CHAPTER 1 INVENTORIES 4.

Intended Learning Outcomes After reading this chapter, you should

be able to: 1. describe the nature of inventories; 2. identify the items and costs included in
inventories; 3. account for initial recognition of and subsequent transactions affecting inventories
using both the perpetual inventory system and periodic inventory system; compute inventory cost
using the different inventory costing procedures; 5. evaluate the effects of inventory costing methods
for both financial reporting and tax reporting; analyze the effects of inventory errors on current and
future financial statements; measure inventories based on the lower of cost and net realizable value;
calculate the cost of inventories using the applicable estimating procedures; and identify information
relating to inventories required to be 9. disclosed in the financial statements. 6. 7. 8. Introduction One
of the biggest challenges of an enterprise is to maintain the appropriate volume of inventories and
control its cost of sales. One businessman states that success in business is more than good products;
success depends on assigning and monitoring costs of inventory and applying sound inventory
management procedures. NATURE OF INVENTORIES As described in International Accounting
Standards (IAS) 2, paragraph 6, inventories are assets of an enterprise, which are (a) (b) (c) -held for
sale in the ordinary course of business; in the process of production for such sales; or in the form of
materials or supplies to be consumed in the production process or in the rendering of services.
hapter 1 Inventorld merchandise inventory). inventory exactly the same form as they Inventory or
simply Inventory. for products that are partially completed at the end of a period. the tangible goods,
acquired by manufacturing concern for use in the production process. Raw Materials Inventory
includes COST OF INVENTORIES The cost of inventories should comprise all costs of purchase,
costs of conversion and other costs incurred in bringing the inventories to their present location and
condition. Costs of Purchase The cost of purchase of inventories includes the purchase price, import
duties and other taxes, and transport, 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 costs of purchase. (IAS 2, Inventories, paragraph 11). Costs of
Conversion The costs of conversion of inventories include costs directly related to the units of
production, such as direct labor as well as an allocation of fixed and variable production overhead,
which were incurred in converting materials into finished goods. indirect costs of production that
remain relatively constant regardless of the Fixed production overheads are those volume of
production, such as depreciation and maintenance of factory administration Variable production
overheads are those indirect costs of Inventories encompas goods purchased and held for finished
goods produced finished process inventory) as well as materials and supplies awaiting use
inventory), or work in progress being produced by the enterprise work in production process
(materials inventory and factory supplies inventory The nature of the business determines the
designation of an item For a manufacturing concern, inventories are classified while for a trading or
merchandising concern, the goods that they sell in Finished Goods, Goods in Process for Work in
Process) and Raw Material are bought are termed as Merchandise products awaiting sale and
contains the same cost components as the Finished Goods Inventory includes the completed
manufactured goods in process inventory. Goods in Process for Work in Process) Inventory consists
of raw materials, direct labor and manufacturing overhead costs buildings and equipment and the cost
of factory management and production that vary directly, or nearly directly, with the volume of
Theresa
Chapteri inventories productionsuch as Indirect materials and indirect lubos AS a Inventores,
paragraph 121 Cost of Agricultural Produce Harvested from Biological Assets Inventories
comprising agricultural produce that an entity has harvested from its biological assets are measured
on initial recognition at their fair value less estimated cost to sell at the point of harvest. IAS 1
Agriculture Other Costs Other costs are included in the cost of inventories only to the extent that they
are incurred in bringing the inventories to their present location and condition. Exclusions from Cost
of Inventories The following costs are excluded from the cost of inventories. They are recognized as
expenses in the period in which they are incurred. Abnormal amounts of wasted materials, labor, or
other production costs Storage costs, unless those costs are necessary in the production process prior
to a further production stage Administrative overheads that do not contribute to bringing inventories
to their present location and condition Selling costs (IAS 2, Inventories, paragraph 16) Labor and
other costs relating to sales and general administrative personnel Profit margins or non-attributable
overheads that are often factored into prices charged by service providers (IAS 2, Inventories,
paragraph 19) Financing element involved in purchases under deferred payment arrangement (IAS 2,
Inventories, paragraph 18). In general, borrowing costs incurred in connection with inventory
acquisition are recognized as finance costs. These include borrowing costs incurred to purchase
merchandise inventory and borrowing costs attributable to inventories that are manufactured, or
otherwise produced, in large A detailed discussion of accounting for biological assets and
agricultural produce is found in Chapter 5, Biological Assets, 3
quantities on a repetitive basis . However , borrowing of time for their production or development
discrete project of the enterprise and take substant are capitalized as inventory costs when inventories
que of Volume 1 of the Intermediate Accounting series , the purchase of goods Similar to the seller's
viewpoint discussed in Chapter 2 Receivable Under the gross price method of recording purchases , the
purchase is recorded at the gross amount and a Purchase Discount is recognized recorded net of trade
discounts , while cash discounts may be accounted for generally reported as a deduction from gross
purchases to arrive at net Inventories Chapter Trade and Cash Discounts using one of the following
methods: method, and allowance method. the gross price method, net when payment is made within
the discount period. purchases. Purchase Discount is The Under the net price method, the purchase is
recorded at the price of goods, net of cash discounts. The discount is recorded only if it is not taken; that
is, when payment is made after the discount period. discount not taken is recorded in Purchase
Discounts Lost or Interest Expense account, which is reported on the Statement of Comprehensive
Income as a finance cost. Under the allowance method, purchases are recorded at net prices and
accounts payable at gross prices, with the difference debited to an allowance account. Theoretically, the
net price method produces the correct inventory cost, i.e., invoice cost less all available discounts.
Purchase Discounts Lost should be treated as a financing expense for the period and should not be
added to the cost of inventory 3 ITEMS TO BE INCLUDED IN INVENTORY QUANTITIES The basic criterion
for including items in inventory is economic control rather than physical possession. For inventory,
economic control is usually consistent with legal ownership. For convenience and practicality, goods are
recorded in inventory when received by the purchaser and recorded as sold by the seller when shipped.
When financial statements are prepared, however, all goods under economic control of the enterprise
should be included in inventory whether or not the company has physical or legal possession of these
goods. Some examples are goods in transit IAS 23 Borrowing Costs provides guidance for capitalization
of borrowing costs. See chapter 2 of this book for a more detailed discussion. For an illustration of the
entries under the gross method and net method, see Chapter 5, Financial Liabilities, Volume 1 of the
Intermediate Accounting Series.

Chapter 1 Inventarten arrangements purchased For shipping point. mode in transit sold POB destination
goods sold with buyback arrangements, and goods under product financing Items that may require
special attention in determining the proper inventory items at the end of the period Goods in Transit
customers at the reporting date. Normally, some inventories are in transit to the company or its When
goods are in transit at the end of the reporting period, the terms of shipment determine whether the
seller or the buyer includes them in its inventory. If the goods are shipped FOB (Free on Board) shipping
point, legal title to (and economic control of the goods passes with the loading of goods at the point of
shipment. The buyer should include these goods in its inventory and a corresponding liability is
recognized. In addition, freight cost under FOB shipping point is for the account of the buyer. If,
however, the seller prepays for the shipping cost (termed as FOB shipping point, freight prepaid), freight
cost is added to the amount receivable from the uyer (or amount payable to the seller) If goods are
shipped FOB destination, legal title (and control) is not transferred until the goods are delivered to the
buyer's destination. Physical receipt of the goods by the buyer normally determines when it should
record the inventory in its accounting system. Freight cost under FOB destination is for the account of
the seller. If, however, the buyer paid the shipping cost upon receipt of the goods (termed as FOB
destination, freight collect), freight cost is deducted from the amount payable to the seller (or amount
receivable from the buyer). To illustrate, assume that ABC Company purchased goods costing P100,000
from XYZ Corporation. Freight cost is P10,000. Further assume that both companies use periodic
inventory system. If goods were shipped FOB shipping point and XYZ Corporation paid the freight cost of
P10,000, journal entries in both books are: ABC Company (Buyer) Purchases 100,000 Freight-in 10,000
Accounts Payable 110,000 XYZ Corporation (Seller) Accounts Receivable 110,000 Sales 100,000 Cash
10,000 If the goods were shipped FOB destination and ABC Company paid the freight cost of P10,000,
journal entries are: ABC Company (Buyer) Purchases 100,000 Accounts Payable 90,000 Cash 10,000 XYZ
Corporation (Seller) Accounts Receivable 90,000 Freight-out 10,000 Sales 100,000 5

Legal ownership of goods in transit also determines risk of loss for uds damaged or lost during shipment.
Ownership of goods still in transit In international business, other terms used for shipment of goods Free
alongside means that the risk of loss shifts from the seller to the buyer include "Free Alongside (FAS)"
and "Cost, Insurance and Freight (CIF). other hand, means that the seller arranges for the delivery of
goods by sea at a named port alongside a vessel designated by the buyer. The seller also provides the
buyer with the Goods may be transferred from one party to another for purposes of while the company
receiving the goods, called consignee, attempts to sell The company delivering the goods, called
consignor, retains ownership, sale without the ownership and ultimate economic control changing
hands. documents necessary to obtain the goods from the carrier. completion, revenue is considered to
have been earned, and shall, Anwentortes Disposition by Buyer Include Exclude Seller Exclude Include
TV be summarized as follows: Terms of Shipment FOB shipping point FOB destination CIF, on the to a
port of destination. Consigned Goods them. If the goods are sold, the consignee earns a commission and
remits the net amount to the consignor; whereas if the goods are not sold, they are returned to the
consignor. The goods must be included in the inventory of the consignor, at cost, plus the handling and
shipping costs incurred in the delivery of the goods to the consignee. The consignee, acting as an agent,
does not own the goods; hence, neither the peso amount of the consigned goods nor the financial
obligation for such goods is reported on its financial statements. In summary, the consignor includes
goods out on consignment in its inventory while the consignee excludes goods held on consignment in
its inventory. Segregated Goods customer Special order goods manufactured according to specifications,
even if still in the possession of the selling company, should be considered as sold when completed, and
therefore excluded from the selling company's inventory. The rationale for this treatment is that the
manufacturer undertakes and completes the processing of the goods based on the order and
specifications by the customers. Thus, at the point of therefore, be recognized.
However Hoods that are customarily mamando stock items of the enterprise even if physically and
unsold, until they ar actually delivered or picked up by the Conditional Sales and Installment Sales
Despite retention of title by the seller under the installment already passed to the buyer. contract, the
substance of the transaction is that control over the woods ha The seller anticipates completion of the
contract and the ultimate passing of title, and therefore recognizes the transaction as a regular sale. The
seller removes the goods from the reported inventory at the time of sale. The goods are recorded as
sold when delivered and excluded from the inventory of the seller. Other merchandise owned by an
enterprise but in the possession of others, such as goods in the hands of salespersons and agents, goods
held by customer on approval and goods held by others for storage, processing or shipment, should also
be shown as part of the ending inventory of the enterprise that economically controls the goods, Goods
Sold with Buyback Agreement A buyback agreement, accompanying sale of goods, is in substance, 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, which covers all costs of inventory plus related
holding costs. In effect, the inventory is used as collateral for a loan obtained either directly from the
buyer, or from a financing company with the buyer as intermediary. In such a case, the customer does
not obtain control of the asset (the inventory), and the transferor shall account for the transfer as a
financing arrangement and shall retain the inventory in its books. Any consideration received from the
transfer shall be credited to a financial liability (based on pars. B66 and 168, IFRS 15). 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. To account for the transfer of products with a right to return, an entity
shall recognize (a) revenue for the transferred products (at the amount of the transaction price), (b) a
refund liability, and (c) an asset for its right to recover the products from the customer on settling the
refund liability (pars. B21 to B25, IFRS 15 Revenue from Contracts with Customers). The recognition of
revenue implies that the corresponding transferred goods be removed from the inventory at their
carrying amount.

Lay away plans and bill and holdsales

As part of an entity's sales promotion scheme, lay away plans an Under this scenario, the customer pays
fraction or a portion of the selling price of merchandise and agrees to pay in merchandise and delivers
to customer only upon full payment of the goods installment or pay the full amount at a future date.
The store holds the product but retains physical possession of that product until it is This is similar to
bill-and-hold sale in which an entity bills a customer for a customer has already made payments of a
substantial portion of the goods' Under these circumstances, revenue is recognized when the customer
obtains control over the product, that is, when the following separately as already belonging to the
customer; (b) the product must be conditions have been met: (a) the product must have been identified
use the product or to direct it to another customer (based on pars. B79 and ready for transfer to the
customer; (c) and the entity does not have ability to transferred to the customer at a point in time, for
example, when a The recognition of revenue is made simultaneous to Chapter 1 Inventories Lay Away
Plans and Bill and Hold Sales being offered to customers. selling price. B81, IFRS 15). derecognition of
inventory in the seller's accounting records INVENTORY ACCOUNTING SYSTEMS Inventory quantities and
costs may be accounted for using either the periodic system or the perpetual system. Periodic System A
company using the periodic system, also called as physical system, does not maintain a continuous
record of the physical quantities (or costs) of inventory on hand. Therefore, the company will not be
able to determine its inventory accurately until a physical inventory is taken at the end of the period. At
that time, the following computation is used to determine the cost of goods sold of a merchandising
concern: Pxcx Merchandise Inventory, beginning Add net cost of purchases Cost of goods available for
sale Less Merchandise Inventory, end Cost of Goods Sold Under the periodic system, all acquisitions of
inventory are charged to a nominal account Purchases. Separate accounts are usually maintained for
purchases returns and allowances, purchases discounts, and freight-in. Net cost of purchases is the sum
of purchases and freight-in reduced by purchase discounts, returns, and allowances. Рxx xx Pxx

Chapter 1 - Inve The following are the pro-forma entries to record transactions using periodic inventory
system: Transaction Pro-forma entries a. Purchase of goods b. Purchase returns Purchases Accounts
Payable/ Cash Accounts Payable/Cash Purchase Returns c. Sale of goods xx Accounts Receivable/Cash
Sales d. Sales returns Sales Returns Accounts Receivable/Cash xx e. Year-end entry to set up ending
inventory Merchandise Inventory, end Income Summary XOX f. Year-end entry to close beginning
inventory Income Summary Merchandise Inventory, beg. Alternatively, the entry to set up ending
inventory and to close beginning inventory may be made simultaneously, setting up cost of sales for the
period. Such year-end entry is: Merchandise Inventory, ending Cost of Sales Purchase Returns and
Allowances Purchase Discounts Freight in Merchandise Inventory, beginning Purchases The periodic
inventory system is appropriate for relatively low value, but numerous inventory items, particularly
when the costs of a perpetual inventory system are likely to outweigh its benefits. Enterprises
presenting expenses on the statement of comprehensive income according to nature neither computes
nor sets up cost of sales. Rather, the net cost of purchases (adjusted for the change in inventories from
the beginning to the end of the period), is shown among operating expenses classified according to
nature. Thus, no cost of sales and gross profit are presented. In such a case, the entry to set up the
ending Enventory as an asset is xx Merchandise Inventory, ending Income Summary xx

Chapter I Inventories The beginning inventory is brought to zero balance in the process income showing
expenses according to nature, the balance of the net In the profit or loss section of the statement of
comprehensive purchases and the change in ending inventory will be shown as follows: closing the
books, with this entry: OX Income Summary Merchandise Inventory, beginning Pxx Net sales revenue
Other income XX Total income Pxx Operating expenses Pxx Net purchases (Increase) Decrease in
inventory Salaries XX Depreciation XX Other operating expenses XX Total operating expenses Pxx Profit
before interest and income tax XX Perpetual System A company using the perpetual system maintains a
continuous record of the movement of the items in its inventory. Such a system is essential when
management wants to maintain effective planning and control over inventory. Companies maintaining
inventory items in small quantities with high unit costs usually adopt this method. The purchase, or
production, and use of each item of inventory are recorded in detailed subsidiary records either in units
only, or in both costs and units. A retail firm that uses a perpetual inventory system and records the cost
of inventory transactions would prepare the following journal entries. Transaction Pro-forma entries a.
Purchase of goods Merchandise Inventory Accounts Payable/Cash XX b. Purchase returns Accounts
Payable/Cash Merchandise Inventory XX c. Sale of goods XX Accounts Receivable/ Cash Sales xx XX Cost
of Sales Merchandise Inventory xx

Chapter d. Sales returns Sales Returns Accounts Receivable/Cash Merchandise Inventory Cost of Sales At
the end of the reporting period, because the inventory account is updated, no adjusting entry is
necessary to set up ending inventory. information on a timely basis but requires the maintenance of a
full set of The perpetual system has the advantage of providing inventory inventory records. For internal
control purposes, a physical count is made at least once a year, but not necessarily at year-end, to
confirm the inventory balance per books. Variation between the physical count and the ledger balance
may result from errors in recording, shrinkage, waste, breakage, theft, and other causes. The cost of the
difference in the two quantities is entered into the accounts to bring the perpetual records into
agreement with the physical count. Any excess of the balance of the inventory control account over the
physical count, if due to normal causes, such as shrinkage and breakage, is debited to cost of sales (using
the function of expense method) or may be debited to Inventory Shortage (using either the function of
expense method or nature of expense method). Any balance in the Inventory Shortage account is
presented as other operating expenses in profit or loss section of the statement of comprehensive
income. If the excess of inventory control account over the physical count is due to theft, a separate loss
account is charged. COST FORMULAS A primary issue in accounting for inventories is the determination
of the amount to be recognized as an asset and the amount to be recognized as expense. IAS 2,
Inventories, prescribes that inventories are reported in the statement of financial position at the lower
of cost and net realizable value. IAS 2 also provides guidance on the determination of cost and its
subsequent recognition as an expense including any write-down to net realizable value as well as cost
formulas that are used to assign costs to inventories. The cost of goods available for sale is allocated
between the cost of goods sold and the ending inventory by means of a cost flow assumption. The
physical flow of goods does not need to match the assumed flow of costs used for financial statements.

Chapter 1 Inventories Inventory items that are not ordinarily interchangeable The cost of inventory
items that are not ordinarily interchangeable determined using the specific identification method.
Specific items of inventory segregated for a specific project, regardless of whether they have been
bought or produced This method requires a means of identifying the historical cost of each unit of
inventory up to the time of sale. With this method, the flow or recorded costs matches the physical flow
of goods; thus, assuring an exact matching of costs and revenues. Inventory items that are ordinarily
interchangeable The cost of inventory items that are ordinarily interchangeable is determined using
either the first-in, first out method or the weighted average method. First-in, First-out (FIFO) The FIFO
method of costing inventory is based on the assumption that costs should be charged against revenue in
the order in which they were incurred. Hence, the inventory remaining is measured based on the most
recent costs. An appropriate measurement of inventory is achieved under this method because the
ending inventory is reported at the approximate replacement cost. Meanwhile, it will be observed that
there is no proper matching of cost against revenue since earliest (old) costs are matched to current
revenues. The FIFO periodic and the FIFO perpetual methods result in the same inventory cost because
the goods are assumed to be sold in the same sequence that they were acquired. Compared with other
costing formulas, in periods of rising prices (inflation), FIFO reports the lowest cost of goods sold and the
highest amount of ending inventory and profit, whereas in periods of decreasing prices (deflation), FIFO
reports the highest cost of goods sold and the lowest amount of ending inventory and profit. Weighted
Average This method considers goods to be undistinguishable and are, therefore, valued at an average
of the costs incurred. Moving average method (perpetual system). This method requires a computation
of new unit cost after each purchase and subsequent issues are priced at the latest average unit cost.
Weighted average method (periodic system). Under the weighted average 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. 12
The weighted average method moving average for perpetual inventory system and weighted average for
periodic inventory system Chapter 1 Inventories weighted average method produces a not so high cost
of goods and was not so low profit as the earlier Tower costs and to statalize the effect increasing prices
on both cost of goods sold and ending inventory Dams a period of decreasing prices, the weighted
average method produers and tend to stabilize the effect of decreasing prices on both east of generiai
and ending inventory. IAS 2, Inventories does not permit the use of the last in, first tout (LIFO) formula
to measure the cost of inventories. Under the LIPO metho, the cost of the most recent purchase is
charged to cost of sales, hence, the cost of inventory is based on the cost of the earliest acquisition
Illustration of the Inventory Cost Allocation Methods/Cost Formas The inventory records of ABC
Merchandising showed the line data relative to a particular item sold regularly. Assume transactions the
order given): 2.000 Transaction 1. Inventory 2. Purchases 3. Sales (at P130 per unit) 4. Purchases 5. Sales
(at P135 per unit) 6. Purchases 7.000 6,000 16,000 2,000 Determine the cost of ending inventory, cost of
goods old and you profit under each of the following methods. 1. Specific Identification Method (sales of
Noorinated from the purchase of No. 2; while sales of No 5 onion from No. 2 (11,000 units) and No.
415,000 unita FIFO Method Weighted Average Method Moving Average Method 2. 3. 4. Specific
Identification Method Cost of ending inventory From No. 1 2,000 XP50 From No. 4 1,000 XP55 From No.
6 3,000 XP60 Total cost of ending inventory 13

Innentorte Cost of goods sold No. 3 antes 7.000 x PS2 No. 5 sales 11,000 X 752 5.000 x 255 Total cost of
goods sold 44000 275.000 PL.211.000 Gross profit Sales 7,000 x P130 16,000 x P135 Less cost of goods
sold Gross profit FIFO Periodic Method р 910.000 2,160,000 P3,070,000 1,211,000 P1,859,000 Cost of
ending inventory Most recent cost (3,000 units @ P60) P180,000 Next most recent cost (3,000 units @
P55) 165,000 Total cost of ending inventory P345,000 Cost of goods sold Cost of goods available for sale
2,000 x P50 P100,000 18,000 x P52 936,000 6,000 x P55 330,000 3,000 x P60 180,000 Less cost of ending
inventory Cost of goods sold P1,546,000 345,000 P1,201,000 Gross profit Sales Less cost of goods sold
Gross profit P3,070,000 1,201,000 P1.869.000 FIFO Perpetual Method action Received Issued 18,000@
52-936,000 Balance 2,000 a 50 - 100.000 2,000 @ 50 = 100,000 18,000 @ 52 = 936.000 13,000 @ 52 -
676,000 2,000 @ 50 - 100,000 5,000 @ 52- 260,000 6,000 @ 55 = 330,000 13,000 @ 52 = 676,000 6,000
@ 55 = 330,000 3,000 @ 55 - 165,000 13,000 @ 52= 676,000 3,000 @ 55- 165,000 3,000 a 60 = 180,000
3,000 @ 55 = 165,000 3,000 @ 60 = 180,000 Inventory,end=345,000 CGS = 1,201,000

Chapter 1 Inventories Gross profit Sales Less cost of goods sold Gross profit P3,070,000 1,201,000
P1,869,000 Weighted Average Method (Periodic) Cost of ending inventory Total cost of goods available
for sale Total units available for sale P1,546,000 29,000 units = P53.31 average cost per unit x 6,000 units
on hand P 319,860 Cost of goods sold Cost of goods available for sale Less cost of ending inventory Cost
of goods sold P1,546,000 319,860 P1,226,140 Gross profit Sales Less cost of goods sold Gross profit
P3,070,000 1,226,140 P1,843,860 Moving Average Method (Perpetual) A stock card is prepared as
follows: Transaction Received Issued 1 18,000@52=936,000 7,000@51.80=362,600 2 3 4 5 6 Balance
2,000@50.00= 100,000 20,000@51.80=1,036,000 13,000/a51.80- 673,400 19,000@52.81=1,003,400
3,000@52.81= 158,440 6,000@56.41= 338,440 6,000@55=330,000 16,000@52.81=844,960 3,000
@60=180,000 The procedures for the maintenance of the stock card under the moving average method
are as follows: . The number of units and total cost of the goods received are added to the previous
respective balances to derive the new number of units on hand and the total cost of goods on hand. The
moving (new) average unit cost is determined by dividing the total cost by the total number of units.
Thus, the 18,000 units purchased, in transaction 2, plus 2,000 units previously on hand equals 20,000;
P936,000 cost of purchases of 18,000 units is added to the cost of the previous inventory, P100,000; the
sum is P1,036,000. P1,036,000 is divided by 20,000 units, resulting to a moving average unit cost, after
transaction 2, of P51.80.

