CHAPTER 10

INVENTORIES
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 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
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process or in the rendering of services.

Inventories encompasses goods purchased and held for

resale, for example:

1. Merchandise purchased by a retailer and held for resale

2. 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
1. Trading Concern
2. Manufacturing Concern

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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.

Manufacturing Concern – Buys goods which are altered or

converted into another form before they are made available for
sale.
The inventories of a manufacturing concern are:

A. Finished Goods
B. Goods in Process
C. Raw Materials
D. Factory or Manufacturing Supplies
 DEFINITIONS

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Finished Goods – Completed products, ready for sale.
Goods in Process – Partially completed products which
require further process or work.
Raw Materials – Goods that are to be used in the
production. Their relationship to the end product is
direct.
Factory or Manufacturing Supplies – similar to raw
materials but their relationship to the end product is
indirect. These may be referred as indirect materials.
 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 “
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passing of title “ is legal language which means “the point of
time at which ownership changes.”
LEGAL TEST: Is the entity the owner of the goods to be
inventoried?
If the answer is affirmative, the goods shall be included in
the inventory. Otherwise, exclude it.
THE FOLLOWING ITEMS ARE INCLUDIBLE IN THE INVENTORY:
1. Goods owned and on hand
2. Goods in transit and sold FOB Destination.
3. Goods in transit and purchased FOB Shipping Point
4. Goods out on Consignment
5. Goods in the hands of salesman or agents
6. Goods held by customers on approval or on trial
 EXCEPTION TO THE LEGAL TEST
Installment Contracts may provide for retention of title by
the seller until the selling price is fully collected.
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Following the legal test, the goods sold on installment
basis are still the property of the seller and therefore normally
includible in his inventory.
However, in such case, it is an accepted accounting
procedure to record the installment sale as a regular sale
involving deferred income on the part of the seller and as a
regular purchase on the part of the buyer.
Thus, the goods sold on installment are included in the
inventory of the buyer and excluded from that of the seller,
the legal test to the contrary notwithstanding.
This is a clear example of economic substance prevailing
over form.
 WHO IS THE OWNER OF THE GOODS IN TRANSIT?

FOB Destination – the ownership of goods purchased is

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transferred only upon receipt by the buyer at the point of
destination. The goods in transit are still owned by the
seller. The seller shall be legally responsible for the freight
charges and other expenses up to the point of destination.

FOB Shipping Point – the ownership is transferred upon

shipment of the goods and therefore, the goods in transit
are the property of the buyer. The buyer shall be legally
responsible for the freight and other expenses from the
point of shipment to the point of destination.
 FREIGHT TERMS
Freight Collect – Freight charge on the goods are not yet paid. The
common carrier shall collect the same from the buyer. Freight is
actually paid by the buyer.
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Freight Prepaid – The freight charge on the goods is already paid by
the seller.

*The term FOB Destination and FOB Shipping Point determines the
ownership of goods and the party who is supposed to pay the
freight charges and other expenses from the point of shipment to the
point of destination.

*The terms Freight Collect and Freight Prepaid determine the party
who actually paid for the freight charge but not the party who is
supposed to legally pay for the freight charge.
 MARITIME SHIPPING TERMS
FAS ( Free Alongside ) – 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.
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The buyer bears the cost of loading and shipment and thus title
passes to the buyer when the carrier takes possession of the goods.

CIF (Cost, Insurance and Freight) – The buyer agrees to pay in a lump
sum the cost of the goods, insurance cost and freight charge. The
shipping contract may be modified as CF which means that the buyer
agrees to pay in a lump sum the cost of the goods and freight charge
only. In either case, the seller must pay for the cost of loading. Thus,
title and risk of loss shall pass to the buyer upon delivery of the goods
to the carrier.

EX-SHIP – Seller bears all expenses and risk of loss until the goods are
unloaded at which time and risk of loss shall pass to the buyer.
 CONSIGNED GOODS
It is a method of marketing goods in which the owner called
the consignor transfer physical possession of certain 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 are part of the cost of
goods consigned.
For example, a consignee sells consigned goods for P100,000.
The amount is remitted to the consignor less commission of
P15,000 and advertising of P2,000.
The consignor simply records the cash remittance as follows:
Cash 83,000
Commission 15,000
Advertising 2,000
Sales 100,000
 STATEMENT OF PRESENTATION

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Inventories are generally classified as current assets.

The inventories shall be presented as one line item in

the statement of financial position but the details
disclosed in the notes to financial statements.

The note may consist of Finished Goods, Goods in

Process, Raw Materials and Manufacturing Supplies.
 ACCOUNTING FOR INVENTORIES

Periodic System – Physical counting of goods on hand at the end

of accounting period. The quantities are multiplied by the

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corresponding unit costs to get the inventory value for balance
sheet purposes. This approach gives actual or physical
inventories. Periodic inventory procedure is generally used when
the inventory items have small peso investment.

Perpetual System – requires the maintenance of records called

stock cards that usually offer a running summary of the inventory
inflow and outflow. Inventory increases or decreases are reflected
in the stock cards and the resulting balance represents inventory.
This approach gives book or perpetual inventories. It is generally
used for the inventory items that have relatively large peso
investment. Physical counting of goods on hand shall be made at
least once a year to confirm the balances on stock cards.
 PERIODIC SYSTEM PERPETUAL SYSTEM

Purchase of merchandise on account, P300,000.

