inventory system is used for relatively products with low prices but in large quantities such as groceries, hardware and
auto parts.
➢ It uses purchase-related accounts such as:
(a) Purchases
(b) Freight-in
(c) Purchase returns and allowances
(d) Purchase discounts

Perpetual inventory system

➢ Records called “stock cards” are maintained under this system, from which the quantities and balances of goods on hand and
goods sold can be determined at any given point of time without the need of performing a physical count of inventories.
➢ Physical count is performed only as an internal control to determine the accuracy of the balance per records.
➢ This inventory system used for high-priced products such as automobiles and jewelry.
➢ It does not use purchase-related accounts as mentioned above. All merchandise purchase transactions are recognized in the
merchandise inventory account.

ACCOUNTING FOR DISCOUNTS

There are two types of discounts:
1. Trade discounts
2. Cash discounts

Trade discounts are given to encourage orders in large quantities. Trade discounts do not form part of inventory. They are deducted
from the list price in order to determine the invoice price. Trade discounts are not recorded in the books of either the buyer or seller.
Cash discounts are given to encourage prompt payment. They are deducted from the invoice price to determine the amount of net
payment required within the discount period.

Cash discounts are recorded as purchase discount by the buyer and sales discount by the seller. These are deducted from
purchases to arrive at net purchases and sales discount is deducted from sales to arrive at net sales.

Methods of recording cash discounts

The two methods of recording cash discounts are:
1. Gross method
2. Net method
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Under the gross method, the cost of inventory and accounts payable are recorded gross of cash discounts. Purchase discounts are
recorded only when actually taken.

Under the net method, the cost of inventory and accounts payable are initially recorded net of cash discounts, regardless of whether
such discounts are taken or not. Purchase discounts not taken are recorded under the purchase discounts lost account included as
part of other expense or finance cost.

Theoretically, the net method should be used because it supports the concept of conservativism. However, the gross method is more
commonly used because of cost-benefit considerations and convenience.

COST FORMULAS
1. For items of inventories that are not ordinarily interchangeable
 Specific identification – this shall be used for inventories that are not ordinarily interchangeable (i.e., those that
are individually unique) and those that are segregated for specific projects.
- Specific identification of cost means that specific costs are attributed to identified items of inventory.

2. For items of inventories that are ordinarily interchangeable

 First-In, First-Out (FIFO) – Under this cost 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.
 Average method – Under this cost formula, the cost of each item is determined from the weighted average of the
cost of similar items at the beginning of a period and the cost of similar items purchased or produced during the
period. The average may be calculated on a periodic basis, or as each additional shipment is received.
- Weighted average – the average method under periodic inventory system.
- Moving average – the average method under perpetual inventory system.

IAS 2 does not permit the use of last-in, first-out (LIFO) cost formula.

MEASUREMENT OF INVENTORIES
Inventories shall be measured at the lower of cost and net realizable value.

Inventories are usually written down to net realizable value item by item. In some circumstances, however, it may be appropri ate to
group similar or related items.

Materials and other supplies held for use in the production of inventories are not written down below cost if the finished products in
which they will be incorporated are expected to be sold at or above cost. However, when a decline in the price of materials indicates
that the cost of the finished products exceeds net realizable value, the materials are written down to net realizable value. In such
circumstances, the replacement cost of the materials may be the best available measure of their net realizable value.

PURCHASE COMMITMENTS
Purchase commitments are commitments by a business to purchase goods or services at some future date at a fixed price. A
business will agree to a purchase commitment in order to fix its prices over a period of time.

While purchase commitments can protect the business from price increases, they also create a problem when the price of the product
falls below the contract price. A purchase commitment can either be:
(a) Cancellable
(b) Non-cancellable

A disclosure in the notes to financial statements is required for a cancellable purchase commitment if:
(a) A future loss is possible
(b) The amount of the commitment can be reasonably estimated, and
(c) The amount is material.

No entry is required for a cancellable purchase commitment.

Any material losses which are expected to arise from non-cancelable commitments shall be recognized. A purchase commitment
must be non-cancelable in order that a loss on purchase commitment can be recognized.

Gain on purchase commitment is limited to the loss on purchase commitment previously recognized.