The number of units sold for issued) is deducted from the previous units on hand to determine the new
number of unit number of units issued x the average unit cost before issuance) P362,600 and
P1,036,000 - P362,600 = P673,400; P673.400 Chapter 2 Inventories is deducted from the previous total
cost of goods on hand. unit cost remains unchanged. (Thus, 7.000 units x P51.80 +13,000 units =
P51.80.) ev The S The cost of ending inventory after transaction 6, is the last figure in P 338,440 the
balance column The cost of goods sold is the total cost in the issued column, P362,600 + P844,960
P1,207,560 Gross profit Sales Less cost of goods sold Gross profit P3,070,000 1,207,560 P1,862.440
MEASUREMENT OF INVENTORIES SUBSEQUENT TO INITIAL RECOGNITION Inventories, in the statement
of financial position, should be measured at the lower of cost and net realizable value. Cost is
determined by applying the specific cost formula used by the enterprise as discussed in the preceding
section. Net realizable value is defined as the estimated selling price in the ordinary course of business
less the estimated costs of completion and estimated costs necessary to make the sale. The cost of
inventories may not be recoverable if those inventories are damaged, if they have become wholly or
partially obsolete, or if their selling prices have declined. The cost of inventories may not also be
recoverable if the estimated costs of completion or the estimated costs to be incurred to make the sale
have increased. The practice of writing inventories down below cost to net realizable value is consistent
with the view that assets should not be carried in excess of amounts expected to be realized from their
sale or use. (TAS 2, Inventories, paragraph 28) Inventories are usually written down to net realizable
value on an item by item basis. In some circumstances, however, it may be appropriate to group similar
or related items. This may be the case with items of inventory relating to the same product line that
have similar purposes or end uses, are produced and marketed in the same geographical area, and
cannot be practicably evaluated separately from other items in that product line. It is not appropriate to
write inventories down on the basis of a classification of inventory, for example, finished goods, or all
the inventories in a particular industry or geographical segment. (IAS 2, Inventories, paragraph 29

Chapter 1 Inventortes Estimates of net realizable value are based on the most reliable evidence at the
time the estimates are made as to the amount the inventories are expected to realize. These estimates
take into consideration fluctuations of price as well as the purpose for which the inventory is held. For
example, the net realizable value of the quantity of inventory held to satisfy firm sales or service
contracts is based on the contract price. If the sales contracts are for less than the inventory quantities
held, the net realizable value of the excess is based on general selling prices. (IAS 2, Inventories,
paragraph 31) 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. (IAS 2, Inventories, paragraph 32) To illustrate the application of the lower of cost and
net realizable value rule, assume the following information for different inventory items held by XYZ
Company at December 31, 2019: Item A B с D Cost P185.00 69.00 31.00 75.00 Sales Price P230.00
100.00 43.00 105.00 Selling Expense P35.00 30.00 15.00 37.00 Units 5,000 20,000 15,000 18,000 The
total cost of inventory is determined as follows: A B с D Total 5,000 x P185.00 20,000 x P 69.00 15,000 x
P 31.00 18,000 XP 75.00 P 925,000 1,380,000 465,000 1,350,000 P4,120,000 The inventory value is
determined as follows: NRV (SP- selling Item Cost expense) A P185.00 P195.00 B 69.00 70.00 C с 31.00
28.00 D 75.00 68.00 Total value of inventory Lower of cost and NRV P185.00 69.00 28.00 68.00 Units
5,000 20,000 15,000 18,000 Total Inventory Value P 925,000 1,380,000 420,000 1,224,000 P3,949,000

Chapter 1 Inventories Thus, from total cost of P4,120,000 to total value of inventory using lower of cost
and net realizable value of P3,949,000, there is inventory write down amounting to P171,000. Write
Down of Inventory De Та The amount of any write-down of inventories to net realizable value should be
recognized as an expense in the period the write down occurs. The write down of inventory cost to
lower of cost and net realizable value may be recorded using either direct method or allowance method,
Some entities find the allowance method more convenient to adopt since the method uses a separate
valuation account and a separate loss account, and the effects of the write-down and its subsequent
recovery can be clearly identified in the entity's statement of comprehensive income. Assume the
following data for ABC Merchandising. The company uses periodic system and first-in, first-out method
of cost allocation. Cost Lower of cost and NRV 12/31/2017 P500,000 480,000 12/31/2018 P520,000
490,000 12/31/2019 P600,000 575,000 Direct Method Allowance Method December 31, 2017 To record
ending inventory Inventory Income Summary 480,000 500,000 480,000 500,000 To record inventory at
lower of cost and NRV Loss from Decline in NRV of Inventory Allowance to Reduce Inventory to NRV
20,000 20,000 December 31, 2018 To close beginning inventory Income Summary Inventory 480,000
500,000 480,000 500,000 to record ending inventory Inventory Income Summary 490,000 520,000
490,000 520,000 To record inventory at lower of cost and NR

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Theresa

CHAPTER 1 THE ENVIRONMENT OF FINANCIAL ACCOUNTING AND REPORTING INTRODUCTION

Accounting is an information system, designed to identify, collect, measure, and communicate economic
information about a business entity (firm) to those having interest in the financial affairs of the entity.
Accounting is a social science, developed in a world of scarce resources. It is influenced by, and interacts
with economic, social and political environments. Business is conducted by investor-owned enterprises,
managed and controlled by professional managers, who are held responsible for providing reports to
absentee owners, creditors and other external interested parties. The process of developing general-
purpose financial statements and reporting general-purpose accounting information to various external
users is called financial accounting. In this environment, financial accounting and reporting communicate
information about the economic effects of accounting transactions and other events on a business entity
to these external user groups. Accountants are communicators; Accountancy is the art of
communicating financial information about a business entity to users such as shareholders, creditors
and managers. The communication is generally in the form of financial statements that show in money
terms the economic resources under the control of the management. The art lies in selecting the
information that is relevant to the users and is reliable. Financial statements are prepared and
presented for external users by many entities around the world. Although such financial statements may
appear similar from country to country, there are differences which have probably been caused by a
variety of social, economic and legal circumstances and by different countries having in mind the needs
of different users of financial statements when setting national requirements. Most accounting systems
are designed to generate information for both internal and external reporting. The external information
is much more highly summarized than the information reported internally. Understandably, a company
does not want

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The Environment of Financial Accounting and Reporting 5 to disclose every detail of its internal financial
dealings to outsiders. For this reason, external financial reporting is governed by an established body of
standards or principles that are designed to carefully define what information a firm must disclose to
outsiders. Financial accounting standards also establish a uniform method of presenting information so
that financial reports for different companies can be more easily compared. The International
Accounting Standards Board (ASB), the International Standard- Setting body is committed to narrowing
these difference by seeking to harmonize regulations, accounting standards and relating to the
preparation and presentation of financial statements. It believes that further harmonization can best be
pursued by focusing on financial statements that are prepared for the purpose of providing information
that is useful in making economic decisions. Financial statements are most commonly prepared in
accordance with an accounting model based on recoverable historical cost and the nominal financial
capital maintenance concept. Other models and concepts may be more appropriate in order to meet the
objective of providing information that is useful for making economic decisions although there is at
present no consensus for change. OBJECTIVE OF FINANCIAL REPORTING The objective of general
purpose financial reporting is to provide financial information that is useful to users in making decisions
relating to providing resources to the entity. Users' decisions involve decisions about buying, selling or
holding equity or debt instruments providing or settling loans and other forms of credit voting, or
otherwise influencing management's actions . To make these decisions, users assess prospects for future
net cash to the entity management's stewardship of the entity's economic resources . To make both
these assessments, users need information about both the entity's economic resources, claims against
the entity and changes in those resources and claims how efficiently and effectively management has
discharged its responsibilities to use the entity's economic resources,

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6 Chapter 1 ACCOUNTING INFORMATION USERS AND THEIR NEEDS The basic role of accountants is to
provide useful economic information to external and internal decision makers (users) as explained
below: a. External decision makers include present and potential stockholders, investors, creditors,
suppliers, customers, legislators, trade associations and others, who lack direct access to the
information generated by the internal operations of the business and must rely on general-purpose
financial statements to make their investment, credit and public policy decisions. 1) Investors. The
providers of risk capital and their advisers are concerned with the risk inherent in, and return provided
by their investments. Shareholders require periodic information that the managers are accounting
properly for the resources under their control. This information helps the shareholders to evaluate the
performance of the managers. The performance measured by the accountant shows the extent to which
the economic resources of the business have grown or diminished during the year. Shareholders are also
interested in information such as the enterprise's ability to generate cash and the timing and certainly of
its generation. They also need information to help them control the business and make investment
decisions. 2) Employees. Employees and their representative groups are interested in information about
the stability and profitability of their employers. They are also interested in information which enables
them to assess the ability of the enterprise to provide remuneration, retirement benefits and
employment opportunities. 3) Lenders. Lenders are interested in information that enables them to
determine whether their loans, and the interest attaching to them will be paid when due. 4) Suppliers
and other trade creditors. Suppliers and other creditors are interested in information that enables them
to determine whether amounts owing to them will be paid when due. Trade creditors are likely to be
interested in an enterprise over a shorter period than lenders unless they are dependent upon the
continuation of the enterprise as a major customer

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The Environment of Financial Accounting and Reporting 7 5) Customers. Customers have an interest in
information about the continuance of an enterprise, especially when they have a long-term involvement
with, or are dependent on, the enterprise. 6) Governments and their agencies, Governments and their
agencies are interested in the allocation of resources and therefore, the activities of enterprises. They
also require information in order to regulate the activities of enterprises, determine taxation policies
and as the basis for national income and similar statistics. 7) Public. Enterprises affect members of the
public in a variety of ways. For example, enterprises may make a substantial contribution to the local
economy in many ways, including the number of people they employ and their patronage of local
suppliers. Einancial statements may assist the public by providing information about the trends and
recent developments in the prosperity of the enterprise and the range of its activities. b. Internal
decision makers are the managers of a business entity, responsible for managing efficiently and
effectively, and who have the power and authority to obtain whatever economic information they need.
The process of providing accounting information to internal decision makers is called management
accounting. THE NEED TO DEVELOP STANDARDS - Users of financial accounting statements have both
coinciding and conflicting needs for information of various types. To meet these needs, and to satisfy
the stewardship reporting responsibility of management, companies prepare a single set of general-
purpose financial statements. Users expect these statements to present fairly, clearly, and completely
the company's financial operations. The accounting profession has attempted to develop a set of
standards that are generally accepted and universally practiced. Otherwise, each company would have
to develop its own standards. Further, readers of financial statements would have to familiarize
themselves with every company's peculiar accounting and reporting practices. It would be almost
impossible to prepare statements that could be compared Accounting Standards help accountants meet
the information demands of users by providing guidelines and limits for financial reporting. Accounting
standards also improve the comparability of financial reports among different companies. These

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8 Chapter are many different ways to account for the same underlying economic events, and users are
never satisfied with the amount of financial information they receive they always want to know more.
By defining which methods to use and how much information to disclose, accounting standards save
time and money for accountants. Users also benefit because they can learn one set of accounting rules
to apply to all companies. AND SOURCES OF FINANCIAL REPORTING DEVELOPMENT STANDARDS To a
large extent, accounting is a product of its environment; that is, it is shaped by, reflects, and reinforces
particular characteristics unique to its national environment. Like business in general, corporate
accounting and information disclosure practices are influenced by a variety of economic, social and even
political factors. While there are many differences in national environments, with corresponding varying
effects on accounting systems and reporting, there are also many similarities. Because business is
increasingly conducted across national borders, companies must be able to use their financial
statements to communicate with external users all over the world. As a result, divergent national
accounting practices are now converging to an overall global standard. As companies around the world
compete for investors' money, investors are requiring information that is comparable across investment
alternatives. For example, a Japanese investor can invest in a Japanese company, a German company, or
a U.S company. To make the best investment decision, financial information must be comparable. Thus,
investors and creditors are demanding that similar accounting methods be used around the world so
that investment options can be compared. The International Accounting Standards Board (TASB) was
formed in 1973 to develop worldwide accounting standards in an attempt to harmonize conflicting
national standards. The IASB now has a formal working relationship with the national accounting
standard setters from a number of countries, including the FASB in the United States. For non-U.S.
companies that have listed their shares on U.S. stock exchanges, the SEC accepts financial statements
prepared using IASB standards.

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The Environment of Financial Accounting and Reporting 9 Accounting Variations Ameng Countries One
might infer that these historical developments had a uniform effect on accounting systems throughout
the world, yet nothing could be further from the truth. Despite some similarities, there are at least as
many accounting systems as there are countries, and no two systems are exactly alike. The underlying
reasons for these differences are essentially environmental accounting systems evolve from and reflect
the environments they serve, just as in Genoa, Florence, and Venice in the 1400s. The reality of the
world is that environments have not evolved uniformly or simultaneously. Countries today are at stages
of economic development ranging from subsistence, barter economies to highly complex industrial
societies. While accounting practices evolved, there were, for example, differences in the amount of
private ownership, the degree of industrialization, the rate of inflation, and the level of economic
growth. Given these differences in economic conditions, differences in accounting practices should not
be surprising. Just as the accounting needs of a small proprietorship are different from those of a
multinational corporation, so are the accounting needs of an underdeveloped, agrarian country different
from those of a highly developed industrial country. Economic factors, however, are not the only
influences. Educational systems, legal systems, political systems, and sociocultural characteristics also
influence the need for accounting and the direction and speed of its development. For example, in some
Muslim countries where religious doctrine does not permit the charging of interest, there are unlikely to
be elaborate accounting procedures related to interest. Implications of Differences in Accounting Among
Nations There is some benefit to understanding how different nations do things. After all, there is always
something to be learned from the experiences of others. As a case in point, consider inflation. Suppose a
country has never experienced any significant inflation and has therefore never developed accounting
procedures related to inflation. What would happen the first time the country experienced substantial
and persistent inflation? At the present time, the most important reason for understanding different
national accounting systems lies in the increasingly internationalized world of business in which people
buy and sell, invest and disinvest, from one country to another. For example, if an enterprise is
considering granting credit to or acquiring a company

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10 Chapter 1 in another country, it must be able to assess the financial position of that company not an
easy thing to do. When the foreign company offers a balance sheet and income statement for analysis,
several things become immediately evident First, the language and the currency are different. Second,
the terminology is different; certain terms (accounts) have no counterparts in the other language or
accounting system, or they mean different things. Third, the types and amount of information disclosed
are likely to be different. In addition, there are a host of less obvious but perhaps more important
differences. For example, the procedures that were followed to arrive at the final figures are likely to be
different and less likely to be explained. Differences in procedures, such as rules of valuation,
recognition, or realization, render the financial statements meaningless unless the analyst is familiar
with the foreign country's accounting system. National accounting standards made sense when
companies raised money, and investors and lenders looked for investment opportunities, in their home
country. The world's capital markets began to globalize over 30 years ago, and the investment
community and the accounting profession quickly recognized the need for a cooperative international
effort in the development of accounting standards - and the benefits of a common global accounting
language. Calls for Global Harmonization of Accounting Standards As the world's capital markets
globalized in the last quarter of the 20th century. investors and creditors became increasingly frustrated
when trying to compare the financial statements of companies in different countries. They urged that
accounting standards around the world be harmonized. The International Accounting Standards
Committee was formed in 1973, and it developed a body of accounting standards suitable for use
around the world. By and large, however, the major developed countries continued to develop and use
their own national accounting principles. In 2001, the ASC was reorganized into the International
Accounting Standards Board. The IASB's objective is to raise the quality and consistency of financial
reporting and to have a platform of high quality and improved standards. It aims to bring about greater
transparency and a higher degree of comparability in financial reporting, both of which will benefit the
investors and are essential in achieving the goal of one uniform and globally accepted financial reporting
standards.

Theresa

The Environment of Financial Accounting and Reporting 11 In 2002, the European Union adopted an
accounting regulation requiring all publicly traded EU companies to use International Financial Reporting
Standards (IFRSs) developed by the IASB, rather than their home country standards, starting in 2005.
Some non-European countries have also replaced their national standards with IFRSs, while other
countries such as the United States, Japan, Thailand, Taiwan and others have adopted programs that
retain their national standards but converge them as closely as possible with IFRSs. As of 2006, there
were already 102 countries including the Philippines which have fully adopted the IFRSs. By 2011, the
IASB has projected that 150 countries would be IFRS compliant with the United States completing its full
convergence. Accounting Standard-Setting in the Philippines Prior to 1981, the Philippine Institute of
Certified Public Accountants (PICPA) designated the Committee on Accounting Principles, to provide
guidelines in the adoption of generally accepted accounting principles (GAAP) in the Philippines. The
Philippine GAAP were principally US-GAAP based. In 1981, the Philippine Institute of Certified Public
Accountants (PICPA) created the Accounting Standards Council (ASC) to formalize the accounting
standard- setting function in the Philippines. Its main function was to establish and improve accounting
standards that would be generally accepted in the Philippines. The approved statements of the ASC
were called, "Statement of Financial Accounting Standards (SFAS) which were still principally based on
accounting standards issued by the US-based Financial Accounting Standards Board (FASB). Between
1997 and 2004, the Philippines started adopting the International Financial Accounting and Reporting
Standards promulgated by the International Accounting Standards Committee (IASC). The IASC was
reorganized in 2001 and is now known as the International Accounting Standards Board (LASB). The
decision to move totally to International Accounting Standards was prompted by the (a) Support of the
Philippine Regulatory Agencies such as the Board of Accountancy, Securities and Exchange Commission,
Bangko Sentral ng Pilipinas and the Philippine Institute of CPAS (PICPA). (b) Increasing
internationalization of business which heightened the interest in a common language for financial
reporting. (c) Increasing recognition of International Accounting Standards by the World Bank, Asian
Development Bank and World Trade Organization.

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12 Chapter In 2004, the Accounting Standards Cound ASC) was replaced by the Financial Reporting
Standards Council (RSC). These is now the accounting Mandard setting body in the Philippines created
by the Professional Regulation Commission upon the recommendation of the Board of Accountancy
(BOA) to assist BOA in carrying out its powers and functions provided under Republic No. 20% known as
the Philippine Accountancy Act of 2004. In the same year, the FRSC approved the issuance of the new
and revised Philippine Accounting Standards (PAS) and the new Philippine Financial Reporting Standards
(PFRS) which directly correspond to IASB's IAS and IFRS. All of the issued standards took effect on
January 1, 2005 which was the date set by FRSC for the Philippines' full adoption of the IFRSs. SOURCES
OF ACCOUNTING STANDARDS Setting financial reporting standards is a complex process occurring within
a political environment that influences both what reporting is required and when Businesses, trade and
consumer associations, courts, public accounting firms, individual users, and government can and do
influence reporting practice. The following provides the authoritative support for these accounting
standards: a. International Accounting Standards Board (ASB) {Formerly International Accounting
Standards Council (IASC)). In an attempt to harmonize conflicting standards, the International
Accounting Standards Council was formed in 1973 to develop worldwide accounting standards. The
original IASC was founded by representatives of professional bodies in Australia, Canada, France,
Germany, Japan, Mexico, the Netherlands, the United Kingdom, Ireland, and the United States. By 2012,
out of 196 countries, over 120 countries have either fully or partially adopted and permitted the use of
International Financial Reporting Standards. The accounting standards produced by the IASB are
referred to as International Financial Reporting Standards (IFRSs) and International Accounting
Standards (IAS). The difference between these two sets of standards is merely one of timing; the IASB
standards issued before 2001 are called IAS and those issued since 2001 are called IFRS. In practice, the
entire body of IASB standards is referred to simply as IFRS. The International Financial Reporting
Interpretations Committee (IFRIC) which was called the Standing Interpretations Committee (SIC) before
2002

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The Environment of Financial Accounting and Reporting 13 provides technical assistance and support to
the IASB in the implementation of the standards Rationale for the Adoption of International Financial
Reporting Standards (IFRSs) In view of the greatly magnified emphasis on international commerce and
capital flows over the past thirty years, the need for global accounting standards has been increasingly
recognized. Multinational companies have grown dramatically in both size and importance over this
period, assuming very important and dominant roles in many market segments and affecting almost
every country, every government, and every person. From a financial reporting perspective, both
individual accountants and the professional bodies that establish accounting and auditing standards,
face a daunting challenge and difficulty because of the complexity of conducting international business
operations across borders each with a different set of business regulations and often different
accounting methods. Differences in applicable accounting, auditing and tax standards and regulations
may negatively impact the ability of the enterprise to prepare reliable financial information and for the
evaluation of investment opportunities vital to their further expansion or growth. Hence, it was
envisioned that IFRSs which should be capable of worldwide acceptance can contribute to a significant
improvement in the quantity and comparability of corporate financial reports. They are the set of
standards that can be used by all companies regardless of where they are based. In fact, IFRSs may
eventually supplement or even replace standards set by national standard setters. Standard-Setting Due
Process As part of its due process in developing new or revised Standards, the IASB publishes an
Exposure Draft of the proposed Standard for public comment in order to obtain the views of all
interested parties. It also publishes a "Basis for Conclusions" to its Exposure Drafts and Standards to
explain how it reached its conclusions and to give background information. When one or more Board
members disagree with a Standard, the Board publishes those dissenting opinions with the Standard. To
obtain advice on major projects, the Board often forms advisory committees or other specialist groups
and may also hold public hearings and conduct field tests on proposed Standards.

