UNIVERSITY OF PERPETUAL HELP SYSTEM DALTA
CALAMBA CAMPUS, BRGY. PACIANO RIZAL
CALAMBA CITY, LAGUNA, PHILIPPINES
Chapter 9 – PAS 2: INVENTORIES EDMUND E. HILARIO, CPA, MBA
FINANCIAL ACCOUNTING 1St SEMESTER 2019 – 2020
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A. Definition of inventories
PAS 2 defines inventories as “Inventories are
assets which are held are 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”, Inventories encompass the
following:
 Goods purchased and held for resale including for
example, merchandise purchased by a retailer
and held for resale, or land and other property
held for resale by a subdivision entity and real
estate developer.
 Finished goods produced
 Goods in process
 Materials and supplies awaiting use in the
production process.
In case of service provider, inventories include
the cost of the service for which the entity has not
yet recognized the related revenue. The cost of
service consists primarily of the labor and other cost
of personnel directly engaged in providing the
service, including supervisory personnel and other
overhead.
B. Classes of inventories
Inventories are broadly classified into two:
 Inventories of a trading concern - A trading
concern is one that buys and sells goods in the
same form purchased. The term “merchandise
inventory” is generally applied to goods held by a
trading concern.
 Inventories of manufacturing concern. – A
manufacturing concern is one that buys goods
which are altered or converted into another form
before they are made available for sale. The
term “finished goods”, “goods in process,” “raw
materials”, and “factory or manufacturing
supplies” refer to inventories of a manufacturing
concern.
 Finished goods are completed products
which are ready for sale. Finished goods
have assigned their full share of
manufacturing costs.
 Goods in process or work in process are
partially completed products which require
further process or work before they can be
sold. No work or process has been done on
them as yet by the company inventorying
them. Broadly, raw materials cover all
materials used in the manufacturing
operations but frequently this is restricted to
materials that will be physically incorporated
in the production of other goods and which
can be traced directly to the end product of
the production process.
 Factory or manufacturing supplies are
similar to raw materials but their relationship
to the end product is indirect. These supplies
may be referred to as indirect materials. It is
indirect because they are not physically
incorporated in the products being
manufactured. However, there are other
manufacturing supplies like paint and nails
which become part of the finished product
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but since the amounts involved are
insignificant it is impractical to attempt to
allocate their costs directly to the product.
These supplies find their way into the
product cost as part of the manufacturing
overhead.
 Factory supplies are embraced in the term
“in inventories” because they are currently
consumed in the production of goods to be
sold in the ordinary course of business.
C. Measurement of inventory
 PAS 2 provides the following principles
concerning measurement of inventory, namely
 Inventories shall be measured at the lower
of cost or net realizable value
 The cost of inventories shall be determined
by using either the FIFO method or weighted
average method.
 The cost of inventories that are not
ordinarily interchangeable and inventories
that are segregated for specific projects shall
be determined by using specific identification
method
 The cost of inventories shall comprise the
following:
 Cost of purchase
The cost of purchase of inventories
comprises the purchase prices, 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
The cost of conversion of inventories
includes cost directly related to the units of
production such as direct labor. It also
includes a systematic allocation of fixed and
variables 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. Examples are as follows:
a) Depreciation
b) Maintenance of factory building and
equipment
c) Cost of factory management and
administration
Variable production overhead is the indirect
cost of production and varies directly with
the volume of production. Examples are as
follows:
a) Indirect labor
b) Indirect materials
 Other cost
This refers to other cost which is included in
the cost of inventories only to the extent
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 UNIVERSITY OF PERPETUAL HELP SYSTEM DALTA
CALAMBA CAMPUS, BRGY. PACIANO RIZAL
CALAMBA CITY, LAGUNA, PHILIPPINES
Chapter 9 – PAS 2: INVENTORIES EDMUND E. HILARIO, CPA, MBA
FINANCIAL ACCOUNTING
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that it is incurred in bringing the inventories
to their present location and conditions. For
examples the cost of design for specific