INVENTORY ESTIMATION PROCEDURES

1. Gross profit method
2. Retail inventory method

Reasons for the need to approximate or estimate the amount of inventory

1. The inventory is destroyed by fire and other catastrophe, or theft of the merchandise has occurred and the amount of
inventory is required for insurance purposes.
2. A physical count of the goods on hand is made and it is necessary to prove the correctness or reasonableness of such count
by making an estimate.
3. Interim financial statements are prepared.

GROSS PROFIT METHOD

This method is based on the assumption that the gross profit rate remains approximately the same from period to period and therefore
the ratio of cost of goods sold to net sales is relatively constant from period to period.

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Treatment of sales allowances and sales discounts
Sales allowances and sales discounts are ignored in computing net sales for purposes of inventory estimation. These items decrease
the amount of sales but do not affect the physical flow of goods.

Including these items will result to overstatement of inventory with a consequent understatement of cost of goods sold and
overstatement of gross profit.

RETAIL METHOD
This method is often used in the retail industry (e.g., supermarkets and department stores) for measuring large quantities of inventories
with rapidly changing items and with similar margins and for which it is impracticable to use other costing methods. N et markups and
net markdowns are considered in this method.

Information required
The use of the retail inventory method requires that records be kept which must show the following data:
(a) Beginning inventory at cost and at retail price (or selling price)
(b) Purchases during the period at cost and at retail price
(c) Adjustments to the original retail price such as additional markup, markup cancellation, markdown and markdown
cancellation.
(d) Other adjustments such as departmental transfer, breakage, shrinkage, theft, damaged goods and employee discount

Treatment of items

Item Treatment
Beginning inventory Added to goods available for sale at cost and at retail.
Purchases Added to goods available for sale at cost and at retail.
Freight in Added to purchases at cost only.
Purchase returns Deducted from purchases at cost and at retail.
Purchase allowance Deducted from purchases at cost only.
Purchase discount Deducted from purchases at cost only.
Departmental transfer in (or debit) Addition to purchases at cost and at retail.
Departmental transfer out (or credit) Deduction from purchases at cost and retail.
Sales returns (or sales returns and allowances) Deducted from sales.
Sales allowances and sales discounts Disregarded
Employee discounts Added to sales
Normal losses (shortage, shrinkage, spoilage, breakage) Added to sales
Abnormal losses (shortage, shrinkage, spoilage, breakage) Deducted from goods available for sale at cost and at retail so
as not to distort the cost ratio.

Items related to retail method

The original selling price is frequently raised or lowered particularly at the end of the selling season where replacement co sts are
changing.

(a) Initial markup – original markup on the cost of goods.

(b) Original retail – the sales price at which the goods are first offered for sale.
(c) Additional markup – increase in sales price above the original sales price.
(d) Markup cancellation – decrease in sales price that does not decrease the sales price below the original sales price.
(e) Net markup – markup – markup cancellation
(f) Markdown – decrease in sales price below the original sales price.
(g) Markdown cancellation – increase in sales price that does not increase the sales price above the original sales price.
(h) Net markdown – markdown minus markdown cancellation.

APPROACHES IN THE USE OF RETAIL METHOD

The retail method is applied using:
1. Average cost approach
2. FIFO approach
3. Conservative approach

PRACTICE EXERCISES

1. Which is incorrect? Inventories are assets

A. Held for sale in the ordinary course of business.
B. In the process of production for sale.
C. In the form of materials or supplies to be consumed in the production process or in the rendering of services.
D. Held for use in the production or supply of goods or services.

2. Which of these items are not included in the measurement of cost of inventories?
I. Import duties
II. Nonrefundable taxes
III. Refundable taxes
IV. Storage cost of partly finished goods
V. Storage cost of finished goods
VI. Marketing costs

A. I, II, IV
B. II, IV, VI
C. III, V, VI

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D. I, III, V, VI

3. The purchase cost of inventories includes all of the following, except

A. Purchase price
B. Import duties and non-refundable taxes.
C. Freight cost incurred in bringing the inventory to its intended location
D. VAT paid by a VAT-registered entity.