Theresa

b. Filmneval Reporting Shulard Councit (FRSO (Formerly Accounting 14 Chapter Standards Council (ASC)
The Professional Regulation Commission (PRC) of the Republic of the Philippines upon the
recommendation of the Board of Accountancy created an accounting standard setting body known as
the Financial Reporting Standards Council (ERS) to assist the Board in carrying out its powers and
functions provided for in Article II, Section 9 (g) of the Philippine Accountancy Act of 2004 (R.A. 9298)
and Section 9 (a) of the Implementing Rules and Regulations of the said law, The FRSC is composed of
fifteen (15) members with a Chairman, who had been or presently a senior accounting practitioner in
any of the scope of accounting practice and fourteen (14) representatives from the following: 1 (a)
Board of Accountancy (b) Securities and Exchange Commission (c) Bangko Sentral ng Pilipinas (d) Bureau
of Internal Revenue (e) A major organization composed of preparers and users of financial statements (f)
Commission on Audit (g) Accredited National Professional Organization of CPAs Public Practice 2
Commerce and Industry 2 Academe/Education 2 Government 2 8 The FRSC actively participates in the
evaluation and deliberation of proposed IFRSs forwarded by the IASB to the country's standard setting
body and submits to the Board of Accountancy its recommendation for the adoption of the proposed
IFRS. Once approved, the IFRS is designated as Philippine Financial Reporting Standard (PFRS).

Theresa

The Environment of Financial Accounting and Reporting 15 Other Organizations Influencing Financial
and Reporting Accounting Standards Securities and Exchange Commission (SEC). The Securities and
Exchange Commission has the legal authority to prescribe accounting principles and practices for usually
all companies issuing publicly traded securities. To date, the SEC has participated in the formulation of
accounting principles. In addition, the SEC administers the extensive disclosure requirements of the
Securities Act. d. Philippine Institute of Certified Public Accountants (PICPA). The Philippine Institute of
Certified Public Accountants, the PRC accredited professional organization is in the forefront in the
standard setting activities in the country. Representatives from the four sectors of the organization
(public practice, commerce and industry, education and government) are appointed to FRSC. Other
professional associations also influence the development of accounting standards. The Financial
Executives Institute (FINEX) is composed mainly of high-level financial executives. The Institute of
Management Accountants (IMA), emphasizes managerial and cost accountancy. Each of these
organizations provides input to the Philippine Financial Reporting Standards (PFRS) through
representation in the FRSC. Technical papers and publications of accounting educators are also included
as sources of accounting standards. f. Bureau of Internal Revenue (BIR). The Bureau of Internal Revenue
administers the provisions of the Internal Revenue Code. These provisions do not always reflect the
goals of financial accounting. However, they do at times influence the choice of accounting methods and
procedures. e. FINANCIAL REPORTING FRAMEWORK A financial reporting framework is vital to financial
governance of entities. This is a set of accounting principles, standards, interpretation and
pronouncements that must be adopted in the preparation and submission of the annual financial
statements of a particular class of entities. It includes, but not limited to the Philippine Financial
Reporting Standards. Figure 1.1 shows the Financial Reporting Framework adopted in the Philippines as
of January 1, 2018. Discussion of the significant provisions in the Revised Conceptual Framework
approved by the IASB on March 29, 2018 is included in this textbook.

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18 Chapter ! SIC-7 SIC-10 SIC-15 Standards Interpretation Committee (SIC) Issuances Introduction of the
Euro Government Assistance - No Specific Relation to Operating Activities Operating Leases - Incentives
Income Taxes - Changes in the Tax Status of an Entity or its Shareholders Service Concession
Arrangements: Disclosures. Intangible Assets - Web Site Costs SIC-25 SIC-29 SIC-32 MAJOR CHALLENGES
IN FINANCIAL REPORTING ENVIRONMENT While our reporting model has worked well in capturing and
organizing financial information in a useful and reliable fashion, much still needs to be done. For
example, if we move to the year 2030 and look back at financial reporting today, we might read the
following. A. IFRS / PRFS in a Political Environment The implementation of Financial Accounting and
Reporting Standards affects the interest of many user groups. User groups are possibly the most
influential group in the development of accounting standards. They consist of those most interested in
or affected by accounting rules and may want particular economic events accounted for and reported in
a particular way. They fight hard through participation in the formulation of these accounting rules or try
hard to influence or persuade the formulation of such. User groups that may influence the formulation
of accounting standards include: 1. Business entities 2. Financial community 3. Preparers 4. Government
5. Industry accounts 6. CPAs and Accounting firms 7. Professional organizations (e.g., PICPA, ACPAPP) 8.
Industry public 9. Academicians These user groups often target the IASB to pressure it to influence
changes in the existing rules and the development of new ones.

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The Environment of Financial Accounting and Reporting 19 B. The Expectation Gap The expectations gap
- what the public think accountant should do and what accountants think they can do, is difficult to
eliminate. Inspite of the Securities and Exchange Commission's increase in its policy efforts, approving
new auditor independence rules and materiality guidelines for financial reporting, accounting scandals,
poor reporting practices still occur. Due to the number of fraudulent reporting cases, some sectors
question whether the profession is doing enough. The profession on the other hand can argue rightfully
that accounting cannot be responsible for every financial catastrophe and it must continue to meet the
needs of the society. The downside however, of efforts to meet these needs through highly transparent
clear and reliable system is that considerable resources will be required and will prove to be more costly
to society. C. Financial Reporting Issues Nonfinuneial measurements. Financial reports fail to provide
some key performance measures widely used by management, such as customer satisfaction indexes,
backlog information, rejection rates on goods purchased, as well as the results of companies'
sustainability efforts. • Forward-looking information. Financial reports fail to provide forward-looking
information needed by present and potential investors and creditors. One individual noted that financial
statements in 2017 should have started with the phrase, "Once upon a time," to signify their use of
historical cost and accumulation of past events. Soft assets. Financial reports focus on hard assets
inventory, plant assets) but fail to provide much information about a company's soft assets (intangibles).
The best assets are often intangible. Consider Jollibee's know-how and market dominance, Purgold's
expertise in supply chain management, and Rustans brand image. • Timeliness. Companies only prepare
financial statement quarterly and provide audited financial annually. Little to no real-time financial
statement information is available.

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20 Chapter 1 D. The Constraints on Useful Financial Reporting Economic decision makers must recognize
that the information they receive from accountants cortstitutes only a part of the information they need
to make sound economic decisions. The financial statements also have limitations and imperfections
which the users should keep in mind. Some of the constraints are: Cost-Benefit Balancing The costs of
providing financial information fall initially on the preparer (the company) and then are passed on to
consumers (external users). These costs include the cost of collecting, processing, auditing, and
communicating the information as well as those associated with losing a competitive advantage by
disclosing the information. The benefits are enjoyed by a diverse group of investors and creditors, by
customers (because they are assured a steady supply of goods and services), and by the preparer itself
(for use in internal decision making). To be reported, accounting information not only must be relevant
and reliable but it also must satisfy the benefit/cost constraint. That is, the IASB must have reasonable
assurance that the costs of implementing a standard will not exceed the benefits. Balance between
Qualitative Characteristics In practice, a balancing, or trade-off, between qualitative characteristics is
often necessary. Generally, the aim is to achieve an appropriate balance among the characteristics in
order to meet the objective of financial statements. The relative importance of the characteristics in
different cases is a matter of professional judgment. True and Fair View Presentation Financial
statements are frequently described as presenting fairly the financial position, performance and changes
in financial position of an enterprise. Although this framework does not deal directly with such concepts,
the application of the principal qualitative characteristics and of appropriate accounting standards
normally results in financial statements that convey what is generally understood as presenting fairly
such information

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The Environment of Financial Accounting and Reporting 21 ENHANCING THE EXISTING SYSTEM OF
FINANCIAL REPORTING Investors have expressed concerns that one-size-fits-all financial reports do not
meet the needs of the spectrum of investors who rely on those reports. While many individual investors
are more interested in summarized, plain- English reports, market analysts and other investment
professionals may desire information at a far more detailed level than is currently provided. Technology
may help customize the information that the different types of investors desire. Companies also express
concerns with the complexity of the financial reporting system. Companies assert that when preparing
financial reports, it is difficult to ensure compliance with the voluminous and complex requirements
contained in SEC reporting rules. This is a particularly heavy burden on smaller, non-public companies,
which may have fewer resources to comply with the wide range of rules, We also need to consider the
broader array of information that investors need to make informed decisions. As some have noted, the
percentage of a company's market value that can be attributed to accounting book value has declined
significantly from the days of a bricks-and-mortar economy. Thus, we may want to consider a more
comprehensive business reporting model, including both financial and nonfinancial key performance
indicators. Finally, we must also consider how to deliver all of this information in a timelier manner. In a
world where messages can be sent across the world in a blink of an eye, it is ironic that the analysis of
financial information is still subject to many manual processes, resulting in delays, increased costs and
errors. ETHICS IN THE ACCOUNTING ENVIRONMENT Ethics is a term that refers to a code or moral
system that provides criteria for evaluating right and wrong. One of the elements that many believe
distinguishes a profession from other occupations is the acceptance by its members of a responsibility
for the interests of those it serves. Because of the important role of accounting in society, accountants
must maintain high ethical standards. Facing pressures and influence of numerous groups with
conflicting interests, the accountant should always be alert about ethical behavior. The Code of Ethics
promulgated by the Board of Accountancy provides guidelines for practicing accountants. However, the
code does not present a structured approach to resolving ethical dilemmas and conflicts.

Theresa
22 Chapter / In general, the accountant should be able to recognize and understand ethical issues to
identify and evaluate the possible consequences of each of the alternative solutions and to select the
best alternative which will ensure relevant, reliable, comparable and consistent financial information to
serve the best of the users' interests as a whole, CPAs as well as other accountants are expected to
make unswerving commitment to honorable behavior, even at the sacrifice of personal advantage. The
public accounting profession has worked hard to gain the public trust and it benefits monetarily from
that trust as the sole legally acceptable provider of assurance services for companies and other
organizations. For that trust and economic advantage to be maintained, it is essential that professional
integrity be based on personal moral standards and reinforced by codes of conduct. Whenever a
"scandal" surfaces, the profession is diminished and CPAs are personally ruined. External auditors need
to exhibit the highest standard of ethical principles in order to function. It is not difficult to find oneself
in ethically compromising situations without realizing it. Accounting professionals are often faced with
difficult types of ethical dilemma. For example, if the public does not have confidence in the
independence and integrity of auditors, it will not subscribe any value of the auditor's work. Professional
accountants in business (i.e., CPAs in commerce and industry, government and education) oftentimes
have to make judgements that involve ethically charged issues and without an ethical framework, an
ethical dilemma may not be resolved in a thoughtful manner. Therefore, careless work or lack of
integrity on the part of any CPA may lead to a negative view toward the entire profession. THE ROLE OF
EXTERNAL AUDITORS An audit consists of examining enough of the company's records to determine
whether the financial statements are prepared in the applicable financial reporting standards. An
external auditor, a CPA is an independent professional who conducts the audit in accordance with the
Standards on Auditing. When the audit is completed, the auditor makes no claim as to the accuracy of
the financial statements he has audited What he tries to achieve is reasonable assurance that there are
no material misstatements in those financial statements. He issues a report containing the "audit
opinion" as to the company's compliance with IFRS/PFRS.

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quiz1.docx

quiz1-converted.pdf

10:57 AM

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Chapter 1 Inventorld merchandise inventory). inventory exactly the same form as they Inventory or
simply Inventory. for products that are partially completed at the end of a period. the tangible goods,
acquired by manufacturing concern for use in the production process. Raw Materials Inventory includes
COST OF INVENTORIES The cost of inventories should comprise all costs of purchase, costs of conversion
and other costs incurred in bringing the inventories to their present location and condition. Costs of
Purchase The cost of purchase of inventories includes the purchase price, import duties and other taxes,
and transport, 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
costs of purchase. (IAS 2, Inventories, paragraph 11). Costs of Conversion The costs of conversion of
inventories include costs directly related to the units of production, such as direct labor as well as an
allocation of fixed and variable production overhead, which were incurred in converting materials into
finished goods. indirect costs of production that remain relatively constant regardless of the Fixed
production overheads are those volume of production, such as depreciation and maintenance of factory
administration Variable production overheads are those indirect costs of Inventories encompas goods
purchased and held for finished goods produced finished process inventory) as well as materials and
supplies awaiting use inventory), or work in progress being produced by the enterprise work in
production process (materials inventory and factory supplies inventory The nature of the business
determines the designation of an item For a manufacturing concern, inventories are classified while for
a trading or merchandising concern, the goods that they sell in Finished Goods, Goods in Process for
Work in Process) and Raw Material are bought are termed as Merchandise products awaiting sale and
contains the same cost components as the Finished Goods Inventory includes the completed
manufactured goods in process inventory. Goods in Process for Work in Process) Inventory consists of
raw materials, direct labor and manufacturing overhead costs buildings and equipment and the cost of
factory management and production that vary directly, or nearly directly, with the volume of

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Chapteri inventories productionsuch as Indirect materials and indirect lubos AS a Inventores, paragraph
121 Cost of Agricultural Produce Harvested from Biological Assets Inventories comprising agricultural
produce that an entity has harvested from its biological assets are measured on initial recognition at
their fair value less estimated cost to sell at the point of harvest. IAS 1 Agriculture Other Costs Other
costs are included in the cost of inventories only to the extent that they are incurred in bringing the
inventories to their present location and condition. Exclusions from Cost of Inventories The following
costs are excluded from the cost of inventories. They are recognized as expenses in the period in which
they are incurred. Abnormal amounts of wasted materials, labor, or other production costs Storage
costs, unless those costs are necessary in the production process prior to a further production stage
Administrative overheads that do not contribute to bringing inventories to their present location and
condition Selling costs (IAS 2, Inventories, paragraph 16) Labor and other costs relating to sales and
general administrative personnel Profit margins or non-attributable overheads that are often factored
into prices charged by service providers (IAS 2, Inventories, paragraph 19) Financing element involved in
purchases under deferred payment arrangement (IAS 2, Inventories, paragraph 18). In general,
borrowing costs incurred in connection with inventory acquisition are recognized as finance costs. These
include borrowing costs incurred to purchase merchandise inventory and borrowing costs attributable
to inventories that are manufactured, or otherwise produced, in large A detailed discussion of
accounting for biological assets and agricultural produce is found in Chapter 5, Biological Assets, 3

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quantities on a repetitive basis . However , borrowing of time for their production or development
discrete project of the enterprise and take substant are capitalized as inventory costs when inventories
que of Volume 1 of the Intermediate Accounting series , the purchase of goods Similar to the seller's
viewpoint discussed in Chapter 2 Receivable Under the gross price method of recording purchases , the
purchase is recorded at the gross amount and a Purchase Discount is recognized recorded net of trade
discounts , while cash discounts may be accounted for generally reported as a deduction from gross
purchases to arrive at net Inventories Chapter Trade and Cash Discounts using one of the following
methods: method, and allowance method. the gross price method, net when payment is made within
the discount period. purchases. Purchase Discount is The Under the net price method, the purchase is
recorded at the price of goods, net of cash discounts. The discount is recorded only if it is not taken; that
is, when payment is made after the discount period. discount not taken is recorded in Purchase
Discounts Lost or Interest Expense account, which is reported on the Statement of Comprehensive
Income as a finance cost. Under the allowance method, purchases are recorded at net prices and
accounts payable at gross prices, with the difference debited to an allowance account. Theoretically, the
net price method produces the correct inventory cost, i.e., invoice cost less all available discounts.
Purchase Discounts Lost should be treated as a financing expense for the period and should not be
added to the cost of inventory 3 ITEMS TO BE INCLUDED IN INVENTORY QUANTITIES The basic criterion
for including items in inventory is economic control rather than physical possession. For inventory,
economic control is usually consistent with legal ownership. For convenience and practicality, goods are
recorded in inventory when received by the purchaser and recorded as sold by the seller when shipped.
When financial statements are prepared, however, all goods under economic control of the enterprise
should be included in inventory whether or not the company has physical or legal possession of these
goods. Some examples are goods in transit IAS 23 Borrowing Costs provides guidance for capitalization
of borrowing costs. See chapter 2 of this book for a more detailed discussion. For an illustration of the
entries under the gross method and net method, see Chapter 5, Financial Liabilities, Volume 1 of the
Intermediate Accounting Series.

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Chapter 1 Inventarten arrangements purchased For shipping point. mode in transit sold POB destination
goods sold with buyback arrangements, and goods under product financing Items that may require
special attention in determining the proper inventory items at the end of the period Goods in Transit
customers at the reporting date. Normally, some inventories are in transit to the company or its When
goods are in transit at the end of the reporting period, the terms of shipment determine whether the
seller or the buyer includes them in its inventory. If the goods are shipped FOB (Free on Board) shipping
point, legal title to (and economic control of the goods passes with the loading of goods at the point of
shipment. The buyer should include these goods in its inventory and a corresponding liability is
recognized. In addition, freight cost under FOB shipping point is for the account of the buyer. If,
however, the seller prepays for the shipping cost (termed as FOB shipping point, freight prepaid), freight
cost is added to the amount receivable from the uyer (or amount payable to the seller) If goods are
shipped FOB destination, legal title (and control) is not transferred until the goods are delivered to the
buyer's destination. Physical receipt of the goods by the buyer normally determines when it should
record the inventory in its accounting system. Freight cost under FOB destination is for the account of
the seller. If, however, the buyer paid the shipping cost upon receipt of the goods (termed as FOB
destination, freight collect), freight cost is deducted from the amount payable to the seller (or amount
receivable from the buyer). To illustrate, assume that ABC Company purchased goods costing P100,000
from XYZ Corporation. Freight cost is P10,000. Further assume that both companies use periodic
inventory system. If goods were shipped FOB shipping point and XYZ Corporation paid the freight cost of
P10,000, journal entries in both books are: ABC Company (Buyer) Purchases 100,000 Freight-in 10,000
Accounts Payable 110,000 XYZ Corporation (Seller) Accounts Receivable 110,000 Sales 100,000 Cash
10,000 If the goods were shipped FOB destination and ABC Company paid the freight cost of P10,000,
journal entries are: ABC Company (Buyer) Purchases 100,000 Accounts Payable 90,000 Cash 10,000 XYZ
Corporation (Seller) Accounts Receivable 90,000 Freight-out 10,000 Sales 100,000 5

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However Hoods that are customarily mamando stock items of the enterprise even if physically and
unsold, until they ar actually delivered or picked up by the Conditional Sales and Installment Sales
Despite retention of title by the seller under the installment already passed to the buyer. contract, the
substance of the transaction is that control over the woods ha The seller anticipates completion of the
contract and the ultimate passing of title, and therefore recognizes the transaction as a regular sale. The
seller removes the goods from the reported inventory at the time of sale. The goods are recorded as
sold when delivered and excluded from the inventory of the seller. Other merchandise owned by an
enterprise but in the possession of others, such as goods in the hands of salespersons and agents, goods
held by customer on approval and goods held by others for storage, processing or shipment, should also
be shown as part of the ending inventory of the enterprise that economically controls the goods, Goods
Sold with Buyback Agreement A buyback agreement, accompanying sale of goods, is in substance, 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, which covers all costs of inventory plus related
holding costs. In effect, the inventory is used as collateral for a loan obtained either directly from the
buyer, or from a financing company with the buyer as intermediary. In such a case, the customer does
not obtain control of the asset (the inventory), and the transferor shall account for the transfer as a
financing arrangement and shall retain the inventory in its books. Any consideration received from the
transfer shall be credited to a financial liability (based on pars. B66 and 168, IFRS 15). 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. To account for the transfer of products with a right to return, an entity
shall recognize (a) revenue for the transferred products (at the amount of the transaction price), (b) a
refund liability, and (c) an asset for its right to recover the products from the customer on settling the
refund liability (pars. B21 to B25, IFRS 15 Revenue from Contracts with Customers). The recognition of
revenue implies that the corresponding transferred goods be removed from the inventory at their
carrying amount.

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CHAPTER 1 INVENTORIES 4. Intended Learning Outcomes After reading this chapter, you should be able
to: 1. describe the nature of inventories; 2. identify the items and costs included in inventories; 3.
account for initial recognition of and subsequent transactions affecting inventories using both the
perpetual inventory system and periodic inventory system; compute inventory cost using the different
inventory costing procedures; 5. evaluate the effects of inventory costing methods for both financial
reporting and tax reporting; analyze the effects of inventory errors on current and future financial
statements; measure inventories based on the lower of cost and net realizable value; calculate the cost
of inventories using the applicable estimating procedures; and identify information relating to
inventories required to be 9. disclosed in the financial statements. 6. 7. 8. Introduction One of the
biggest challenges of an enterprise is to maintain the appropriate volume of inventories and control its
cost of sales. One businessman states that success in business is more than good products; success
depends on assigning and monitoring costs of inventory and applying sound inventory management
procedures. NATURE OF INVENTORIES As described in International Accounting Standards (IAS) 2,
paragraph 6, inventories are assets of an enterprise, which are (a) (b) (c) -held for sale in the ordinary
course of business; in the process of production for such sales; or in the form of materials or supplies to
be consumed in the production process or in the rendering of services.