customer. However, the following costs are
excluded from the cost 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 necessary in the
production process prior to a further
production stage, thus storage costs on
goods in process are capitalized but
storage costs on finished goods are
expensed.
c) Administrative overhead
d) Distribution or selling costs
Cost of inventories of a service provider
The cost of inventories of a service provider 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 costs relating to sales and general
administrative personnel are not included but are
recognized as expenses in the period in which they
incurred.
D. COST FORMULAS:
PAS 2, paragraph 25, expressly provides that the cost
of inventories shall be determined by using either
FIFO and weighted average.
FIFO method
Under this method, the goods first purchased are first
sold
 Under this method, the ending inventory is
expressed in terms of new prices, while the cost
of goods sold is expressed in terms of old prices
 Under this method, in a period of inflation or
rising prices, the FIFO method would result to a
higher net income but in a period of deflation or
declining prices, this method would result to the
a lower net income
 The objection of this method is that there is
improper matching of cost against revenue
because the goods sold are stated at older prices
resulting in understatement of cost of sales.
Weighted average
 Under this method, the weighted average unit
cost is computed by dividing the total cost of
goods available for sale (the cost of the
beginning inventory plus the total cost of
purchases during the period) by total units
available for sale.
 The argument for this method is that it is
relatively easy to apply and it produces inventory
valuation that approximates the current value.
 When prices are rising, the inventory valuation
will be less than the current cost while, when
prices are declining the inventory valuation will
be more than current cost.
Specific identification
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1St SEMESTER 2019 – 2020
 Specific identification means that the 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
 This method is appropriate for inventories that
are segregated for a specific project and
inventories that are not ordinarily
interchangeable.
E. Measurement of inventory
PAS 2, paragraph 9, provides that inventories shall
be measured at the lower of cost and net realizable
value. The cost of inventory is determined by using
either FIFO or average method. The measurement
of inventory at the lower of cost and net realizable
value is known as LCNRV.
F. Net realizable value
NRV is the estimated selling price in the ordinary
course of business less the estimated cost of
completion and the estimated cost of disposal. The
cost of inventories may not be recoverable under the
following circumstances:
1. The inventories are damaged
2. The inventories have become wholly or partially
obsolete
3. The selling price have declined
4. The estimated cost of completion or the
estimated cost of disposal has increased
Inventories are usually written down to NRV on an
item by item or individual basis.
G. Accounting for inventory writedown
If the cost is lower than NRV, there is no accounting
problem because the inventory is stated at cost and
the increase in value is not recognized.
If the NRV is lower than cost, the inventory is
measured at NRV.
In this case, the problem is the proper treatment of
the writedown of the inventory to NRV. The
writedown of inventory is to NRV is accounted for
using the allowance method.
H. Allowance method
The inventory is recorded at cost and any loss on
inventory writedown is accounted for separately.
This method is also known as loss method because a
loss account “lost on inventory writedown” is debited
and a valuation account “allowance for inventory
writedown” is credited.
In subsequent years, this allowance account is
adjusted upward or downward depending on the
difference between the cost and NRV of the
inventory at year-end. If the required allowance
decreases, a gain or reversal of inventory writedown
is recorded,
However, the gain is limited only to the extent of the
allowance balance. The allowance method is used in
order to effects of writedown and reversal of
writedown can be clearly identified. As a matter of
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 UNIVERSITY OF PERPETUAL HELP SYSTEM DALTA
CALAMBA CAMPUS, BRGY. PACIANO RIZAL
CALAMBA CITY, LAGUNA, PHILIPPINES

Chapter 9 – PAS 2: INVENTORIES EDMUND E. HILARIO, CPA, MBA

FINANCIAL ACCOUNTING 1St SEMESTER 2019 – 2020
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facts, PAS 2 paragraph 36, require disclosure of the
amount of any inventory writedown and the amount
of any reversal of inventory writedown.

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