4. Who should properly shoulder the freight of the goods shipped?

A. The buyer
B. The seller
C. The shipper
D. The entity who owns the goods

5. Under these shipping terms, the buyer pays for the freight, which legally must be borne by the seller.
A. FOB shipping point, freight prepaid
B. FOB destination, freight collect
C. FOB shipping point, freight collect
D. FOB destination, freight prepaid

6. Under these shipping terms, the seller pays for the freight, which legally must be borne by the buyer.
A. FOB shipping point, freight prepaid
B. FOB destination, freight collect
C. FOB shipping point, freight collect
D. FOB destination, freight prepaid

7. Which of the following is incorrect regarding the accounting for consigned goods?
A. Consigned goods are properly included in the inventory of the consignor and not the consignee.
B. Freight incurred by the consignor in delivering the consigned goods to the consignee forms part of the cost of the consigned
goods.
C. The consignee records goods received from the consignor through journal entries.
D. The consignor should not recognize revenue until the consigned goods are sold by the consignee to third parties.

8. A merchandising entity utilizes an automated accounting system in which the entity inputs the serial number of each item of
inventory in the system. This enables the entity to track the movement of each inventory. Which inventory system is most likely
to be used by the said entity?
A. Periodic system
B. Perpetual system
C. Advanced accounting system
D. Either A or B

9. Under this inventory system, a physical count is necessary before profit is determined.
A. Periodic system
B. Perpetual system
C. SME inventory system
D. Under no such system

10. Under this inventory system, a physical count is necessary only for internal control purposes
A. Periodic system
B. Perpetual system
C. Large multinational entity system
D. Under no such system

11. Under the gross method of recording purchases

A. Cash discounts are initially ignored and are recorded only when taken.
B. Cash discounts are deducted from the cost of inventory on initial recognition.
C. Cash discounts lost are debited to “purchase discounts lost” account
D. B and C

12. Under the net method of recording purchases

A. Cash discounts are initially ignored and are recorded only when taken.
B. Cash discounts are deducted from the cost of inventory on initial recognition.
C. Cash discounts lost are debited to “purchase discounts lost” account
D. B and C

13. LUMA NA Co. buys and sells antiques. Each product in unique. If the entity adopts IAS 2 Inventories, the entity
A. Is required to use specific identification.
B. Is required to use FIFO.
C. Is required to use average method
D. Has the option of using either FIFO or specific identification

14. Which of the following inventory method reports most closely the current cost of inventory?
A. FIFO
B. Specific identification
C. Weighted average
D. LIFO

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15. In a period of falling prices, the use of which inventory cost flow method would typically result in the highest cost of goods sold?
A. FIFO
B. LIFO
C. Weighted average
D. Specific identification

16. In a period of rising prices, the inventory cost allocation method that tends to result in the highest reported net income is
A. FIFO
B. LIFO
C. Moving average
D. Weighted average

17. During periods of rising prices, when the FIFO inventory cost flow method is used, a perpetual inventory system would
A. Not be permitted.
B. Result in a higher ending inventory than a periodic inventory system.
C. Result in the same ending inventory than a periodic inventory system.
D. Result in a lower ending inventory than a periodic inventory system.

18. When using the moving average method of inventory valuation, a new average unit cost must be computed after each
A. Purchase
B. Issuance from inventory
C. Both A and B
D. Month-end

19. IFRS prohibits which of the following cost flow assumptions?

A. FIFO
B. LIFO
C. Specific identification
D. Average

20. When applying the LCNRV, inventories are

A. Usually written down to NRV on an item by item basis.
B. Usually not written down below fair value.
C. Usually written down to NRV on per classification basis e.g., as finished goods, work-in-progress, and raw materials.
D. All of the foregoing are true.

21. Raw materials and manufacturing supplies held for use in the production of inventories are
A. Required under IAS 2 Inventories to be separately presented from the other inventories.
B. Not disclosed since they are normally immaterial.
C. Not written down below cost if the finished products in which they will be incorporated are expected to be sold at or above
cost.
D. All of these.

22. According to IAS 2 Inventories, the best evidence of the NRV of raw materials is
A. Estimated selling price less costs to sell
B. Estimated selling price less costs to complete and costs to sell
C. Replacement cost
D. Fair value less costs to sell

23. The credit balance that arises when a loss on a purchase commitment is recognized should be
A. Presented as a current liability.
B. Subtracted from ending inventory.
C. Presented as appropriation of retained earnings.
D. Presented in the income statement.

END OF HANDOUT

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