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Legal ownership of goods in transit also determines risk of loss for uds damaged or lost during shipment.
Ownership of goods still in transit In international business, other terms used for shipment of goods Free
alongside means that the risk of loss shifts from the seller to the buyer include "Free Alongside (FAS)"
and "Cost, Insurance and Freight (CIF). other hand, means that the seller arranges for the delivery of
goods by sea at a named port alongside a vessel designated by the buyer. The seller also provides the
buyer with the Goods may be transferred from one party to another for purposes of while the company
receiving the goods, called consignee, attempts to sell The company delivering the goods, called
consignor, retains ownership, sale without the ownership and ultimate economic control changing
hands. documents necessary to obtain the goods from the carrier. completion, revenue is considered to
have been earned, and shall, Anwentortes Disposition by Buyer Include Exclude Seller Exclude Include
TV be summarized as follows: Terms of Shipment FOB shipping point FOB destination CIF, on the to a
port of destination. Consigned Goods them. If the goods are sold, the consignee earns a commission and
remits the net amount to the consignor; whereas if the goods are not sold, they are returned to the
consignor. The goods must be included in the inventory of the consignor, at cost, plus the handling and
shipping costs incurred in the delivery of the goods to the consignee. The consignee, acting as an agent,
does not own the goods; hence, neither the peso amount of the consigned goods nor the financial
obligation for such goods is reported on its financial statements. In summary, the consignor includes
goods out on consignment in its inventory while the consignee excludes goods held on consignment in
its inventory. Segregated Goods customer Special order goods manufactured according to specifications,
even if still in the possession of the selling company, should be considered as sold when completed, and
therefore excluded from the selling company's inventory. The rationale for this treatment is that the
manufacturer undertakes and completes the processing of the goods based on the order and
specifications by the customers. Thus, at the point of therefore, be recognized.

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As part of an entity's sales promotion scheme, lay away plans an Under this scenario, the customer pays
fraction or a portion of the selling price of merchandise and agrees to pay in merchandise and delivers
to customer only upon full payment of the goods installment or pay the full amount at a future date.
The store holds the product but retains physical possession of that product until it is This is similar to
bill-and-hold sale in which an entity bills a customer for a customer has already made payments of a
substantial portion of the goods' Under these circumstances, revenue is recognized when the customer
obtains control over the product, that is, when the following separately as already belonging to the
customer; (b) the product must be conditions have been met: (a) the product must have been identified
use the product or to direct it to another customer (based on pars. B79 and ready for transfer to the
customer; (c) and the entity does not have ability to transferred to the customer at a point in time, for
example, when a The recognition of revenue is made simultaneous to Chapter 1 Inventories Lay Away
Plans and Bill and Hold Sales being offered to customers. selling price. B81, IFRS 15). derecognition of
inventory in the seller's accounting records INVENTORY ACCOUNTING SYSTEMS Inventory quantities and
costs may be accounted for using either the periodic system or the perpetual system. Periodic System A
company using the periodic system, also called as physical system, does not maintain a continuous
record of the physical quantities (or costs) of inventory on hand. Therefore, the company will not be
able to determine its inventory accurately until a physical inventory is taken at the end of the period. At
that time, the following computation is used to determine the cost of goods sold of a merchandising
concern: Pxcx Merchandise Inventory, beginning Add net cost of purchases Cost of goods available for
sale Less Merchandise Inventory, end Cost of Goods Sold Under the periodic system, all acquisitions of
inventory are charged to a nominal account Purchases. Separate accounts are usually maintained for
purchases returns and allowances, purchases discounts, and freight-in. Net cost of purchases is the sum
of purchases and freight-in reduced by purchase discounts, returns, and allowances. Рxx xx Pxx

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As part of an entity's sales promotion scheme, lay away plans an Under this scenario, the customer pays
fraction or a portion of the selling price of merchandise and agrees to pay in merchandise and delivers
to customer only upon full payment of the goods installment or pay the full amount at a future date.
The store holds the product but retains physical possession of that product until it is This is similar to
bill-and-hold sale in which an entity bills a customer for a customer has already made payments of a
substantial portion of the goods' Under these circumstances, revenue is recognized when the customer
obtains control over the product, that is, when the following separately as already belonging to the
customer; (b) the product must be conditions have been met: (a) the product must have been identified
use the product or to direct it to another customer (based on pars. B79 and ready for transfer to the
customer; (c) and the entity does not have ability to transferred to the customer at a point in time, for
example, when a The recognition of revenue is made simultaneous to Chapter 1 Inventories Lay Away
Plans and Bill and Hold Sales being offered to customers. selling price. B81, IFRS 15). derecognition of
inventory in the seller's accounting records INVENTORY ACCOUNTING SYSTEMS Inventory quantities and
costs may be accounted for using either the periodic system or the perpetual system. Periodic System A
company using the periodic system, also called as physical system, does not maintain a continuous
record of the physical quantities (or costs) of inventory on hand. Therefore, the company will not be
able to determine its inventory accurately until a physical inventory is taken at the end of the period. At
that time, the following computation is used to determine the cost of goods sold of a merchandising
concern: Pxcx Merchandise Inventory, beginning Add net cost of purchases Cost of goods available for
sale Less Merchandise Inventory, end Cost of Goods Sold Under the periodic system, all acquisitions of
inventory are charged to a nominal account Purchases. Separate accounts are usually maintained for
purchases returns and allowances, purchases discounts, and freight-in. Net cost of purchases is the sum
of purchases and freight-in reduced by purchase discounts, returns, and allowances. Рxx xx Pxx

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Chapter 1 - Inve The following are the pro-forma entries to record transactions using periodic inventory
system: Transaction Pro-forma entries a. Purchase of goods b. Purchase returns Purchases Accounts
Payable/ Cash Accounts Payable/Cash Purchase Returns c. Sale of goods xx Accounts Receivable/Cash
Sales d. Sales returns Sales Returns Accounts Receivable/Cash xx e. Year-end entry to set up ending
inventory Merchandise Inventory, end Income Summary XOX f. Year-end entry to close beginning
inventory Income Summary Merchandise Inventory, beg. Alternatively, the entry to set up ending
inventory and to close beginning inventory may be made simultaneously, setting up cost of sales for the
period. Such year-end entry is: Merchandise Inventory, ending Cost of Sales Purchase Returns and
Allowances Purchase Discounts Freight in Merchandise Inventory, beginning Purchases The periodic
inventory system is appropriate for relatively low value, but numerous inventory items, particularly
when the costs of a perpetual inventory system are likely to outweigh its benefits. Enterprises
presenting expenses on the statement of comprehensive income according to nature neither computes
nor sets up cost of sales. Rather, the net cost of purchases (adjusted for the change in inventories from
the beginning to the end of the period), is shown among operating expenses classified according to
nature. Thus, no cost of sales and gross profit are presented. In such a case, the entry to set up the
ending Enventory as an asset is xx Merchandise Inventory, ending Income Summary xx

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Chapter I Inventories The beginning inventory is brought to zero balance in the process income showing
expenses according to nature, the balance of the net In the profit or loss section of the statement of
comprehensive purchases and the change in ending inventory will be shown as follows: closing the
books, with this entry: OX Income Summary Merchandise Inventory, beginning Pxx Net sales revenue
Other income XX Total income Pxx Operating expenses Pxx Net purchases (Increase) Decrease in
inventory Salaries XX Depreciation XX Other operating expenses XX Total operating expenses Pxx Profit
before interest and income tax XX Perpetual System A company using the perpetual system maintains a
continuous record of the movement of the items in its inventory. Such a system is essential when
management wants to maintain effective planning and control over inventory. Companies maintaining
inventory items in small quantities with high unit costs usually adopt this method. The purchase, or
production, and use of each item of inventory are recorded in detailed subsidiary records either in units
only, or in both costs and units. A retail firm that uses a perpetual inventory system and records the cost
of inventory transactions would prepare the following journal entries. Transaction Pro-forma entries a.
Purchase of goods Merchandise Inventory Accounts Payable/Cash XX b. Purchase returns Accounts
Payable/Cash Merchandise Inventory XX c. Sale of goods XX Accounts Receivable/ Cash Sales xx XX Cost
of Sales Merchandise Inventory xx

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Chapter d. Sales returns Sales Returns Accounts Receivable/Cash Merchandise Inventory Cost of Sales At
the end of the reporting period, because the inventory account is updated, no adjusting entry is
necessary to set up ending inventory. information on a timely basis but requires the maintenance of a
full set of The perpetual system has the advantage of providing inventory inventory records. For internal
control purposes, a physical count is made at least once a year, but not necessarily at year-end, to
confirm the inventory balance per books. Variation between the physical count and the ledger balance
may result from errors in recording, shrinkage, waste, breakage, theft, and other causes. The cost of the
difference in the two quantities is entered into the accounts to bring the perpetual records into
agreement with the physical count. Any excess of the balance of the inventory control account over the
physical count, if due to normal causes, such as shrinkage and breakage, is debited to cost of sales (using
the function of expense method) or may be debited to Inventory Shortage (using either the function of
expense method or nature of expense method). Any balance in the Inventory Shortage account is
presented as other operating expenses in profit or loss section of the statement of comprehensive
income. If the excess of inventory control account over the physical count is due to theft, a separate loss
account is charged. COST FORMULAS A primary issue in accounting for inventories is the determination
of the amount to be recognized as an asset and the amount to be recognized as expense. IAS 2,
Inventories, prescribes that inventories are reported in the statement of financial position at the lower
of cost and net realizable value. IAS 2 also provides guidance on the determination of cost and its
subsequent recognition as an expense including any write-down to net realizable value as well as cost
formulas that are used to assign costs to inventories. The cost of goods available for sale is allocated
between the cost of goods sold and the ending inventory by means of a cost flow assumption. The
physical flow of goods does not need to match the assumed flow of costs used for financial statements.

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determined using either the first-in, first out method or the weighter Anentories Inventory items that
are not ordinarily interchangeable The cost of inventory items that are not ordinarily interchangeab
Identification of cost means that specific costs are attributed to ident This is the appropriate treatment
for items that segregated for a specific project, regardless of whether they have This method requires a
means of identifying the historical cost recorded costs matches the physical flow of goods; thus, assuring
an exas each unit of inventory up to the time of sale. With this method, the low bought or produced. the
determined using Spec items of inventory matching of costs and revenues. Inventory items that are
ordinarily interchangeable The cost of inventory items that are ordinarily interchangeable average
method. First-in, First-out (FIFO) The FIFO method of costing inventory is based on the assumption that
costs should be charged against revenue in the order in which they were incurred. Hence, the inventory
remaining is An appropriate measurement measured based on the most recent costs. of inventory is
achieved under this method because the ending inventory is Meanwhile, it will be reported at the
approximate replacement cost. observed that there is no proper matching of cost against revenue since
earliest (old) costs are matched to current revenues. The FIFO periodic and the FIFO perpetual methods
result in the same inventory cost because the goods are assumed to be sold in the same sequence that
they were acquired. Compared with other costing formulas, in periods of rising prices (inflation), FIFO
reports the lowest cost of goods sold and the highest amount of ending inventory and profit, whereas in
periods of decreasing prices (deflation), FIFO reports the highest cost of goods sold and the lowest
amount of ending inventory and profit. Weighted Average This method considers goods to be
undistinguishable and are, therefore, valued at an average of the costs incurred. Moving average
method (perpetual system). This method requires a computation of new unit cost after each purchase
and subsequent issues are priced at the latest average unit cost. Weighted average method (periodic
system) Under the weighted average 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. 12

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The weighted average method moving average for perpetual inventory system and weighted average for
periodic inventory system Chapter 1 Inventories weighted average method produces a not so high cost
of goods and was not so low profit as the earlier Tower costs and to statalize the effect increasing prices
on both cost of goods sold and ending inventory Dams a period of decreasing prices, the weighted
average method produers and tend to stabilize the effect of decreasing prices on both east of generiai
and ending inventory. IAS 2, Inventories does not permit the use of the last in, first tout (LIFO) formula
to measure the cost of inventories. Under the LIPO metho, the cost of the most recent purchase is
charged to cost of sales, hence, the cost of inventory is based on the cost of the earliest acquisition
Illustration of the Inventory Cost Allocation Methods/Cost Formas The inventory records of ABC
Merchandising showed the line data relative to a particular item sold regularly. Assume transactions the
order given): 2.000 Transaction 1. Inventory 2. Purchases 3. Sales (at P130 per unit) 4. Purchases 5. Sales
(at P135 per unit) 6. Purchases 7.000 6,000 16,000 2,000 Determine the cost of ending inventory, cost of
goods old and you profit under each of the following methods. 1. Specific Identification Method (sales of
Noorinated from the purchase of No. 2; while sales of No 5 onion from No. 2 (11,000 units) and No.
415,000 unita FIFO Method Weighted Average Method Moving Average Method 2. 3. 4. Specific
Identification Method Cost of ending inventory From No. 1 2,000 XP50 From No. 4 1,000 XP55 From No.
6 3,000 XP60 Total cost of ending inventory 13

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identification of cost means that specific costs are attributed to identified This is the appropriate
treatment for items that are Chapter 1 Inventories Inventory items that are not ordinarily
interchangeable The cost of inventory items that are not ordinarily interchangeable determined using
the specific identification method. Specific items of inventory segregated for a specific project,
regardless of whether they have been bought or produced This method requires a means of identifying
the historical cost of each unit of inventory up to the time of sale. With this method, the flow or
recorded costs matches the physical flow of goods; thus, assuring an exact matching of costs and
revenues. Inventory items that are ordinarily interchangeable The cost of inventory items that are
ordinarily interchangeable is determined using either the first-in, first out method or the weighted
average method. First-in, First-out (FIFO) The FIFO method of costing inventory is based on the
assumption that costs should be charged against revenue in the order in which they were incurred.
Hence, the inventory remaining is measured based on the most recent costs. An appropriate
measurement of inventory is achieved under this method because the ending inventory is reported at
the approximate replacement cost. Meanwhile, it will be observed that there is no proper matching of
cost against revenue since earliest (old) costs are matched to current revenues. The FIFO periodic and
the FIFO perpetual methods result in the same inventory cost because the goods are assumed to be sold
in the same sequence that they were acquired. Compared with other costing formulas, in periods of
rising prices (inflation), FIFO reports the lowest cost of goods sold and the highest amount of ending
inventory and profit, whereas in periods of decreasing prices (deflation), FIFO reports the highest cost of
goods sold and the lowest amount of ending inventory and profit. Weighted Average This method
considers goods to be undistinguishable and are, therefore, valued at an average of the costs incurred.
Moving average method (perpetual system). This method requires a computation of new unit cost after
each purchase and subsequent issues are priced at the latest average unit cost. Weighted average
method (periodic system). Under the weighted average 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. 12

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Innentorte Cost of goods sold No. 3 antes 7.000 x PS2 No. 5 sales 11,000 X 752 5.000 x 255 Total cost of
goods sold 44000 275.000 PL.211.000 Gross profit Sales 7,000 x P130 16,000 x P135 Less cost of goods
sold Gross profit FIFO Periodic Method р 910.000 2,160,000 P3,070,000 1,211,000 P1,859,000 Cost of
ending inventory Most recent cost (3,000 units @ P60) P180,000 Next most recent cost (3,000 units @
P55) 165,000 Total cost of ending inventory P345,000 Cost of goods sold Cost of goods available for sale
2,000 x P50 P100,000 18,000 x P52 936,000 6,000 x P55 330,000 3,000 x P60 180,000 Less cost of ending
inventory Cost of goods sold P1,546,000 345,000 P1,201,000 Gross profit Sales Less cost of goods sold
Gross profit P3,070,000 1,201,000 P1.869.000 FIFO Perpetual Method action Received Issued 18,000@
52-936,000 Balance 2,000 a 50 - 100.000 2,000 @ 50 = 100,000 18,000 @ 52 = 936.000 13,000 @ 52 -
676,000 2,000 @ 50 - 100,000 5,000 @ 52- 260,000 6,000 @ 55 = 330,000 13,000 @ 52 = 676,000 6,000
@ 55 = 330,000 3,000 @ 55 - 165,000 13,000 @ 52= 676,000 3,000 @ 55- 165,000 3,000 a 60 = 180,000
3,000 @ 55 = 165,000 3,000 @ 60 = 180,000 Inventory,end=345,000 CGS = 1,201,000

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Innentorte Cost of goods sold No. 3 antes 7.000 x PS2 No. 5 sales 11,000 X 752 5.000 x 255 Total cost of
goods sold 44000 275.000 PL.211.000 Gross profit Sales 7,000 x P130 16,000 x P135 Less cost of goods
sold Gross profit FIFO Periodic Method р 910.000 2,160,000 P3,070,000 1,211,000 P1,859,000 Cost of
ending inventory Most recent cost (3,000 units @ P60) P180,000 Next most recent cost (3,000 units @
P55) 165,000 Total cost of ending inventory P345,000 Cost of goods sold Cost of goods available for sale
2,000 x P50 P100,000 18,000 x P52 936,000 6,000 x P55 330,000 3,000 x P60 180,000 Less cost of ending
inventory Cost of goods sold P1,546,000 345,000 P1,201,000 Gross profit Sales Less cost of goods sold
Gross profit P3,070,000 1,201,000 P1.869.000 FIFO Perpetual Method action Received Issued 18,000@
52-936,000 Balance 2,000 a 50 - 100.000 2,000 @ 50 = 100,000 18,000 @ 52 = 936.000 13,000 @ 52 -
676,000 2,000 @ 50 - 100,000 5,000 @ 52- 260,000 6,000 @ 55 = 330,000 13,000 @ 52 = 676,000 6,000
@ 55 = 330,000 3,000 @ 55 - 165,000 13,000 @ 52= 676,000 3,000 @ 55- 165,000 3,000 a 60 = 180,000
3,000 @ 55 = 165,000 3,000 @ 60 = 180,000 Inventory,end=345,000 CGS = 1,201,000

Theresa

Chapter 1 Inventories Gross profit Sales Less cost of goods sold Gross profit P3,070,000 1,201,000
P1,869,000 Weighted Average Method (Periodic) Cost of ending inventory Total cost of goods available
for sale Total units available for sale P1,546,000 29,000 units = P53.31 average cost per unit x 6,000 units
on hand P 319,860 Cost of goods sold Cost of goods available for sale Less cost of ending inventory Cost
of goods sold P1,546,000 319,860 P1,226,140 Gross profit Sales Less cost of goods sold Gross profit
P3,070,000 1,226,140 P1,843,860 Moving Average Method (Perpetual) A stock card is prepared as
follows: Transaction Received Issued 1 18,000@52=936,000 7,000@51.80=362,600 2 3 4 5 6 Balance
2,000@50.00= 100,000 20,000@51.80=1,036,000 13,000/a51.80- 673,400 19,000@52.81=1,003,400
3,000@52.81= 158,440 6,000@56.41= 338,440 6,000@55=330,000 16,000@52.81=844,960 3,000
@60=180,000 The procedures for the maintenance of the stock card under the moving average method
are as follows: . The number of units and total cost of the goods received are added to the previous
respective balances to derive the new number of units on hand and the total cost of goods on hand. The
moving (new) average unit cost is determined by dividing the total cost by the total number of units.
Thus, the 18,000 units purchased, in transaction 2, plus 2,000 units previously on hand equals 20,000;
P936,000 cost of purchases of 18,000 units is added to the cost of the previous inventory, P100,000; the
sum is P1,036,000. P1,036,000 is divided by 20,000 units, resulting to a moving average unit cost, after
transaction 2, of P51.80.

