CHAPTER 10

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.

Inventories encompass:

a. goods purchased and held for resale (trading/merchandising)

b. finished goods produced (manufacturing)

c. work in progress being produced (manufacturing)

d. materials and supplies used in the production process (manufacturing)

e. in the case of a service provider, the cost of the service for which the enterprise has not yet recognized the
related revenue.

RECOGNITION AND OWNERSHIP OF INVENTORIES

• Inventories are recorded as assets and are reported on the balance sheet when the following conditions are met:

➢ It is probable that the future economic benefits are associated with the inventories will flow to the
enterprise.
➢ Inventories have cost or value that can be measured reliably.

ITEMS INCLUDED IN INVENTORY QUANTITIES

BASIC CRITERION

• economic control rather than physical possession.

1. GOODS IN TRANSIT

FOB SHIPPING POINT

- legal title to (and control of) the goods is transferred at the shipping point when the seller delivers them
to the shipping company.

FOB DESTINATION POINT

– legal title (and control) is not transferred until the goods are delivered to the buyer’s place.

2. CONSIGNED GOODS

CONSIGNMENT – a special marketing arrangement wherein the consignee acts as the agent in charge of
selling the goods.

• Goods out on consignment remain the property of the consignor.

3. SALES WITH BUYBACK AGREEMENTS

• Also referred to as parking transaction.

• Inventory remains in the books of the seller. No sale is recorded.

4. Sales on installments

• A type of sale in which payment is required in periodic installments over an extended period of time.

• Goods sold on an installment basis are excluded from the seller’s inventory.

5. Segregated goods

• Pertains to special order goods manufactured according to customer’s specifications.

• These are excluded from seller’s inventory (even if it is still in the possession of the seller).

6. Goods out on approval

• Goods are owned by the seller until approved by the customer.

Cost of Inventories

1. Cost of purchase

• Include purchase price, import duties and irrecoverable taxes, freight, handling and other cost directly
attributable to the acquisition of finished goods, materials and services.

• Net of trade discounts and rebates.

2. Cost of conversion

• Include cost directly related to the units of production (ex: direct labor, allocation of fixed and variable
production overhead)

• Fixed production overhead – indirect costs of production that remains relatively constant regardless of the
volume of production. (ex: Depreciation and maintenance of factory building and equipment)

• Variable production overhead – indirect costs of production that vary directly with the volume of
production. (indirect labor and indirect materials)

3. Other costs

• Costs incurred in bringing the inventories to their present location and condition.

• The following are excluded from the cost of inventories and are recognized as expenses:

1. Abnormal amounts of wasted materials, labor and other production cost

2. Storage costs not unless these are necessary in the production process prior to a further production stage

3. Administrative overheads that do not contribute to bringing inventories to their present location and
condition.

4. Selling cost

Cost of Inventories of a Service Provider

• labor and other costs of personnel directly engaged in providing the service including supervisory personnel
and attributable overhead

• costs relating to sales and general administrative personnel are not included but are recognized as expenses.
INVENTORY ACCOUNTING SYSTEMS

1. Periodic System

➢ Also called the physical system

➢ Does not maintain continuous record of the physical quantities (or costs) of inventory on hand

➢ Physical count is taken at least once a year.

➢ Uses the account titles: Purchases, Purchase Discounts, Purchase Returns and Allowances, and Freight-in.

2. Perpetual System

➢ Maintains continuous records (detailed subsidiary records) of the movement of the items in the inventory.

➢ Uses the account titles Merchandise Inventory and Cost of Goods Sold

➢ A physical count is made at least once a year to confirm the inventory balance per books

➢ Makes use of the account Inventory Over and Short to reconcile the difference between inventory balance
and the physical count.

➢ The Inventory Over and Short is usually closed to cost of goods sold because this is often the result of
normal shrinkage and breakage in inventory.

➢ However, abnormal and material shortage should be separately classified and presented as other expense.

TRADE DISCOUNTS AND CASH DISCOUNTS

Trade discounts

➢ Trade discounts are deduction from the list or catalog price in order to arrive at the invoice price which is the
amount actually charged to the buyer. Thus, trade discounts are not recorded.

Cash discounts

➢ Cash discounts are reductions in invoice price of purchases resulting from payment of accounts within the
discount period. The objective of the seller in offering the discounts is to encourage early payment of accounts
by the buyer.

➢ Cash discounts are recorded as purchase discount by the buyer and sales discount by the seller.

RECORDING OF PURCHASES

Purchases may be recorded at gross invoice price (gross method) or at gross invoice price less available cash
discounts (net method).

 Under the gross method, cash discounts are recorded only when availed by the company and are credited to
the account “Purchases Discounts” or “Inventory”. Cash discounts that were not availed are not reflected in the
records. The Purchases Discounts account is reported in the income statement as deduction from gross
purchases.

 Under the net method, cash discounts are immediately deducted from the gross invoice price. The
“Purchases” account or “Inventory” account is debited for the net invoice price upon purchase of the goods. If
payment of account is made after the discount period; the account “Purchase Discount Lost” is debited for the
amount of discounts lost. The amount of discounts availed is not reflected in the records. The Purchase
Discounts Lost account is reported in the income statement as other operating expense item.
INVENTORY COST FLOW COST FORMULAS

PAS 2, paragraph 25, expressly provides that the cost of inventories shall be determined by using either: a. First
in, First out b. Weighted Average The standard does not permit anymore the use of last in, first out (LIFO)
method.

 FIFO (First in First out)

▪ The first goods purchased are first sold.

▪ Ending inventory is presumed to consist of the most recent costs.

▪ There is no proper matching of costs and revenues since old costs are matched against current revenues.

▪ Favors the balance sheet/statement of financial position because ending inventory approximates current
replacement costs.

▪ In a period of declining prices (deflation), the FIFO method result to the lowest net income.

Average cost

▪ Considers goods to be indistinguishable

▪ Goods are valued at an average of the costs incurred.

▪ Weighted average (periodic system) and moving average (perpetual system).

LIFO (Last in First out) – the new standard prohibits the use of LIFO inventory costing.

▪ The last goods purchased are first sold.

▪ The cost of goods sold comes from the most recent purchases.

▪ Ending inventory is presumed to consist of the earlier costs.

▪ Favors the income statement because there is proper matching of costs against revenue.

▪ In a period of rising prices (inflation), the LIFO method result to the lowest net income.

 Specific identification

▪ Specific costs are attributed to identified items of inventory

▪ The cost of inventory is determined by simply multiplying the units on hand by their actual unit cost.

▪ Applicable for inventory with a small number and are easily distinguishable.

▪ Makes possible to manipulate net income  Relative Sales Price method

▪ When different commodities are purchased at a lumpsum, the single cost is apportioned among the
commodities based on their relative sales price.