Purchases 300,000 Merchandise Inventory 300,000

Accounts Payable Accounts Payable
300,000 300,000
Payment of Freight on the purchase, P20,000.
Freight In 20,000 Merchandise Inventory 20,000
Cash 20,000 Cash 20,000
Return of merchandise purchased to a supplier, P30,000.
Accounts Payable 30,000 Accounts Payable 30,000
Purchase Return Merchandise Inventory
30,000 30,000
Sale of merchandise on account, P400,000, at 40% gross profit. The cost of merchandise
is 60% or P240,000

Accounts Receivable 400,000 Accounts Receivable 400,000

Sales 400,000 Sales 400,000
Cost of goods sold 240,000
Merchandise Inventory
240,000
 Return of merchandise sold from customer, P25,000.

Sales Return 25,000 Sales Return 25,000

Accounts Receivable Accounts Receivable
25,000 25,000
Merchandise Inventory
15,000
Cost of Goods Sold
Adjustment of Ending Inventory:
15,000

Merchandise Inventory-End As a rule, the ending inventory is not

65,000 adjusted. The balance represents the
Income Summary ending inventory.
65,000
 INVENTORY SHORTAGE/OVERAGE
If at the end of the accounting period, a physical count
indicates a different amount, an adjustment is necessary to
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recognize any inventory shortage/overage.
For example, Merchandise inventory account has a debit
balance of 65,000. Physical count of goods amounted only to
55,000, the following adjustment is necessary.

Inventory Shortage 10,000

Merchandise Inventory 10,000

The inventory shortage is usually closed to COGS because

this is often the result of normal shrinkage and breakage in
the inventory.
 TRADE DISCOUNTS AND CASH DISCOUNTS

Trade Discounts are deductions from the list or catalog

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price in order to arrive at the invoice price which is the
amount actually charged to the buyer.
Trade discounts are not recorded.
The purpose of trade discounts is to encourage trading or
increase sales. Trade discounts also suggest to the buyer the
price at which the goods may be resold.
Cash Discounts are deductions from the invoice price
when payment is made within the discount period. The
purpose is to encourage prompt payment.
Cash Discounts are recorded as purchase discount by the
buyer and sales discount by the seller.
ILLUSTRATION:

The list price of a merchandise purchased is P500,000 less 20% and 10%, with
credit terms of 5/10, n/30.

List Price 
500,000
First Trade Discount (20% x 500,000) (100,000)
400,000
Second Trade Discount (10% x 400,000) ( 40,000)
Invoice Price 360,000
Cash Discount (10% x 360,000) ( 18,000)
Payment within discount period 342,000

The journal entry to record the purchase is :

Purchases 360,000
Accounts Payable 360,000

The journal entry to record the payment of the invoice:

Accounts Payable 360,000
Cash 342,000
Purchase Discounts 18,000
 METHODS OF RECORDING PURCHASES
Gross Method – Purchases and A/P are recorded at gross.
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Net Method -- Purchases and A/P are recorded at net.
Net Method VS. Gross Method

The cost under net method • In practice most entities record

represents the cash equivalent price purchases at gross invoice amount.
on the date of payment and • Violates the matching principle because
discounts are recorded only when
therefore the theoretically correct
taken or when cash is paid rather than
historical cost.
when purchase that give rise to the
discounts are made.
• Despite theoretical shortcomings, gross
method is supported on practical
grounds.
• More convenient from bookkeeping
standpoint.
 Gross Method Net Method

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

Purchases 200,000 Purchases 196,000

Accounts Payable Accounts Payable
200,000 196,000
Assume payment is made within discounted period.

Accounts Payable 200,000

Accounts Payable 196,000
Cash 196,000
Cash 196,000
Purchase Discount
4,000 Assume payment is made beyond the discounted period.

Accounts Payable 200,000 Accounts Payable 196,000

Cash 200,000 Purchase Discount Lost 4,000
Cash 200,000
Assume that there is no payment at the end of
the period and the discount period has expired.

Purchase Discount Lost 4,000

Accounts Payable 4,000
 COST OF INVENTORIES SHALL COMPRISE:
1. Cost of Purchase
2. Cost of Conversion
3. Other cost incurred in bringing the inventories to their present
location and condition.
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Cost of Purchase – comprises the purchase price, import duties, and
irrecoverable taxes, freight, handling and other cost 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
foreign currency.
Moreover, when inventories purchased are with deferred settlement
terms, the difference between the purchase price and the amount paid is
recognized as interest expense over the period of financing.
COST OF CONVERSION

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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 -- Indirect cost of production that

remains relatively constant regardless of the volume of
production.

Variable Production Overhead -- Indirect cost of production

that varies directly with the volume of production.
 ALLOCATION OF FIXED PRODUCTION OVERHEAD
The allocation of fixed production overhead to the cost of
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conversion is based on the normal capacity of the production
facilities. Normal capacity is the production expected to be
achieved on average over a number of periods.
*Unallocated fixed overhead is recognized as expense in the
period in which it is incurred.

ALLOCATION OF VARIABLE PRODUCTION OVERHEAD

Variable production overhead is allocated to each unit of
production on the basis of the actual use of the production
facilities.
 OTHER COST
It 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.
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However, the following costs are excluded from the cost of
inventories:

A. Abnormal amounts of wasted materials, labor and other

prod. Costs.
B. Storage Costs, unless necessary in production process.
Thus, Storage cost on goods in process are capitalized but
those on finished goods are expensed.
C. Administrative Overheads
D. Distribution or Selling Cost
COST OF INVENTORIES OF A SERVICE PROVIDER

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

Labor and other cost relating to sales and general

administrative personnel are not included but are
recognized as expense in the period in which they incurred
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