Theresa

The number of units sold for issued) is deducted from the previous units on hand to determine the new
number of unit number of units issued x the average unit cost before issuance) P362,600 and
P1,036,000 - P362,600 = P673,400; P673.400 Chapter 2 Inventories is deducted from the previous total
cost of goods on hand. unit cost remains unchanged. (Thus, 7.000 units x P51.80 +13,000 units =
P51.80.) ev The S The cost of ending inventory after transaction 6, is the last figure in P 338,440 the
balance column The cost of goods sold is the total cost in the issued column, P362,600 + P844,960
P1,207,560 Gross profit Sales Less cost of goods sold Gross profit P3,070,000 1,207,560 P1,862.440
MEASUREMENT OF INVENTORIES SUBSEQUENT TO INITIAL RECOGNITION Inventories, in the statement
of financial position, should be measured at the lower of cost and net realizable value. Cost is
determined by applying the specific cost formula used by the enterprise as discussed in the preceding
section. Net realizable value is defined as the estimated selling price in the ordinary course of business
less the estimated costs of completion and estimated costs necessary to make the sale. The cost of
inventories may not be recoverable if those inventories are damaged, if they have become wholly or
partially obsolete, or if their selling prices have declined. The cost of inventories may not also be
recoverable if the estimated costs of completion or the estimated costs to be incurred to make the sale
have increased. The practice of writing inventories down below cost to net realizable value is consistent
with the view that assets should not be carried in excess of amounts expected to be realized from their
sale or use. (TAS 2, Inventories, paragraph 28) Inventories are usually written down to net realizable
value on an item by item basis. In some circumstances, however, it may be appropriate to group similar
or related items. This may be the case with items of inventory relating to the same product line that
have similar purposes or end uses, are produced and marketed in the same geographical area, and
cannot be practicably evaluated separately from other items in that product line. It is not appropriate to
write inventories down on the basis of a classification of inventory, for example, finished goods, or all
the inventories in a particular industry or geographical segment. (IAS 2, Inventories, paragraph 29)

Theresa

Chapter 1 Inventortes Estimates of net realizable value are based on the most reliable evidence at the
time the estimates are made as to the amount the inventories are expected to realize. These estimates
take into consideration fluctuations of price as well as the purpose for which the inventory is held. For
example, the net realizable value of the quantity of inventory held to satisfy firm sales or service
contracts is based on the contract price. If the sales contracts are for less than the inventory quantities
held, the net realizable value of the excess is based on general selling prices. (IAS 2, Inventories,
paragraph 31) 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. (IAS 2, Inventories, paragraph 32) To illustrate the application of the lower of cost and
net realizable value rule, assume the following information for different inventory items held by XYZ
Company at December 31, 2019: Item A B с D Cost P185.00 69.00 31.00 75.00 Sales Price P230.00
100.00 43.00 105.00 Selling Expense P35.00 30.00 15.00 37.00 Units 5,000 20,000 15,000 18,000 The
total cost of inventory is determined as follows: A B с D Total 5,000 x P185.00 20,000 x P 69.00 15,000 x
P 31.00 18,000 XP 75.00 P 925,000 1,380,000 465,000 1,350,000 P4,120,000 The inventory value is
determined as follows: NRV (SP- selling Item Cost expense) A P185.00 P195.00 B 69.00 70.00 C с 31.00
28.00 D 75.00 68.00 Total value of inventory Lower of cost and NRV P185.00 69.00 28.00 68.00 Units
5,000 20,000 15,000 18,000 Total Inventory Value P 925,000 1,380,000 420,000 1,224,000 P3,949,000

Theresa
Chapter 1 Inventories Thus, from total cost of P4,120,000 to total value of inventory using lower of cost
and net realizable value of P3,949,000, there is inventory write down amounting to P171,000. Write
Down of Inventory De Та The amount of any write-down of inventories to net realizable value should be
recognized as an expense in the period the write down occurs. The write down of inventory cost to
lower of cost and net realizable value may be recorded using either direct method or allowance method,
Some entities find the allowance method more convenient to adopt since the method uses a separate
valuation account and a separate loss account, and the effects of the write-down and its subsequent
recovery can be clearly identified in the entity's statement of comprehensive income. Assume the
following data for ABC Merchandising. The company uses periodic system and first-in, first-out method
of cost allocation. Cost Lower of cost and NRV 12/31/2017 P500,000 480,000 12/31/2018 P520,000
490,000 12/31/2019 P600,000 575,000 Direct Method Allowance Method December 31, 2017 To record
ending inventory Inventory Income Summary 480,000 500,000 480,000 500,000 To record inventory at
lower of cost and NRV Loss from Decline in NRV of Inventory Allowance to Reduce Inventory to NRV
20,000 20,000 December 31, 2018 To close beginning inventory Income Summary Inventory 480,000
500,000 480,000 500,000 to record ending inventory Inventory Income Summary 490,000 520,000
490,000 520,000 To record inventory at lower of cost and NRV 19

Theresa

Chapter 1 - Inventories Loss from Decline in NRV of Inventory Allowance to Reduce Inventory 10,000 to
NRV 10,000 December 31, 2019 490,000 520,000 To close beginning inventory Income Summary
Inventory To record ending inventory Inventory Income Summary 490,000 520,000 575,000 600,000
575,000 600,000 To record inventory at lower of cost and NRV Allowance to Reduce Inventory to NRV
Recovery in NRV of Inventory 5,000 5,000 Assuming the same information, but the company uses the
perpetual inventory system, journal entries to reflect the valuation at the lower of cost and net
realizable value are: Direct Method Allowance Method December 31, 2017 20,000 Cost of Goods Sold
Inventory 20,000 20,000 Loss from Decline in NRV of Inventory Allowance to Reduce Inventory 20,000 to
NRV December 31, 2018 30,000 Cost of Goods Sold Inventory 30,000 10,000 Loss from Decline in NRV of
Inventory Allowance to Reduce Inventory to NRV 10,000 December 31, 2019 25,000 Cost of Goods Sold
Inventory 25,000 19

Chapter 1 - Inventories Allowance to Reduce Inventory to NRV Recovery in NRV of Inventory 5,000 5,000
Presentation in Profit or Loss The effects of adjusting the inventory to lower of cost and net realizable
value are shown on the face of the statement of comprehensive income. The foregoing illustration for
ABC Merchandising and the other additional information below are used to present the effects of the
application of the lower of cost and net realizable value. Sales Purchases General and Administrative
Expenses 2019 2018 P3,500,000 P3,000,000 2,000,000 1,800,000 850,000 750,000 Direct Method Under
this method, the beginning and ending inventories are directly measured at the lower of cost and net
realizable value in the computation of the cost of goods sold. 2019 2018 Beginning inventory P 490,000
P. 480,000 Purchases 2,000,000 1,800,000 Total cost of goods available for sale P2,490,000 P 2,280,000
Ending inventory 575,000 490,000 Cost of goods sold P1,915,000 P1,790,000 The profit is computed as
follows: Sales Cost of goods sold Gross profit General and administrative expenses Profit 2019
P3,500,000 1,915,000 P1,585,000 850,000 P 735,000 2018 P3,000,000 1,790,000 P1,210,000 750,000 P
460,000 The inventories are reported directly at the lower of cost and net realizable value; hence, the
decline in net realizable value is absorbed by the cost of goor's sold. Other than cost of good sold, no
other line item relating to decline in (or recovery of) net realizable value of inventory is presented on the
face of the profit or loss.

Under the allowance method, both the beginning and ending Chapter Inventaries Allowance Method
income recovery) or other operating panas (derline) in profit us sold. The adjustment in a
bla...comowance is presented as other 2019 Cost of goods sold: Beginning inventory P520,000
Purchases Total cost of goods available for sale 2.000.000 Ending inventory P2,120,000 Cost of goods
sola 600,000 The profit is computed as follows: PL 920.000 P 500,000 1,800,000 P 2,300,000 520,000 P
1.780.000 2018 P3,000,000 1,780,000 P1,220,000 2019 P3,500,000 1,920,000 P1,580,000 5,000
(850,000) Sales Cost of goods sold Gross profit Recovery in NRV of inventory General and administrative
expenses Loss from decline in value of inventory Profit (750,000) (10,000) P460,000 P735,000 It will be
noted that the cost of goods sold differ but the operating profits are the same under the two methods.
OTHER INVENTORY ISSUES Purchase Commitments Companies often contract with suppliers to purchase
a specified quantity of materials during a future period at an agreed unit cost. This is usually done to lock
in prices and insure sufficient quantities. Purchase commitments may be subject to revision or
cancellation before the end of the contract period, Other purchase commitments, however, are non-
cancelable and are not subject to revision, A disclosure in the notes to financial statements is required
for a purchase contract subject to revision or cancellation if (1) a future loss is possible; (2) the amount
of the commitment can be reasonably estimated: and (3) the amount is material. The note disclosure
gives the relevant aspects of the contingency. No entry is required for purchase contracts subject to
revision and cancellation, When purchase contracts are non-cancelable, and when a loss is probable and
material and can be reasonably estimated, the loss and related liability should be recorded in the
accounts, 21

To illustrate, assume that on October 1, 2019. ABC entered at PIO ech, months after date. On December
31, 2019, the aver Purchase price of the inventory item is P2.00 per unit. The market decine When the
actual purchase is made on April 1, 2020, the avera Chapter Inventories G x units) is recorded on 31 Loss
on Purchase Commitments Estimated Liability on Purchase Commitments 100,000 100,000 purchase
price of the inventory item decreased further to P8,50 per unit The purchase is recorded as Purchases
Loss on Purchase Commitments Estimated Liability on Purchase Commitments Accounts Payable
850,000 50,000 100,000 1,000,000 The loss is thus assigned to the period in which the decline takes
place. It is reported on the statement of comprehensive income among the operating expenses while
the estimated liability on purchase commitments is reported on the statement of financial position as a
current liability. When there is a full or partial recovery of the purchase price, the recovery would be
recognized as a gain in the period during which the recovery takes place. Thus, if the average purchase
price at-April 1, 2020 is P9.25 per unit, the purchase entry would be as follows: Purchases 925,000
Estimated Liability on Purchase Commitments 100,000 Accounts Payable Recovery of Loss on Purchase
Commitments 1,000,000 25,000 Recovery of loss on purchase commitments is reported on the
Statement of Comprehensive Income as other operating income. The amount of recovery that is taken
up, however, is limited to the loss recorded in the previous period for the same purchase commitment.
INVENTORY ESTIMATION METHODS When inventory items cannot be physically counted anymore
because the goods may have been damaged by or lost in catastrophes such as fire or flood, or when the
inventory or cost of goods sold would be presented in the interim financial statements such that a
complete physical count may be too impractical, or to validate inventory figures determined through
physical count, the value of inventory may be determined using an estimating procedure. There are two
common methods of estimating the cost of inventory: the gross profit method and the retail inventory
method.

The gross profit method of estimating inventory costs is based on a med lationship between gross profit
and sales or between gross pront est of sales The gross profit method depends on the accuracy of the
grown profit That accuracy may be enhanced by adjustments for known hanges in the relationship
between gross profit and sales or between grona pm and cost of sales and varying gross profit rates in
diferent prenents or types of inventory The calculation of inventory under this method is as follows:
Beginning inventory Pxx Add net purchases Cost of goods available for sale Pxx Less estimated cost of
goods sold: (a) Gross profit rate is based on sales Net sales x (100% - GP rate) (b) Gross profit rate is
based on cost Net sales + (100% + GP rate) Estimated cost of ending inventory Pxx The amount obtained
is reported as ending inventory for interim financial reporting purposes or is considered the amount of
loss in cases of fire. Flood, theft, and similar events unless there are undamaged or partially damaged
merchandise. Or To illustrate, assume the following figures for RME Company for the Six months ended
June 30, 2019: Inventory, January 1, 2019 Purchases Sales Purchase retums Purchase discounts Seles
returns Sales discounts P 500,000 2,000,000 3,000,000 80,000 5,000 60,000 4,000 Determine the
estimated cost of June 30, 2019 inventory assuming that the company maintains a gross profit rate of
25% based on on sales 25% based on cost of sales The cost of goods available for sale is determined as
follows

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BAON TUESDAY QALA PA

Theresa
CHAPTER 1 THE ENVIRONMENT OF FINANCIAL ACCOUNTING AND REPORTING INTRODUCTION
Accounting is an information system, designed to identify, collect, measure, and communicate economic
information about a business entity (firm) to those having interest in the financial affairs of the entity.
Accounting is a social science, developed in a world of scarce resources. It is influenced by, and interacts
with economic, social and political environments. Business is conducted by investor-owned enterprises,
managed and controlled by professional managers, who are held responsible for providing reports to
absentee owners, creditors and other external interested parties. The process of developing general-
purpose financial statements and reporting general-purpose accounting information to various external
users is called financial accounting. In this environment, financial accounting and reporting communicate
information about the economic effects of accounting transactions and other events on a business entity
to these external user groups. Accountants are communicators; Accountancy is the art of
communicating financial information about a business entity to users such as shareholders, creditors
and managers. The communication is generally in the form of financial statements that show in money
terms the economic resources under the control of the management. The art lies in selecting the
information that is relevant to the users and is reliable. Financial statements are prepared and
presented for external users by many entities around the world. Although such financial statements may
appear similar from country to country, there are differences which have probably been caused by a
variety of social, economic and legal circumstances and by different countries having in mind the needs
of different users of financial statements when setting national requirements. Most accounting systems
are designed to generate information for both internal and external reporting. The external information
is much more highly summarized than the information reported internally. Understandably, a company
does not want

Theresa

The Environment of Financial Accounting and Reporting 5 to disclose every detail of its internal financial
dealings to outsiders. For this reason, external financial reporting is governed by an established body of
standards or principles that are designed to carefully define what information a firm must disclose to
outsiders. Financial accounting standards also establish a uniform method of presenting information so
that financial reports for different companies can be more easily compared. The International
Accounting Standards Board (ASB), the International Standard- Setting body is committed to narrowing
these difference by seeking to harmonize regulations, accounting standards and relating to the
preparation and presentation of financial statements. It believes that further harmonization can best be
pursued by focusing on financial statements that are prepared for the purpose of providing information
that is useful in making economic decisions. Financial statements are most commonly prepared in
accordance with an accounting model based on recoverable historical cost and the nominal financial
capital maintenance concept. Other models and concepts may be more appropriate in order to meet the
objective of providing information that is useful for making economic decisions although there is at
present no consensus for change. OBJECTIVE OF FINANCIAL REPORTING The objective of general
purpose financial reporting is to provide financial information that is useful to users in making decisions
relating to providing resources to the entity. Users' decisions involve decisions about buying, selling or
holding equity or debt instruments providing or settling loans and other forms of credit voting, or
otherwise influencing management's actions . To make these decisions, users assess prospects for future
net cash to the entity management's stewardship of the entity's economic resources . To make both
these assessments, users need information about both the entity's economic resources, claims against
the entity and changes in those resources and claims how efficiently and effectively management has
discharged its responsibilities to use the entity's economic resources,

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6 Chapter 1 ACCOUNTING INFORMATION USERS AND THEIR NEEDS The basic role of accountants is to
provide useful economic information to external and internal decision makers (users) as explained
below: a. External decision makers include present and potential stockholders, investors, creditors,
suppliers, customers, legislators, trade associations and others, who lack direct access to the
information generated by the internal operations of the business and must rely on general-purpose
financial statements to make their investment, credit and public policy decisions. 1) Investors. The
providers of risk capital and their advisers are concerned with the risk inherent in, and return provided
by their investments. Shareholders require periodic information that the managers are accounting
properly for the resources under their control. This information helps the shareholders to evaluate the
performance of the managers. The performance measured by the accountant shows the extent to which
the economic resources of the business have grown or diminished during the year. Shareholders are also
interested in information such as the enterprise's ability to generate cash and the timing and certainly of
its generation. They also need information to help them control the business and make investment
decisions. 2) Employees. Employees and their representative groups are interested in information about
the stability and profitability of their employers. They are also interested in information which enables
them to assess the ability of the enterprise to provide remuneration, retirement benefits and
employment opportunities. 3) Lenders. Lenders are interested in information that enables them to
determine whether their loans, and the interest attaching to them will be paid when due. 4) Suppliers
and other trade creditors. Suppliers and other creditors are interested in information that enables them
to determine whether amounts owing to them will be paid when due. Trade creditors are likely to be
interested in an enterprise over a shorter period than lenders unless they are dependent upon the
continuation of the enterprise as a major customer

Theresa

The Environment of Financial Accounting and Reporting 7 5) Customers. Customers have an interest in
information about the continuance of an enterprise, especially when they have a long-term involvement
with, or are dependent on, the enterprise. 6) Governments and their agencies, Governments and their
agencies are interested in the allocation of resources and therefore, the activities of enterprises. They
also require information in order to regulate the activities of enterprises, determine taxation policies
and as the basis for national income and similar statistics. 7) Public. Enterprises affect members of the
public in a variety of ways. For example, enterprises may make a substantial contribution to the local
economy in many ways, including the number of people they employ and their patronage of local
suppliers. Einancial statements may assist the public by providing information about the trends and
recent developments in the prosperity of the enterprise and the range of its activities. b. Internal
decision makers are the managers of a business entity, responsible for managing efficiently and
effectively, and who have the power and authority to obtain whatever economic information they need.
The process of providing accounting information to internal decision makers is called management
accounting. THE NEED TO DEVELOP STANDARDS - Users of financial accounting statements have both
coinciding and conflicting needs for information of various types. To meet these needs, and to satisfy
the stewardship reporting responsibility of management, companies prepare a single set of general-
purpose financial statements. Users expect these statements to present fairly, clearly, and completely
the company's financial operations. The accounting profession has attempted to develop a set of
standards that are generally accepted and universally practiced. Otherwise, each company would have
to develop its own standards. Further, readers of financial statements would have to familiarize
themselves with every company's peculiar accounting and reporting practices. It would be almost
impossible to prepare statements that could be compared Accounting Standards help accountants meet
the information demands of users by providing guidelines and limits for financial reporting. Accounting
standards also improve the comparability of financial reports among different companies. These

Theresa

8 Chapter are many different ways to account for the same underlying economic events, and users are
never satisfied with the amount of financial information they receive they always want to know more.
By defining which methods to use and how much information to disclose, accounting standards save
time and money for accountants. Users also benefit because they can learn one set of accounting rules
to apply to all companies. AND SOURCES OF FINANCIAL REPORTING DEVELOPMENT STANDARDS To a
large extent, accounting is a product of its environment; that is, it is shaped by, reflects, and reinforces
particular characteristics unique to its national environment. Like business in general, corporate
accounting and information disclosure practices are influenced by a variety of economic, social and even
political factors. While there are many differences in national environments, with corresponding varying
effects on accounting systems and reporting, there are also many similarities. Because business is
increasingly conducted across national borders, companies must be able to use their financial
statements to communicate with external users all over the world. As a result, divergent national
accounting practices are now converging to an overall global standard. As companies around the world
compete for investors' money, investors are requiring information that is comparable across investment
alternatives. For example, a Japanese investor can invest in a Japanese company, a German company, or
a U.S company. To make the best investment decision, financial information must be comparable. Thus,
investors and creditors are demanding that similar accounting methods be used around the world so
that investment options can be compared. The International Accounting Standards Board (TASB) was
formed in 1973 to develop worldwide accounting standards in an attempt to harmonize conflicting
national standards. The IASB now has a formal working relationship with the national accounting
standard setters from a number of countries, including the FASB in the United States. For non-U.S.
companies that have listed their shares on U.S. stock exchanges, the SEC accepts financial statements
prepared using IASB standards.

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The Environment of Financial Accounting and Reporting 9 Accounting Variations Ameng Countries One
might infer that these historical developments had a uniform effect on accounting systems throughout
the world, yet nothing could be further from the truth. Despite some similarities, there are at least as
many accounting systems as there are countries, and no two systems are exactly alike. The underlying
reasons for these differences are essentially environmental accounting systems evolve from and reflect
the environments they serve, just as in Genoa, Florence, and Venice in the 1400s. The reality of the
world is that environments have not evolved uniformly or simultaneously. Countries today are at stages
of economic development ranging from subsistence, barter economies to highly complex industrial
societies. While accounting practices evolved, there were, for example, differences in the amount of
private ownership, the degree of industrialization, the rate of inflation, and the level of economic
growth. Given these differences in economic conditions, differences in accounting practices should not
be surprising. Just as the accounting needs of a small proprietorship are different from those of a
multinational corporation, so are the accounting needs of an underdeveloped, agrarian country different
from those of a highly developed industrial country. Economic factors, however, are not the only
influences. Educational systems, legal systems, political systems, and sociocultural characteristics also
influence the need for accounting and the direction and speed of its development. For example, in some
Muslim countries where religious doctrine does not permit the charging of interest, there are unlikely to
be elaborate accounting procedures related to interest. Implications of Differences in Accounting Among
Nations There is some benefit to understanding how different nations do things. After all, there is always
something to be learned from the experiences of others. As a case in point, consider inflation. Suppose a
country has never experienced any significant inflation and has therefore never developed accounting
procedures related to inflation. What would happen the first time the country experienced substantial
and persistent inflation? At the present time, the most important reason for understanding different
national accounting systems lies in the increasingly internationalized world of business in which people
buy and sell, invest and disinvest, from one country to another. For example, if an enterprise is
considering granting credit to or acquiring a company

Theresa

10 Chapter 1 in another country, it must be able to assess the financial position of that company not an
easy thing to do. When the foreign company offers a balance sheet and income statement for analysis,
several things become immediately evident First, the language and the currency are different. Second,
the terminology is different; certain terms (accounts) have no counterparts in the other language or
accounting system, or they mean different things. Third, the types and amount of information disclosed
are likely to be different. In addition, there are a host of less obvious but perhaps more important
differences. For example, the procedures that were followed to arrive at the final figures are likely to be
different and less likely to be explained. Differences in procedures, such as rules of valuation,
recognition, or realization, render the financial statements meaningless unless the analyst is familiar
with the foreign country's accounting system. National accounting standards made sense when
companies raised money, and investors and lenders looked for investment opportunities, in their home
country. The world's capital markets began to globalize over 30 years ago, and the investment
community and the accounting profession quickly recognized the need for a cooperative international
effort in the development of accounting standards - and the benefits of a common global accounting
language. Calls for Global Harmonization of Accounting Standards As the world's capital markets
globalized in the last quarter of the 20th century. investors and creditors became increasingly frustrated
when trying to compare the financial statements of companies in different countries. They urged that
accounting standards around the world be harmonized. The International Accounting Standards
Committee was formed in 1973, and it developed a body of accounting standards suitable for use
around the world. By and large, however, the major developed countries continued to develop and use
their own national accounting principles. In 2001, the ASC was reorganized into the International
Accounting Standards Board. The IASB's objective is to raise the quality and consistency of financial
reporting and to have a platform of high quality and improved standards. It aims to bring about greater
transparency and a higher degree of comparability in financial reporting, both of which will benefit the
investors and are essential in achieving the goal of one uniform and globally accepted financial reporting
standards.

Theresa

The Environment of Financial Accounting and Reporting 11 In 2002, the European Union adopted an
accounting regulation requiring all publicly traded EU companies to use International Financial Reporting
Standards (IFRSs) developed by the IASB, rather than their home country standards, starting in 2005.
Some non-European countries have also replaced their national standards with IFRSs, while other
countries such as the United States, Japan, Thailand, Taiwan and others have adopted programs that
retain their national standards but converge them as closely as possible with IFRSs. As of 2006, there
were already 102 countries including the Philippines which have fully adopted the IFRSs. By 2011, the
IASB has projected that 150 countries would be IFRS compliant with the United States completing its full
convergence. Accounting Standard-Setting in the Philippines Prior to 1981, the Philippine Institute of
Certified Public Accountants (PICPA) designated the Committee on Accounting Principles, to provide
guidelines in the adoption of generally accepted accounting principles (GAAP) in the Philippines. The
Philippine GAAP were principally US-GAAP based. In 1981, the Philippine Institute of Certified Public
Accountants (PICPA) created the Accounting Standards Council (ASC) to formalize the accounting
standard- setting function in the Philippines. Its main function was to establish and improve accounting
standards that would be generally accepted in the Philippines. The approved statements of the ASC
were called, "Statement of Financial Accounting Standards (SFAS) which were still principally based on
accounting standards issued by the US-based Financial Accounting Standards Board (FASB). Between
1997 and 2004, the Philippines started adopting the International Financial Accounting and Reporting
Standards promulgated by the International Accounting Standards Committee (IASC). The IASC was
reorganized in 2001 and is now known as the International Accounting Standards Board (LASB). The
decision to move totally to International Accounting Standards was prompted by the (a) Support of the
Philippine Regulatory Agencies such as the Board of Accountancy, Securities and Exchange Commission,
Bangko Sentral ng Pilipinas and the Philippine Institute of CPAS (PICPA). (b) Increasing
internationalization of business which heightened the interest in a common language for financial
reporting. (c) Increasing recognition of International Accounting Standards by the World Bank, Asian
Development Bank and World Trade Organization.

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12 Chapter In 2004, the Accounting Standards Cound ASC) was replaced by the Financial Reporting
Standards Council (RSC). These is now the accounting Mandard setting body in the Philippines created
by the Professional Regulation Commission upon the recommendation of the Board of Accountancy
(BOA) to assist BOA in carrying out its powers and functions provided under Republic No. 20% known as
the Philippine Accountancy Act of 2004. In the same year, the FRSC approved the issuance of the new
and revised Philippine Accounting Standards (PAS) and the new Philippine Financial Reporting Standards
(PFRS) which directly correspond to IASB's IAS and IFRS. All of the issued standards took effect on
January 1, 2005 which was the date set by FRSC for the Philippines' full adoption of the IFRSs. SOURCES
OF ACCOUNTING STANDARDS Setting financial reporting standards is a complex process occurring within
a political environment that influences both what reporting is required and when Businesses, trade and
consumer associations, courts, public accounting firms, individual users, and government can and do
influence reporting practice. The following provides the authoritative support for these accounting
standards: a. International Accounting Standards Board (ASB) {Formerly International Accounting
Standards Council (IASC)). In an attempt to harmonize conflicting standards, the International
Accounting Standards Council was formed in 1973 to develop worldwide accounting standards. The
original IASC was founded by representatives of professional bodies in Australia, Canada, France,
Germany, Japan, Mexico, the Netherlands, the United Kingdom, Ireland, and the United States. By 2012,
out of 196 countries, over 120 countries have either fully or partially adopted and permitted the use of
International Financial Reporting Standards. The accounting standards produced by the IASB are
referred to as International Financial Reporting Standards (IFRSs) and International Accounting
Standards (IAS). The difference between these two sets of standards is merely one of timing; the IASB
standards issued before 2001 are called IAS and those issued since 2001 are called IFRS. In practice, the
entire body of IASB standards is referred to simply as IFRS. The International Financial Reporting
Interpretations Committee (IFRIC) which was called the Standing Interpretations Committee (SIC) before
2002

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The Environment of Financial Accounting and Reporting 13 provides technical assistance and support to
the IASB in the implementation of the standards Rationale for the Adoption of International Financial
Reporting Standards (IFRSs) In view of the greatly magnified emphasis on international commerce and
capital flows over the past thirty years, the need for global accounting standards has been increasingly
recognized. Multinational companies have grown dramatically in both size and importance over this
period, assuming very important and dominant roles in many market segments and affecting almost
every country, every government, and every person. From a financial reporting perspective, both
individual accountants and the professional bodies that establish accounting and auditing standards,
face a daunting challenge and difficulty because of the complexity of conducting international business
operations across borders each with a different set of business regulations and often different
accounting methods. Differences in applicable accounting, auditing and tax standards and regulations
may negatively impact the ability of the enterprise to prepare reliable financial information and for the
evaluation of investment opportunities vital to their further expansion or growth. Hence, it was
envisioned that IFRSs which should be capable of worldwide acceptance can contribute to a significant
improvement in the quantity and comparability of corporate financial reports. They are the set of
standards that can be used by all companies regardless of where they are based. In fact, IFRSs may
eventually supplement or even replace standards set by national standard setters. Standard-Setting Due
Process As part of its due process in developing new or revised Standards, the IASB publishes an
Exposure Draft of the proposed Standard for public comment in order to obtain the views of all
interested parties. It also publishes a "Basis for Conclusions" to its Exposure Drafts and Standards to
explain how it reached its conclusions and to give background information. When one or more Board
members disagree with a Standard, the Board publishes those dissenting opinions with the Standard. To
obtain advice on major projects, the Board often forms advisory committees or other specialist groups
and may also hold public hearings and conduct field tests on proposed Standards.

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b. Filmneval Reporting Shulard Councit (FRSO (Formerly Accounting 14 Chapter Standards Council (ASC)
The Professional Regulation Commission (PRC) of the Republic of the Philippines upon the
recommendation of the Board of Accountancy created an accounting standard setting body known as
the Financial Reporting Standards Council (ERS) to assist the Board in carrying out its powers and
functions provided for in Article II, Section 9 (g) of the Philippine Accountancy Act of 2004 (R.A. 9298)
and Section 9 (a) of the Implementing Rules and Regulations of the said law, The FRSC is composed of
fifteen (15) members with a Chairman, who had been or presently a senior accounting practitioner in
any of the scope of accounting practice and fourteen (14) representatives from the following: 1 (a)
Board of Accountancy (b) Securities and Exchange Commission (c) Bangko Sentral ng Pilipinas (d) Bureau
of Internal Revenue (e) A major organization composed of preparers and users of financial statements (f)
Commission on Audit (g) Accredited National Professional Organization of CPAs Public Practice 2
Commerce and Industry 2 Academe/Education 2 Government 2 8 The FRSC actively participates in the
evaluation and deliberation of proposed IFRSs forwarded by the IASB to the country's standard setting
body and submits to the Board of Accountancy its recommendation for the adoption of the proposed
IFRS. Once approved, the IFRS is designated as Philippine Financial Reporting Standard (PFRS).

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The Environment of Financial Accounting and Reporting 15 Other Organizations Influencing Financial
and Reporting Accounting Standards Securities and Exchange Commission (SEC). The Securities and
Exchange Commission has the legal authority to prescribe accounting principles and practices for usually
all companies issuing publicly traded securities. To date, the SEC has participated in the formulation of
accounting principles. In addition, the SEC administers the extensive disclosure requirements of the
Securities Act. d. Philippine Institute of Certified Public Accountants (PICPA). The Philippine Institute of
Certified Public Accountants, the PRC accredited professional organization is in the forefront in the
standard setting activities in the country. Representatives from the four sectors of the organization
(public practice, commerce and industry, education and government) are appointed to FRSC. Other
professional associations also influence the development of accounting standards. The Financial
Executives Institute (FINEX) is composed mainly of high-level financial executives. The Institute of
Management Accountants (IMA), emphasizes managerial and cost accountancy. Each of these
organizations provides input to the Philippine Financial Reporting Standards (PFRS) through
representation in the FRSC. Technical papers and publications of accounting educators are also included
as sources of accounting standards. f. Bureau of Internal Revenue (BIR). The Bureau of Internal Revenue
administers the provisions of the Internal Revenue Code. These provisions do not always reflect the
goals of financial accounting. However, they do at times influence the choice of accounting methods and
procedures. e. FINANCIAL REPORTING FRAMEWORK A financial reporting framework is vital to financial
governance of entities. This is a set of accounting principles, standards, interpretation and
pronouncements that must be adopted in the preparation and submission of the annual financial
statements of a particular class of entities. It includes, but not limited to the Philippine Financial
Reporting Standards. Figure 1.1 shows the Financial Reporting Framework adopted in the Philippines as
of January 1, 2018. Discussion of the significant provisions in the Revised Conceptual Framework
approved by the IASB on March 29, 2018 is included in this textbook.

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18 Chapter ! SIC-7 SIC-10 SIC-15 Standards Interpretation Committee (SIC) Issuances Introduction of the
Euro Government Assistance - No Specific Relation to Operating Activities Operating Leases - Incentives
Income Taxes - Changes in the Tax Status of an Entity or its Shareholders Service Concession
Arrangements: Disclosures. Intangible Assets - Web Site Costs SIC-25 SIC-29 SIC-32 MAJOR CHALLENGES
IN FINANCIAL REPORTING ENVIRONMENT While our reporting model has worked well in capturing and
organizing financial information in a useful and reliable fashion, much still needs to be done. For
example, if we move to the year 2030 and look back at financial reporting today, we might read the
following. A. IFRS / PRFS in a Political Environment The implementation of Financial Accounting and
Reporting Standards affects the interest of many user groups. User groups are possibly the most
influential group in the development of accounting standards. They consist of those most interested in
or affected by accounting rules and may want particular economic events accounted for and reported in
a particular way. They fight hard through participation in the formulation of these accounting rules or try
hard to influence or persuade the formulation of such. User groups that may influence the formulation
of accounting standards include: 1. Business entities 2. Financial community 3. Preparers 4. Government
5. Industry accounts 6. CPAs and Accounting firms 7. Professional organizations (e.g., PICPA, ACPAPP) 8.
Industry public 9. Academicians These user groups often target the IASB to pressure it to influence
changes in the existing rules and the development of new ones.

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The Environment of Financial Accounting and Reporting 19 B. The Expectation Gap The expectations gap
- what the public think accountant should do and what accountants think they can do, is difficult to
eliminate. Inspite of the Securities and Exchange Commission's increase in its policy efforts, approving
new auditor independence rules and materiality guidelines for financial reporting, accounting scandals,
poor reporting practices still occur. Due to the number of fraudulent reporting cases, some sectors
question whether the profession is doing enough. The profession on the other hand can argue rightfully
that accounting cannot be responsible for every financial catastrophe and it must continue to meet the
needs of the society. The downside however, of efforts to meet these needs through highly transparent
clear and reliable system is that considerable resources will be required and will prove to be more costly
to society. C. Financial Reporting Issues Nonfinuneial measurements. Financial reports fail to provide
some key performance measures widely used by management, such as customer satisfaction indexes,
backlog information, rejection rates on goods purchased, as well as the results of companies'
sustainability efforts. • Forward-looking information. Financial reports fail to provide forward-looking
information needed by present and potential investors and creditors. One individual noted that financial
statements in 2017 should have started with the phrase, "Once upon a time," to signify their use of
historical cost and accumulation of past events. Soft assets. Financial reports focus on hard assets
inventory, plant assets) but fail to provide much information about a company's soft assets (intangibles).
The best assets are often intangible. Consider Jollibee's know-how and market dominance, Purgold's
expertise in supply chain management, and Rustans brand image. • Timeliness. Companies only prepare
financial statement quarterly and provide audited financial annually. Little to no real-time financial
statement information is available.

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20 Chapter 1 D. The Constraints on Useful Financial Reporting Economic decision makers must recognize
that the information they receive from accountants cortstitutes only a part of the information they need
to make sound economic decisions. The financial statements also have limitations and imperfections
which the users should keep in mind. Some of the constraints are: Cost-Benefit Balancing The costs of
providing financial information fall initially on the preparer (the company) and then are passed on to
consumers (external users). These costs include the cost of collecting, processing, auditing, and
communicating the information as well as those associated with losing a competitive advantage by
disclosing the information. The benefits are enjoyed by a diverse group of investors and creditors, by
customers (because they are assured a steady supply of goods and services), and by the preparer itself
(for use in internal decision making). To be reported, accounting information not only must be relevant
and reliable but it also must satisfy the benefit/cost constraint. That is, the IASB must have reasonable
assurance that the costs of implementing a standard will not exceed the benefits. Balance between
Qualitative Characteristics In practice, a balancing, or trade-off, between qualitative characteristics is
often necessary. Generally, the aim is to achieve an appropriate balance among the characteristics in
order to meet the objective of financial statements. The relative importance of the characteristics in
different cases is a matter of professional judgment. True and Fair View Presentation Financial
statements are frequently described as presenting fairly the financial position, performance and changes
in financial position of an enterprise. Although this framework does not deal directly with such concepts,
the application of the principal qualitative characteristics and of appropriate accounting standards
normally results in financial statements that convey what is generally understood as presenting fairly
such information

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The Environment of Financial Accounting and Reporting 21 ENHANCING THE EXISTING SYSTEM OF
FINANCIAL REPORTING Investors have expressed concerns that one-size-fits-all financial reports do not
meet the needs of the spectrum of investors who rely on those reports. While many individual investors
are more interested in summarized, plain- English reports, market analysts and other investment
professionals may desire information at a far more detailed level than is currently provided. Technology
may help customize the information that the different types of investors desire. Companies also express
concerns with the complexity of the financial reporting system. Companies assert that when preparing
financial reports, it is difficult to ensure compliance with the voluminous and complex requirements
contained in SEC reporting rules. This is a particularly heavy burden on smaller, non-public companies,
which may have fewer resources to comply with the wide range of rules, We also need to consider the
broader array of information that investors need to make informed decisions. As some have noted, the
percentage of a company's market value that can be attributed to accounting book value has declined
significantly from the days of a bricks-and-mortar economy. Thus, we may want to consider a more
comprehensive business reporting model, including both financial and nonfinancial key performance
indicators. Finally, we must also consider how to deliver all of this information in a timelier manner. In a
world where messages can be sent across the world in a blink of an eye, it is ironic that the analysis of
financial information is still subject to many manual processes, resulting in delays, increased costs and
errors. ETHICS IN THE ACCOUNTING ENVIRONMENT Ethics is a term that refers to a code or moral
system that provides criteria for evaluating right and wrong. One of the elements that many believe
distinguishes a profession from other occupations is the acceptance by its members of a responsibility
for the interests of those it serves. Because of the important role of accounting in society, accountants
must maintain high ethical standards. Facing pressures and influence of numerous groups with
conflicting interests, the accountant should always be alert about ethical behavior. The Code of Ethics
promulgated by the Board of Accountancy provides guidelines for practicing accountants. However, the
code does not present a structured approach to resolving ethical dilemmas and conflicts.

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22 Chapter / In general, the accountant should be able to recognize and understand ethical issues to
identify and evaluate the possible consequences of each of the alternative solutions and to select the
best alternative which will ensure relevant, reliable, comparable and consistent financial information to
serve the best of the users' interests as a whole, CPAs as well as other accountants are expected to
make unswerving commitment to honorable behavior, even at the sacrifice of personal advantage. The
public accounting profession has worked hard to gain the public trust and it benefits monetarily from
that trust as the sole legally acceptable provider of assurance services for companies and other
organizations. For that trust and economic advantage to be maintained, it is essential that professional
integrity be based on personal moral standards and reinforced by codes of conduct. Whenever a
"scandal" surfaces, the profession is diminished and CPAs are personally ruined. External auditors need
to exhibit the highest standard of ethical principles in order to function. It is not difficult to find oneself
in ethically compromising situations without realizing it. Accounting professionals are often faced with
difficult types of ethical dilemma. For example, if the public does not have confidence in the
independence and integrity of auditors, it will not subscribe any value of the auditor's work. Professional
accountants in business (i.e., CPAs in commerce and industry, government and education) oftentimes
have to make judgements that involve ethically charged issues and without an ethical framework, an
ethical dilemma may not be resolved in a thoughtful manner. Therefore, careless work or lack of
integrity on the part of any CPA may lead to a negative view toward the entire profession. THE ROLE OF
EXTERNAL AUDITORS An audit consists of examining enough of the company's records to determine
whether the financial statements are prepared in the applicable financial reporting standards. An
external auditor, a CPA is an independent professional who conducts the audit in accordance with the
Standards on Auditing. When the audit is completed, the auditor makes no claim as to the accuracy of
the financial statements he has audited What he tries to achieve is reasonable assurance that there are
no material misstatements in those financial statements. He issues a report containing the "audit
opinion" as to the company's compliance with IFRS/PFRS.

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quiz1.docx

quiz1-converted.pdf

10:57 AM

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Chapter 1 Inventorld merchandise inventory). inventory exactly the same form as they Inventory or
simply Inventory. for products that are partially completed at the end of a period. the tangible goods,
acquired by manufacturing concern for use in the production process. Raw Materials Inventory includes
COST OF INVENTORIES The cost of inventories should comprise all costs of purchase, costs of conversion
and other costs incurred in bringing the inventories to their present location and condition. Costs of
Purchase The cost of purchase of inventories includes the purchase price, import duties and other taxes,
and transport, 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
costs of purchase. (IAS 2, Inventories, paragraph 11). Costs of Conversion The costs of conversion of
inventories include costs directly related to the units of production, such as direct labor as well as an
allocation of fixed and variable production overhead, which were incurred in converting materials into
finished goods. indirect costs of production that remain relatively constant regardless of the Fixed
production overheads are those volume of production, such as depreciation and maintenance of factory
administration Variable production overheads are those indirect costs of Inventories encompas goods
purchased and held for finished goods produced finished process inventory) as well as materials and
supplies awaiting use inventory), or work in progress being produced by the enterprise work in
production process (materials inventory and factory supplies inventory The nature of the business
determines the designation of an item For a manufacturing concern, inventories are classified while for
a trading or merchandising concern, the goods that they sell in Finished Goods, Goods in Process for
Work in Process) and Raw Material are bought are termed as Merchandise products awaiting sale and
contains the same cost components as the Finished Goods Inventory includes the completed
manufactured goods in process inventory. Goods in Process for Work in Process) Inventory consists of
raw materials, direct labor and manufacturing overhead costs buildings and equipment and the cost of
factory management and production that vary directly, or nearly directly, with the volume of

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Chapteri inventories productionsuch as Indirect materials and indirect lubos AS a Inventores, paragraph
121 Cost of Agricultural Produce Harvested from Biological Assets Inventories comprising agricultural
produce that an entity has harvested from its biological assets are measured on initial recognition at
their fair value less estimated cost to sell at the point of harvest. IAS 1 Agriculture Other Costs Other
costs are included in the cost of inventories only to the extent that they are incurred in bringing the
inventories to their present location and condition. Exclusions from Cost of Inventories The following
costs are excluded from the cost of inventories. They are recognized as expenses in the period in which
they are incurred. Abnormal amounts of wasted materials, labor, or other production costs Storage
costs, unless those costs are necessary in the production process prior to a further production stage
Administrative overheads that do not contribute to bringing inventories to their present location and
condition Selling costs (IAS 2, Inventories, paragraph 16) Labor and other costs relating to sales and
general administrative personnel Profit margins or non-attributable overheads that are often factored
into prices charged by service providers (IAS 2, Inventories, paragraph 19) Financing element involved in
purchases under deferred payment arrangement (IAS 2, Inventories, paragraph 18). In general,
borrowing costs incurred in connection with inventory acquisition are recognized as finance costs. These
include borrowing costs incurred to purchase merchandise inventory and borrowing costs attributable
to inventories that are manufactured, or otherwise produced, in large A detailed discussion of
accounting for biological assets and agricultural produce is found in Chapter 5, Biological Assets, 3

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quantities on a repetitive basis . However , borrowing of time for their production or development
discrete project of the enterprise and take substant are capitalized as inventory costs when inventories
que of Volume 1 of the Intermediate Accounting series , the purchase of goods Similar to the seller's
viewpoint discussed in Chapter 2 Receivable Under the gross price method of recording purchases , the
purchase is recorded at the gross amount and a Purchase Discount is recognized recorded net of trade
discounts , while cash discounts may be accounted for generally reported as a deduction from gross
purchases to arrive at net Inventories Chapter Trade and Cash Discounts using one of the following
methods: method, and allowance method. the gross price method, net when payment is made within
the discount period. purchases. Purchase Discount is The Under the net price method, the purchase is
recorded at the price of goods, net of cash discounts. The discount is recorded only if it is not taken; that
is, when payment is made after the discount period. discount not taken is recorded in Purchase
Discounts Lost or Interest Expense account, which is reported on the Statement of Comprehensive
Income as a finance cost. Under the allowance method, purchases are recorded at net prices and
accounts payable at gross prices, with the difference debited to an allowance account. Theoretically, the
net price method produces the correct inventory cost, i.e., invoice cost less all available discounts.
Purchase Discounts Lost should be treated as a financing expense for the period and should not be
added to the cost of inventory 3 ITEMS TO BE INCLUDED IN INVENTORY QUANTITIES The basic criterion
for including items in inventory is economic control rather than physical possession. For inventory,
economic control is usually consistent with legal ownership. For convenience and practicality, goods are
recorded in inventory when received by the purchaser and recorded as sold by the seller when shipped.
When financial statements are prepared, however, all goods under economic control of the enterprise
should be included in inventory whether or not the company has physical or legal possession of these
goods. Some examples are goods in transit IAS 23 Borrowing Costs provides guidance for capitalization
of borrowing costs. See chapter 2 of this book for a more detailed discussion. For an illustration of the
entries under the gross method and net method, see Chapter 5, Financial Liabilities, Volume 1 of the
Intermediate Accounting Series.

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Chapter 1 Inventarten arrangements purchased For shipping point. mode in transit sold POB destination
goods sold with buyback arrangements, and goods under product financing Items that may require
special attention in determining the proper inventory items at the end of the period Goods in Transit
customers at the reporting date. Normally, some inventories are in transit to the company or its When
goods are in transit at the end of the reporting period, the terms of shipment determine whether the
seller or the buyer includes them in its inventory. If the goods are shipped FOB (Free on Board) shipping
point, legal title to (and economic control of the goods passes with the loading of goods at the point of
shipment. The buyer should include these goods in its inventory and a corresponding liability is
recognized. In addition, freight cost under FOB shipping point is for the account of the buyer. If,
however, the seller prepays for the shipping cost (termed as FOB shipping point, freight prepaid), freight
cost is added to the amount receivable from the uyer (or amount payable to the seller) If goods are
shipped FOB destination, legal title (and control) is not transferred until the goods are delivered to the
buyer's destination. Physical receipt of the goods by the buyer normally determines when it should
record the inventory in its accounting system. Freight cost under FOB destination is for the account of
the seller. If, however, the buyer paid the shipping cost upon receipt of the goods (termed as FOB
destination, freight collect), freight cost is deducted from the amount payable to the seller (or amount
receivable from the buyer). To illustrate, assume that ABC Company purchased goods costing P100,000
from XYZ Corporation. Freight cost is P10,000. Further assume that both companies use periodic
inventory system. If goods were shipped FOB shipping point and XYZ Corporation paid the freight cost of
P10,000, journal entries in both books are: ABC Company (Buyer) Purchases 100,000 Freight-in 10,000
Accounts Payable 110,000 XYZ Corporation (Seller) Accounts Receivable 110,000 Sales 100,000 Cash
10,000 If the goods were shipped FOB destination and ABC Company paid the freight cost of P10,000,
journal entries are: ABC Company (Buyer) Purchases 100,000 Accounts Payable 90,000 Cash 10,000 XYZ
Corporation (Seller) Accounts Receivable 90,000 Freight-out 10,000 Sales 100,000 5

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However Hoods that are customarily mamando stock items of the enterprise even if physically and
unsold, until they ar actually delivered or picked up by the Conditional Sales and Installment Sales
Despite retention of title by the seller under the installment already passed to the buyer. contract, the
substance of the transaction is that control over the woods ha The seller anticipates completion of the
contract and the ultimate passing of title, and therefore recognizes the transaction as a regular sale. The
seller removes the goods from the reported inventory at the time of sale. The goods are recorded as
sold when delivered and excluded from the inventory of the seller. Other merchandise owned by an
enterprise but in the possession of others, such as goods in the hands of salespersons and agents, goods
held by customer on approval and goods held by others for storage, processing or shipment, should also
be shown as part of the ending inventory of the enterprise that economically controls the goods, Goods
Sold with Buyback Agreement A buyback agreement, accompanying sale of goods, is in substance, 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, which covers all costs of inventory plus related
holding costs. In effect, the inventory is used as collateral for a loan obtained either directly from the
buyer, or from a financing company with the buyer as intermediary. In such a case, the customer does
not obtain control of the asset (the inventory), and the transferor shall account for the transfer as a
financing arrangement and shall retain the inventory in its books. Any consideration received from the
transfer shall be credited to a financial liability (based on pars. B66 and 168, IFRS 15). 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. To account for the transfer of products with a right to return, an entity
shall recognize (a) revenue for the transferred products (at the amount of the transaction price), (b) a
refund liability, and (c) an asset for its right to recover the products from the customer on settling the
refund liability (pars. B21 to B25, IFRS 15 Revenue from Contracts with Customers). The recognition of
revenue implies that the corresponding transferred goods be removed from the inventory at their
carrying amount.

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CHAPTER 1 INVENTORIES 4. Intended Learning Outcomes After reading this chapter, you should be able
to: 1. describe the nature of inventories; 2. identify the items and costs included in inventories; 3.
account for initial recognition of and subsequent transactions affecting inventories using both the
perpetual inventory system and periodic inventory system; compute inventory cost using the different
inventory costing procedures; 5. evaluate the effects of inventory costing methods for both financial
reporting and tax reporting; analyze the effects of inventory errors on current and future financial
statements; measure inventories based on the lower of cost and net realizable value; calculate the cost
of inventories using the applicable estimating procedures; and identify information relating to
inventories required to be 9. disclosed in the financial statements. 6. 7. 8. Introduction One of the
biggest challenges of an enterprise is to maintain the appropriate volume of inventories and control its
cost of sales. One businessman states that success in business is more than good products; success
depends on assigning and monitoring costs of inventory and applying sound inventory management
procedures. NATURE OF INVENTORIES As described in International Accounting Standards (IAS) 2,
paragraph 6, inventories are assets of an enterprise, which are (a) (b) (c) -held for sale in the ordinary
course of business; in the process of production for such sales; or in the form of materials or supplies to
be consumed in the production process or in the rendering of services.

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Legal ownership of goods in transit also determines risk of loss for uds damaged or lost during shipment.
Ownership of goods still in transit In international business, other terms used for shipment of goods Free
alongside means that the risk of loss shifts from the seller to the buyer include "Free Alongside (FAS)"
and "Cost, Insurance and Freight (CIF). other hand, means that the seller arranges for the delivery of
goods by sea at a named port alongside a vessel designated by the buyer. The seller also provides the
buyer with the Goods may be transferred from one party to another for purposes of while the company
receiving the goods, called consignee, attempts to sell The company delivering the goods, called
consignor, retains ownership, sale without the ownership and ultimate economic control changing
hands. documents necessary to obtain the goods from the carrier. completion, revenue is considered to
have been earned, and shall, Anwentortes Disposition by Buyer Include Exclude Seller Exclude Include
TV be summarized as follows: Terms of Shipment FOB shipping point FOB destination CIF, on the to a
port of destination. Consigned Goods them. If the goods are sold, the consignee earns a commission and
remits the net amount to the consignor; whereas if the goods are not sold, they are returned to the
consignor. The goods must be included in the inventory of the consignor, at cost, plus the handling and
shipping costs incurred in the delivery of the goods to the consignee. The consignee, acting as an agent,
does not own the goods; hence, neither the peso amount of the consigned goods nor the financial
obligation for such goods is reported on its financial statements. In summary, the consignor includes
goods out on consignment in its inventory while the consignee excludes goods held on consignment in
its inventory. Segregated Goods customer Special order goods manufactured according to specifications,
even if still in the possession of the selling company, should be considered as sold when completed, and
therefore excluded from the selling company's inventory. The rationale for this treatment is that the
manufacturer undertakes and completes the processing of the goods based on the order and
specifications by the customers. Thus, at the point of therefore, be recognized.

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As part of an entity's sales promotion scheme, lay away plans an Under this scenario, the customer pays
fraction or a portion of the selling price of merchandise and agrees to pay in merchandise and delivers
to customer only upon full payment of the goods installment or pay the full amount at a future date.
The store holds the product but retains physical possession of that product until it is This is similar to
bill-and-hold sale in which an entity bills a customer for a customer has already made payments of a
substantial portion of the goods' Under these circumstances, revenue is recognized when the customer
obtains control over the product, that is, when the following separately as already belonging to the
customer; (b) the product must be conditions have been met: (a) the product must have been identified
use the product or to direct it to another customer (based on pars. B79 and ready for transfer to the
customer; (c) and the entity does not have ability to transferred to the customer at a point in time, for
example, when a The recognition of revenue is made simultaneous to Chapter 1 Inventories Lay Away
Plans and Bill and Hold Sales being offered to customers. selling price. B81, IFRS 15). derecognition of
inventory in the seller's accounting records INVENTORY ACCOUNTING SYSTEMS Inventory quantities and
costs may be accounted for using either the periodic system or the perpetual system. Periodic System A
company using the periodic system, also called as physical system, does not maintain a continuous
record of the physical quantities (or costs) of inventory on hand. Therefore, the company will not be
able to determine its inventory accurately until a physical inventory is taken at the end of the period. At
that time, the following computation is used to determine the cost of goods sold of a merchandising
concern: Pxcx Merchandise Inventory, beginning Add net cost of purchases Cost of goods available for
sale Less Merchandise Inventory, end Cost of Goods Sold Under the periodic system, all acquisitions of
inventory are charged to a nominal account Purchases. Separate accounts are usually maintained for
purchases returns and allowances, purchases discounts, and freight-in. Net cost of purchases is the sum
of purchases and freight-in reduced by purchase discounts, returns, and allowances. Рxx xx Pxx

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As part of an entity's sales promotion scheme, lay away plans an Under this scenario, the customer pays
fraction or a portion of the selling price of merchandise and agrees to pay in merchandise and delivers
to customer only upon full payment of the goods installment or pay the full amount at a future date.
The store holds the product but retains physical possession of that product until it is This is similar to
bill-and-hold sale in which an entity bills a customer for a customer has already made payments of a
substantial portion of the goods' Under these circumstances, revenue is recognized when the customer
obtains control over the product, that is, when the following separately as already belonging to the
customer; (b) the product must be conditions have been met: (a) the product must have been identified
use the product or to direct it to another customer (based on pars. B79 and ready for transfer to the
customer; (c) and the entity does not have ability to transferred to the customer at a point in time, for
example, when a The recognition of revenue is made simultaneous to Chapter 1 Inventories Lay Away
Plans and Bill and Hold Sales being offered to customers. selling price. B81, IFRS 15). derecognition of
inventory in the seller's accounting records INVENTORY ACCOUNTING SYSTEMS Inventory quantities and
costs may be accounted for using either the periodic system or the perpetual system. Periodic System A
company using the periodic system, also called as physical system, does not maintain a continuous
record of the physical quantities (or costs) of inventory on hand. Therefore, the company will not be
able to determine its inventory accurately until a physical inventory is taken at the end of the period. At
that time, the following computation is used to determine the cost of goods sold of a merchandising
concern: Pxcx Merchandise Inventory, beginning Add net cost of purchases Cost of goods available for
sale Less Merchandise Inventory, end Cost of Goods Sold Under the periodic system, all acquisitions of
inventory are charged to a nominal account Purchases. Separate accounts are usually maintained for
purchases returns and allowances, purchases discounts, and freight-in. Net cost of purchases is the sum
of purchases and freight-in reduced by purchase discounts, returns, and allowances. Рxx xx Pxx

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Chapter 1 - Inve The following are the pro-forma entries to record transactions using periodic inventory
system: Transaction Pro-forma entries a. Purchase of goods b. Purchase returns Purchases Accounts
Payable/ Cash Accounts Payable/Cash Purchase Returns c. Sale of goods xx Accounts Receivable/Cash
Sales d. Sales returns Sales Returns Accounts Receivable/Cash xx e. Year-end entry to set up ending
inventory Merchandise Inventory, end Income Summary XOX f. Year-end entry to close beginning
inventory Income Summary Merchandise Inventory, beg. Alternatively, the entry to set up ending
inventory and to close beginning inventory may be made simultaneously, setting up cost of sales for the
period. Such year-end entry is: Merchandise Inventory, ending Cost of Sales Purchase Returns and
Allowances Purchase Discounts Freight in Merchandise Inventory, beginning Purchases The periodic
inventory system is appropriate for relatively low value, but numerous inventory items, particularly
when the costs of a perpetual inventory system are likely to outweigh its benefits. Enterprises
presenting expenses on the statement of comprehensive income according to nature neither computes
nor sets up cost of sales. Rather, the net cost of purchases (adjusted for the change in inventories from
the beginning to the end of the period), is shown among operating expenses classified according to
nature. Thus, no cost of sales and gross profit are presented. In such a case, the entry to set up the
ending Enventory as an asset is xx Merchandise Inventory, ending Income Summary xx

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Chapter I Inventories The beginning inventory is brought to zero balance in the process income showing
expenses according to nature, the balance of the net In the profit or loss section of the statement of
comprehensive purchases and the change in ending inventory will be shown as follows: closing the
books, with this entry: OX Income Summary Merchandise Inventory, beginning Pxx Net sales revenue
Other income XX Total income Pxx Operating expenses Pxx Net purchases (Increase) Decrease in
inventory Salaries XX Depreciation XX Other operating expenses XX Total operating expenses Pxx Profit
before interest and income tax XX Perpetual System A company using the perpetual system maintains a
continuous record of the movement of the items in its inventory. Such a system is essential when
management wants to maintain effective planning and control over inventory. Companies maintaining
inventory items in small quantities with high unit costs usually adopt this method. The purchase, or
production, and use of each item of inventory are recorded in detailed subsidiary records either in units
only, or in both costs and units. A retail firm that uses a perpetual inventory system and records the cost
of inventory transactions would prepare the following journal entries. Transaction Pro-forma entries a.
Purchase of goods Merchandise Inventory Accounts Payable/Cash XX b. Purchase returns Accounts
Payable/Cash Merchandise Inventory XX c. Sale of goods XX Accounts Receivable/ Cash Sales xx XX Cost
of Sales Merchandise Inventory xx

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Chapter d. Sales returns Sales Returns Accounts Receivable/Cash Merchandise Inventory Cost of Sales At
the end of the reporting period, because the inventory account is updated, no adjusting entry is
necessary to set up ending inventory. information on a timely basis but requires the maintenance of a
full set of The perpetual system has the advantage of providing inventory inventory records. For internal
control purposes, a physical count is made at least once a year, but not necessarily at year-end, to
confirm the inventory balance per books. Variation between the physical count and the ledger balance
may result from errors in recording, shrinkage, waste, breakage, theft, and other causes. The cost of the
difference in the two quantities is entered into the accounts to bring the perpetual records into
agreement with the physical count. Any excess of the balance of the inventory control account over the
physical count, if due to normal causes, such as shrinkage and breakage, is debited to cost of sales (using
the function of expense method) or may be debited to Inventory Shortage (using either the function of
expense method or nature of expense method). Any balance in the Inventory Shortage account is
presented as other operating expenses in profit or loss section of the statement of comprehensive
income. If the excess of inventory control account over the physical count is due to theft, a separate loss
account is charged. COST FORMULAS A primary issue in accounting for inventories is the determination
of the amount to be recognized as an asset and the amount to be recognized as expense. IAS 2,
Inventories, prescribes that inventories are reported in the statement of financial position at the lower
of cost and net realizable value. IAS 2 also provides guidance on the determination of cost and its
subsequent recognition as an expense including any write-down to net realizable value as well as cost
formulas that are used to assign costs to inventories. The cost of goods available for sale is allocated
between the cost of goods sold and the ending inventory by means of a cost flow assumption. The
physical flow of goods does not need to match the assumed flow of costs used for financial statements.

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determined using either the first-in, first out method or the weighter Anentories Inventory items that
are not ordinarily interchangeable The cost of inventory items that are not ordinarily interchangeab
Identification of cost means that specific costs are attributed to ident This is the appropriate treatment
for items that segregated for a specific project, regardless of whether they have This method requires a
means of identifying the historical cost recorded costs matches the physical flow of goods; thus, assuring
an exas each unit of inventory up to the time of sale. With this method, the low bought or produced. the
determined using Spec items of inventory matching of costs and revenues. Inventory items that are
ordinarily interchangeable The cost of inventory items that are ordinarily interchangeable average
method. First-in, First-out (FIFO) The FIFO method of costing inventory is based on the assumption that
costs should be charged against revenue in the order in which they were incurred. Hence, the inventory
remaining is An appropriate measurement measured based on the most recent costs. of inventory is
achieved under this method because the ending inventory is Meanwhile, it will be reported at the
approximate replacement cost. observed that there is no proper matching of cost against revenue since
earliest (old) costs are matched to current revenues. The FIFO periodic and the FIFO perpetual methods
result in the same inventory cost because the goods are assumed to be sold in the same sequence that
they were acquired. Compared with other costing formulas, in periods of rising prices (inflation), FIFO
reports the lowest cost of goods sold and the highest amount of ending inventory and profit, whereas in
periods of decreasing prices (deflation), FIFO reports the highest cost of goods sold and the lowest
amount of ending inventory and profit. Weighted Average This method considers goods to be
undistinguishable and are, therefore, valued at an average of the costs incurred. Moving average
method (perpetual system). This method requires a computation of new unit cost after each purchase
and subsequent issues are priced at the latest average unit cost. Weighted average method (periodic
system) Under the weighted average 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. 12

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The weighted average method moving average for perpetual inventory system and weighted average for
periodic inventory system Chapter 1 Inventories weighted average method produces a not so high cost
of goods and was not so low profit as the earlier Tower costs and to statalize the effect increasing prices
on both cost of goods sold and ending inventory Dams a period of decreasing prices, the weighted
average method produers and tend to stabilize the effect of decreasing prices on both east of generiai
and ending inventory. IAS 2, Inventories does not permit the use of the last in, first tout (LIFO) formula
to measure the cost of inventories. Under the LIPO metho, the cost of the most recent purchase is
charged to cost of sales, hence, the cost of inventory is based on the cost of the earliest acquisition
Illustration of the Inventory Cost Allocation Methods/Cost Formas The inventory records of ABC
Merchandising showed the line data relative to a particular item sold regularly. Assume transactions the
order given): 2.000 Transaction 1. Inventory 2. Purchases 3. Sales (at P130 per unit) 4. Purchases 5. Sales
(at P135 per unit) 6. Purchases 7.000 6,000 16,000 2,000 Determine the cost of ending inventory, cost of
goods old and you profit under each of the following methods. 1. Specific Identification Method (sales of
Noorinated from the purchase of No. 2; while sales of No 5 onion from No. 2 (11,000 units) and No.
415,000 unita FIFO Method Weighted Average Method Moving Average Method 2. 3. 4. Specific
Identification Method Cost of ending inventory From No. 1 2,000 XP50 From No. 4 1,000 XP55 From No.
6 3,000 XP60 Total cost of ending inventory 13

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identification of cost means that specific costs are attributed to identified This is the appropriate
treatment for items that are Chapter 1 Inventories Inventory items that are not ordinarily
interchangeable The cost of inventory items that are not ordinarily interchangeable determined using
the specific identification method. Specific items of inventory segregated for a specific project,
regardless of whether they have been bought or produced This method requires a means of identifying
the historical cost of each unit of inventory up to the time of sale. With this method, the flow or
recorded costs matches the physical flow of goods; thus, assuring an exact matching of costs and
revenues. Inventory items that are ordinarily interchangeable The cost of inventory items that are
ordinarily interchangeable is determined using either the first-in, first out method or the weighted
average method. First-in, First-out (FIFO) The FIFO method of costing inventory is based on the
assumption that costs should be charged against revenue in the order in which they were incurred.
Hence, the inventory remaining is measured based on the most recent costs. An appropriate
measurement of inventory is achieved under this method because the ending inventory is reported at
the approximate replacement cost. Meanwhile, it will be observed that there is no proper matching of
cost against revenue since earliest (old) costs are matched to current revenues. The FIFO periodic and
the FIFO perpetual methods result in the same inventory cost because the goods are assumed to be sold
in the same sequence that they were acquired. Compared with other costing formulas, in periods of
rising prices (inflation), FIFO reports the lowest cost of goods sold and the highest amount of ending
inventory and profit, whereas in periods of decreasing prices (deflation), FIFO reports the highest cost of
goods sold and the lowest amount of ending inventory and profit. Weighted Average This method
considers goods to be undistinguishable and are, therefore, valued at an average of the costs incurred.
Moving average method (perpetual system). This method requires a computation of new unit cost after
each purchase and subsequent issues are priced at the latest average unit cost. Weighted average
method (periodic system). Under the weighted average 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. 12

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Innentorte Cost of goods sold No. 3 antes 7.000 x PS2 No. 5 sales 11,000 X 752 5.000 x 255 Total cost of
goods sold 44000 275.000 PL.211.000 Gross profit Sales 7,000 x P130 16,000 x P135 Less cost of goods
sold Gross profit FIFO Periodic Method р 910.000 2,160,000 P3,070,000 1,211,000 P1,859,000 Cost of
ending inventory Most recent cost (3,000 units @ P60) P180,000 Next most recent cost (3,000 units @
P55) 165,000 Total cost of ending inventory P345,000 Cost of goods sold Cost of goods available for sale
2,000 x P50 P100,000 18,000 x P52 936,000 6,000 x P55 330,000 3,000 x P60 180,000 Less cost of ending
inventory Cost of goods sold P1,546,000 345,000 P1,201,000 Gross profit Sales Less cost of goods sold
Gross profit P3,070,000 1,201,000 P1.869.000 FIFO Perpetual Method action Received Issued 18,000@
52-936,000 Balance 2,000 a 50 - 100.000 2,000 @ 50 = 100,000 18,000 @ 52 = 936.000 13,000 @ 52 -
676,000 2,000 @ 50 - 100,000 5,000 @ 52- 260,000 6,000 @ 55 = 330,000 13,000 @ 52 = 676,000 6,000
@ 55 = 330,000 3,000 @ 55 - 165,000 13,000 @ 52= 676,000 3,000 @ 55- 165,000 3,000 a 60 = 180,000
3,000 @ 55 = 165,000 3,000 @ 60 = 180,000 Inventory,end=345,000 CGS = 1,201,000

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Innentorte Cost of goods sold No. 3 antes 7.000 x PS2 No. 5 sales 11,000 X 752 5.000 x 255 Total cost of
goods sold 44000 275.000 PL.211.000 Gross profit Sales 7,000 x P130 16,000 x P135 Less cost of goods
sold Gross profit FIFO Periodic Method р 910.000 2,160,000 P3,070,000 1,211,000 P1,859,000 Cost of
ending inventory Most recent cost (3,000 units @ P60) P180,000 Next most recent cost (3,000 units @
P55) 165,000 Total cost of ending inventory P345,000 Cost of goods sold Cost of goods available for sale
2,000 x P50 P100,000 18,000 x P52 936,000 6,000 x P55 330,000 3,000 x P60 180,000 Less cost of ending
inventory Cost of goods sold P1,546,000 345,000 P1,201,000 Gross profit Sales Less cost of goods sold
Gross profit P3,070,000 1,201,000 P1.869.000 FIFO Perpetual Method action Received Issued 18,000@
52-936,000 Balance 2,000 a 50 - 100.000 2,000 @ 50 = 100,000 18,000 @ 52 = 936.000 13,000 @ 52 -
676,000 2,000 @ 50 - 100,000 5,000 @ 52- 260,000 6,000 @ 55 = 330,000 13,000 @ 52 = 676,000 6,000
@ 55 = 330,000 3,000 @ 55 - 165,000 13,000 @ 52= 676,000 3,000 @ 55- 165,000 3,000 a 60 = 180,000
3,000 @ 55 = 165,000 3,000 @ 60 = 180,000 Inventory,end=345,000 CGS = 1,201,000

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Chapter 1 Inventories Gross profit Sales Less cost of goods sold Gross profit P3,070,000 1,201,000
P1,869,000 Weighted Average Method (Periodic) Cost of ending inventory Total cost of goods available
for sale Total units available for sale P1,546,000 29,000 units = P53.31 average cost per unit x 6,000 units
on hand P 319,860 Cost of goods sold Cost of goods available for sale Less cost of ending inventory Cost
of goods sold P1,546,000 319,860 P1,226,140 Gross profit Sales Less cost of goods sold Gross profit
P3,070,000 1,226,140 P1,843,860 Moving Average Method (Perpetual) A stock card is prepared as
follows: Transaction Received Issued 1 18,000@52=936,000 7,000@51.80=362,600 2 3 4 5 6 Balance
2,000@50.00= 100,000 20,000@51.80=1,036,000 13,000/a51.80- 673,400 19,000@52.81=1,003,400
3,000@52.81= 158,440 6,000@56.41= 338,440 6,000@55=330,000 16,000@52.81=844,960 3,000
@60=180,000 The procedures for the maintenance of the stock card under the moving average method
are as follows: . The number of units and total cost of the goods received are added to the previous
respective balances to derive the new number of units on hand and the total cost of goods on hand. The
moving (new) average unit cost is determined by dividing the total cost by the total number of units.
Thus, the 18,000 units purchased, in transaction 2, plus 2,000 units previously on hand equals 20,000;
P936,000 cost of purchases of 18,000 units is added to the cost of the previous inventory, P100,000; the
sum is P1,036,000. P1,036,000 is divided by 20,000 units, resulting to a moving average unit cost, after
transaction 2, of P51.80.

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The number of units sold for issued) is deducted from the previous units on hand to determine the new
number of unit number of units issued x the average unit cost before issuance) P362,600 and
P1,036,000 - P362,600 = P673,400; P673.400 Chapter 2 Inventories is deducted from the previous total
cost of goods on hand. unit cost remains unchanged. (Thus, 7.000 units x P51.80 +13,000 units =
P51.80.) ev The S The cost of ending inventory after transaction 6, is the last figure in P 338,440 the
balance column The cost of goods sold is the total cost in the issued column, P362,600 + P844,960
P1,207,560 Gross profit Sales Less cost of goods sold Gross profit P3,070,000 1,207,560 P1,862.440
MEASUREMENT OF INVENTORIES SUBSEQUENT TO INITIAL RECOGNITION Inventories, in the statement
of financial position, should be measured at the lower of cost and net realizable value. Cost is
determined by applying the specific cost formula used by the enterprise as discussed in the preceding
section. Net realizable value is defined as the estimated selling price in the ordinary course of business
less the estimated costs of completion and estimated costs necessary to make the sale. The cost of
inventories may not be recoverable if those inventories are damaged, if they have become wholly or
partially obsolete, or if their selling prices have declined. The cost of inventories may not also be
recoverable if the estimated costs of completion or the estimated costs to be incurred to make the sale
have increased. The practice of writing inventories down below cost to net realizable value is consistent
with the view that assets should not be carried in excess of amounts expected to be realized from their
sale or use. (TAS 2, Inventories, paragraph 28) Inventories are usually written down to net realizable
value on an item by item basis. In some circumstances, however, it may be appropriate to group similar
or related items. This may be the case with items of inventory relating to the same product line that
have similar purposes or end uses, are produced and marketed in the same geographical area, and
cannot be practicably evaluated separately from other items in that product line. It is not appropriate to
write inventories down on the basis of a classification of inventory, for example, finished goods, or all
the inventories in a particular industry or geographical segment. (IAS 2, Inventories, paragraph 29)

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Chapter 1 Inventortes Estimates of net realizable value are based on the most reliable evidence at the
time the estimates are made as to the amount the inventories are expected to realize. These estimates
take into consideration fluctuations of price as well as the purpose for which the inventory is held. For
example, the net realizable value of the quantity of inventory held to satisfy firm sales or service
contracts is based on the contract price. If the sales contracts are for less than the inventory quantities
held, the net realizable value of the excess is based on general selling prices. (IAS 2, Inventories,
paragraph 31) 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. (IAS 2, Inventories, paragraph 32) To illustrate the application of the lower of cost and
net realizable value rule, assume the following information for different inventory items held by XYZ
Company at December 31, 2019: Item A B с D Cost P185.00 69.00 31.00 75.00 Sales Price P230.00
100.00 43.00 105.00 Selling Expense P35.00 30.00 15.00 37.00 Units 5,000 20,000 15,000 18,000 The
total cost of inventory is determined as follows: A B с D Total 5,000 x P185.00 20,000 x P 69.00 15,000 x
P 31.00 18,000 XP 75.00 P 925,000 1,380,000 465,000 1,350,000 P4,120,000 The inventory value is
determined as follows: NRV (SP- selling Item Cost expense) A P185.00 P195.00 B 69.00 70.00 C с 31.00
28.00 D 75.00 68.00 Total value of inventory Lower of cost and NRV P185.00 69.00 28.00 68.00 Units
5,000 20,000 15,000 18,000 Total Inventory Value P 925,000 1,380,000 420,000 1,224,000 P3,949,000

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Chapter 1 Inventories Thus, from total cost of P4,120,000 to total value of inventory using lower of cost
and net realizable value of P3,949,000, there is inventory write down amounting to P171,000. Write
Down of Inventory De Та The amount of any write-down of inventories to net realizable value should be
recognized as an expense in the period the write down occurs. The write down of inventory cost to
lower of cost and net realizable value may be recorded using either direct method or allowance method,
Some entities find the allowance method more convenient to adopt since the method uses a separate
valuation account and a separate loss account, and the effects of the write-down and its subsequent
recovery can be clearly identified in the entity's statement of comprehensive income. Assume the
following data for ABC Merchandising. The company uses periodic system and first-in, first-out method
of cost allocation. Cost Lower of cost and NRV 12/31/2017 P500,000 480,000 12/31/2018 P520,000
490,000 12/31/2019 P600,000 575,000 Direct Method Allowance Method December 31, 2017 To record
ending inventory Inventory Income Summary 480,000 500,000 480,000 500,000 To record inventory at
lower of cost and NRV Loss from Decline in NRV of Inventory Allowance to Reduce Inventory to NRV
20,000 20,000 December 31, 2018 To close beginning inventory Income Summary Inventory 480,000
500,000 480,000 500,000 to record ending inventory Inventory Income Summary 490,000 520,000
490,000 520,000 To record inventory at lower of cost and NRV 19

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Chapter 1 - Inventories Loss from Decline in NRV of Inventory Allowance to Reduce Inventory 10,000 to
NRV 10,000 December 31, 2019 490,000 520,000 To close beginning inventory Income Summary
Inventory To record ending inventory Inventory Income Summary 490,000 520,000 575,000 600,000
575,000 600,000 To record inventory at lower of cost and NRV Allowance to Reduce Inventory to NRV
Recovery in NRV of Inventory 5,000 5,000 Assuming the same information, but the company uses the
perpetual inventory system, journal entries to reflect the valuation at the lower of cost and net
realizable value are: Direct Method Allowance Method December 31, 2017 20,000 Cost of Goods Sold
Inventory 20,000 20,000 Loss from Decline in NRV of Inventory Allowance to Reduce Inventory 20,000 to
NRV December 31, 2018 30,000 Cost of Goods Sold Inventory 30,000 10,000 Loss from Decline in NRV of
Inventory Allowance to Reduce Inventory to NRV 10,000 December 31, 2019 25,000 Cost of Goods Sold
Inventory 25,000 19

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Chapter 1 - Inventories Allowance to Reduce Inventory to NRV Recovery in NRV of Inventory 5,000 5,000
Presentation in Profit or Loss The effects of adjusting the inventory to lower of cost and net realizable
value are shown on the face of the statement of comprehensive income. The foregoing illustration for
ABC Merchandising and the other additional information below are used to present the effects of the
application of the lower of cost and net realizable value. Sales Purchases General and Administrative
Expenses 2019 2018 P3,500,000 P3,000,000 2,000,000 1,800,000 850,000 750,000 Direct Method Under
this method, the beginning and ending inventories are directly measured at the lower of cost and net
realizable value in the computation of the cost of goods sold. 2019 2018 Beginning inventory P 490,000
P. 480,000 Purchases 2,000,000 1,800,000 Total cost of goods available for sale P2,490,000 P 2,280,000
Ending inventory 575,000 490,000 Cost of goods sold P1,915,000 P1,790,000 The profit is computed as
follows: Sales Cost of goods sold Gross profit General and administrative expenses Profit 2019
P3,500,000 1,915,000 P1,585,000 850,000 P 735,000 2018 P3,000,000 1,790,000 P1,210,000 750,000 P
460,000 The inventories are reported directly at the lower of cost and net realizable value; hence, the
decline in net realizable value is absorbed by the cost of goor's sold. Other than cost of good sold, no
other line item relating to decline in (or recovery of) net realizable value of inventory is presented on the
face of the profit or loss.

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Under the allowance method, both the beginning and ending Chapter Inventaries Allowance Method
income recovery) or other operating panas (derline) in profit us sold. The adjustment in a
bla...comowance is presented as other 2019 Cost of goods sold: Beginning inventory P520,000
Purchases Total cost of goods available for sale 2.000.000 Ending inventory P2,120,000 Cost of goods
sola 600,000 The profit is computed as follows: PL 920.000 P 500,000 1,800,000 P 2,300,000 520,000 P
1.780.000 2018 P3,000,000 1,780,000 P1,220,000 2019 P3,500,000 1,920,000 P1,580,000 5,000
(850,000) Sales Cost of goods sold Gross profit Recovery in NRV of inventory General and administrative
expenses Loss from decline in value of inventory Profit (750,000) (10,000) P460,000 P735,000 It will be
noted that the cost of goods sold differ but the operating profits are the same under the two methods.
OTHER INVENTORY ISSUES Purchase Commitments Companies often contract with suppliers to purchase
a specified quantity of materials during a future period at an agreed unit cost. This is usually done to lock
in prices and insure sufficient quantities. Purchase commitments may be subject to revision or
cancellation before the end of the contract period, Other purchase commitments, however, are non-
cancelable and are not subject to revision, A disclosure in the notes to financial statements is required
for a purchase contract subject to revision or cancellation if (1) a future loss is possible; (2) the amount
of the commitment can be reasonably estimated: and (3) the amount is material. The note disclosure
gives the relevant aspects of the contingency. No entry is required for purchase contracts subject to
revision and cancellation, When purchase contracts are non-cancelable, and when a loss is probable and
material and can be reasonably estimated, the loss and related liability should be recorded in the
accounts, 21

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non cancelable commitment to purchase 100,000 units of an inventory tem To illustrate, assume that on
October 1, 2019. ABC entered at PIO ech, months after date. On December 31, 2019, the aver Purchase
price of the inventory item is P2.00 per unit. The market decine When the actual purchase is made on
April 1, 2020, the avera Chapter Inventories G x units) is recorded on 31 Loss on Purchase Commitments
Estimated Liability on Purchase Commitments 100,000 100,000 purchase price of the inventory item
decreased further to P8,50 per unit The purchase is recorded as Purchases Loss on Purchase
Commitments Estimated Liability on Purchase Commitments Accounts Payable 850,000 50,000 100,000
1,000,000 The loss is thus assigned to the period in which the decline takes place. It is reported on the
statement of comprehensive income among the operating expenses while the estimated liability on
purchase commitments is reported on the statement of financial position as a current liability. When
there is a full or partial recovery of the purchase price, the recovery would be recognized as a gain in the
period during which the recovery takes place. Thus, if the average purchase price at-April 1, 2020 is
P9.25 per unit, the purchase entry would be as follows: Purchases 925,000 Estimated Liability on
Purchase Commitments 100,000 Accounts Payable Recovery of Loss on Purchase Commitments
1,000,000 25,000 Recovery of loss on purchase commitments is reported on the Statement of
Comprehensive Income as other operating income. The amount of recovery that is taken up, however, is
limited to the loss recorded in the previous period for the same purchase commitment. INVENTORY
ESTIMATION METHODS When inventory items cannot be physically counted anymore because the
goods may have been damaged by or lost in catastrophes such as fire or flood, or when the inventory or
cost of goods sold would be presented in the interim financial statements such that a complete physical
count may be too impractical, or to validate inventory figures determined through physical count, the
value of inventory may be determined using an estimating procedure. There are two common methods
of estimating the cost of inventory: the gross profit method and the retail inventory method.

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Chapter Inventorien Port Atached The Browa prolit method of estimating inventory costs is based on a
med lationship between gross profit and sales or between gross pront est of sales The gross profit
method depends on the accuracy of the grown profit That accuracy may be enhanced by adjustments
for known hanges in the relationship between gross profit and sales or between grona pm and cost of
sales and varying gross profit rates in diferent prenents or types of inventory The calculation of
inventory under this method is as follows: Beginning inventory Pxx Add net purchases Cost of goods
available for sale Pxx Less estimated cost of goods sold: (a) Gross profit rate is based on sales Net sales x
(100% - GP rate) (b) Gross profit rate is based on cost Net sales + (100% + GP rate) Estimated cost of
ending inventory Pxx The amount obtained is reported as ending inventory for interim financial
reporting purposes or is considered the amount of loss in cases of fire. Flood, theft, and similar events
unless there are undamaged or partially damaged merchandise. Or To illustrate, assume the following
figures for RME Company for the Six months ended June 30, 2019: Inventory, January 1, 2019 Purchases
Sales Purchase retums Purchase discounts Seles returns Sales discounts P 500,000 2,000,000 3,000,000
80,000 5,000 60,000 4,000 Determine the estimated cost of June 30, 2019 inventory assuming that the
company maintains a gross profit rate of 25% based on on sales 25% based on cost of sales The cost of
goods available for sale is determined as follows: 23

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Chapter 2 - Inventories P 500,000 Inventory, January 1, 2019 Add: net cost of purchases Purchases
Purchase returns Purchase discounts Total cost of goods available for sale P2,000,000 (80,000) (5,000)
1,915,000 P2.415,000 The cost of June 30, 2019 inventory is further computed under the two
assumptions as follows: (a) (b) GP rate is GP rate is 25% based 25% based on on sales cost of sales Total
cost of goods available for sale P2,415,000 P2,415,000 Estimated cost of goods sold: 2,940,000 x 75%
2,205,000 2,940,000 + 125% 2,342.000 Estimated cost of ending inventory P 210,000 Р 73,000 For
purposes of computing cost of goods available for sale, both purchase returns and purchase discounts,
as well as freight in, if any, are taken into consideration. The reason is that the net cost of purchases is
actually experienced or incurred before setting up the sales price. However, for purposes of computing
the cost of goods sold using the gross profit method, net sales is computed by deducting sales returns
only. Thus, in the illustration given, the net sales of P2,940,000 is computed as P3,000,000 sales less
P60,000 sales returns. The sales discounts of P4,000 was simply ignored. Sales discounts and sales
allowances are normally disregarded in computing net sales, because they do not involve physical flow
of merchandise back to the company. However, in some exceptional cases, when sales discounts are
significant and the company anticipates these discounts in setting sales prices, sales discounts may be
considered. When there is undamaged or partially damaged merchandise, computation of inventory loss
is further continued as follows: Pxx Pxx Estimated cost of ending inventory Less: Cost of undamaged
inventory Realizable value of partially damaged inventory (but not to exceed cost) Estimated inventory
loss XX XX Pxx

Chapter ! Inventories To illustrate, assume the following data. On November 10, 2019, a big flood
caused severe damage to the warehouse of And Merchandising Company The company suffered a
significant loss on its merchandise inventory records of ABC Merchandising Company The following
information was available from the accounting January 1, 2019 to date of flood 2018 Purchases
P200,000 Purchases Returns 1,190,000 1,120,000 Sales 30,000 20,000 1,500,000 1.200,000 Merchandise
Inventory, beg. At the beginning of 2019, the company changed its policy on the selling prices of the
merchandise in order to produce a groms profit rate of 5% higher than the gross profit rate in 2018.
Undamaged merchandise marked to sell at P50,000 and damaged merchandise marked to sell at
P15,000 were salvaged. The damaged merchandise had an estimated realizable value of P4,000
REQUIRED: Determine the estimated cost of merchandise inventory lost from the flood on November
30, 2019, Solution: Step 1. Compute the gross profit rate for year 2018, then followed by the gross profit
rate for year 2019. Cost of goods sold = 1,120,000 - 20,000 - 200,000 - 900,000 Gross profit = 1,200,000 -
900,000 - 300,000 Gross profit rate (2018) = 300,000/1,200,000 - 25% The company increased its gross
profit rate by 5% in 2019, Therefore, gross profit rate in 2019 is 30% (25% + 5%). Step 2. Compute the
estimated cost of merchandise inventory at the of flood. P200,000 1,160,000 P1,360,000 Merchandise
Inventory, January 1, 2019 Add net purchases (1,190,000 - 30,000) Cost of goods available for sale Less
estimated cost of goods sold 1,560,000 x (100% - 30%) Estimated cost of inventory, November 30
1,092,000 P 268,000

Compute the estimated cost of merchandise Chapter 1 - Inventories Step 3 the flood Estimated cost of
inventory, November Less: Cost of undamaged merchandise (50,000 x 70) Estimated realizable value of
demed merchandise Estimated inventory lost from flood *The cost of damaged merchandise is P10.500
1704 * PIST The amount deducted, however, is the estimated realizat de value wat lower than cost. If
the realizable value is higher than the ont of duman merchandise, the amount deducted is the lower
amount costy Other than estimating inventory loss due to catastrophe, the one profit method is also
useful for validating the amount of Inventory determined by physical count and for valuing inventories
and cost of sold for interim reporting purposes. However, the grow profit method estimating inventory
is not allowed for annual external financial report purposes. Retail Inventory Method The retail method
is often used in the retail industry for measuring inventories of large numbers of rapidly changing items
with similar margins for which it is impracticable to use other costing methods. The cost of the inventory
is determined by reducing the sales value of the inventory try the appropriate percentage gross margin.
The percentage used takes into consideration inventory that has been marked down to below its original
selling price. An average percentage for each retail department is often used. (IAS 2, Inventories,
paragraph 22) The retail inventory method requires the maintenance of records of purchases at both
cost and selling price. A ratio of cost to retail is calculated and applied to the ending inventory at retail to
compute the approximate cost. When using the retail inventory method, the appropriate treatments for
freight, discounts, returns and allowances, and other relevant items are as follows: a. b. Freight-in is an
addition to purchases at cost. Purchase discounts and purchase allowances are deductions from
purchases at cost only. Purchase returns are deducted from the cost and retail amounts of purchases,
Sales returns are deducted from retail sales. C. d.
Chapter 1 - Inventories e. f. h. Sales discounts and sales allowances are not deducted from retail sales
and retail amount of purchases. Departmental transfer-in (debit) is an addition to both cost
Departmental transfer-out (credit) is a deduction from both cost and retail amounts of purchases.
Normal losses, shortage, shrinkage are deducted from the goods available for sale at retail, after
computing the cost ratio. i. Abnormal losses are deducted from both cost and retail amounts of
purchases, before computing the cost ratio Discounts to employees and favored customers are
deducted from the goods available for sale at retail, after computing the cost ratio (in effect, this is an
addition to sales). The original selling prices of goods may be modified as a result of some market and
economic forces, thus the following terms: Original retail - the first selling price at which goods are
offered for sale. Markup or additional markup - an increase in the selling price over the original retail
price. Markdown - decrease in the selling price below the original retail price. Markup cancellation - a
decrease in the selling price which does not bring the new selling price below the original retail.
Markdown cancellation - an increase in the selling price which does not bring the new selling price
above the original retail price. Net markup - markup less markup cancellation. Net markdown -
markdown less markdown cancellation Illustration of mark up and mark up cancellation An item costing
P100 is initially marked to sell at P150. The original retail is, therefore, P150. If the selling price of this
merchandise is subsequently increased to P170, additional markup is P20. If the selling price is then
decreased from P170 to P155, the markup cancellation is P15. The difference between additional
markup of P20 and markup cancellation of P15, which is P5, is called net markup.

An item costing P100 is initially marked to sell at P150. "The this merchandise is subsequently If the
selling price is subsequently increased from P135 to P145, The difference between markdown of P15
and markdown Chapter 1 - Inventories Illustration of markdown and markdown cancellation original
retail is, therefore, P150. If the selling price decreased to P135, the markdown is P15. the markdown
cancellation is P10. ret COL cancellation of P10, which is P5, is called net markdown. la th The net
markups and net markdowns, as well as the beginning inventory are included in the computation of the
cost percentage that applied to the ending inventory at retail. This approximated average cost of the
inventory is then compared with the net realizable value. The lower between the cost (approximating
the result of the average cost method) and the net realizable value is the inventory amount that will be
reported on the statement of financial position. The following illustrates the use of the retail inventory
method: (Approximating Average Cost) Cost P70,000 340,000 (20,000) (2,000) (1,200) 4,000 Retail
P126,000 438,000 (24,000) Beginning Inventory Purchases Purchase Returns Purchase Allowances
Purchase Discounts Freight-in Additional Markups (net of cancellations) Markdowns (net of
cancellations) Abnormal Losses Departmental Transfers-out (18,000) (8,800) P294,000 P364,000 24,000
(10,000) (22,000) (12,000) P394,000 P520.000 Goods available for sale Cost-to-retail ratio: Goods
available for sale, at cost P364,000 = 70% Goods available for sale, at retail P520,000 Deduct: Sales Sales
Returns Employee Discounts Normal Losses Total Ending Inventory, at retail P380,000 (15,000) 1,500
2,500 P369,000 P151,000

Chapter 1 - Inventories Ending Inventory, at estimated cost: Ending Inventory at retail x cost percentage
151,000 x 70% P 105,700 When the retail method assumes a FIFO cost flow, the cost and the retail value
of beginning inventory are excluded from the cost ratio computation current cost of purchases to the
current retail prices of these purchases The cost percentage that is developed is the ratio of the
(adjusted for net markups and net markdowns). The approximated cost of the ending inventory is,
therefore, based on the ratio of cost to retail on current period purchases only. FIFO Retail Beginning
Inventory Purchases Purchase Returns Purchase Allowances Purchase Discounts Freight-in Additional
Markups (net of cancellations) Markdowns (net of cancellations) Abnormal Losses Departmental
Transfers-out Cost P70,000 340.000 120,000) 12,000) (1,200) 4,000 Retail P126,000 438,000 (24.000)
(18,000) 18.800) P294,000 P364.000 24,000 (10,000) (22,000) (12,000) P394,000 P520.000 Goods
available for sale Cost-to-retail ratio 294,000/394,000 = 74.62% Deduct: Sales Sales Returns Employee
Discounts Normal Losses Total Ending Inventory, at retail P380,000 (15,000) 1,500 2 500 P369,000
P151,000 Ending Inventory, at estimated cost: Ending Inventory at retail x cost percentage 151,000 x
74.62%% P 112.676 The amount of the ending inventory at retail would be the same in both
computations; however, the estimated cost of the ending inventory would vary, depending on the cost
ratio applied. The method prescribed by IAS 2 is the method that considers both the net markups and
net markdowns in the computation of the cost ratio.

The primary purpose of accounting for inventories is to measure the amount of inventory that is shown
as asset on the statement of finance position and the amount of inventory that will be reported as
expense co measurement of inventory and the recording of purchases can result inaccurate figures on
the statement of financial position and statements Chapter 1 - Inventories EFFECTS OF INVENTORY
ERRORS of goods sold) in the statement of comprehensive income. comprehensive income. Errors in the
B Beginning inventory and purchases form part of expenses and are therefore, inversely related to
profit. Thus, if beginning inventory or the cost of purchases is overstated, profit will be understated;
consequently. beginning inventory or cost of purchases is understated, profit will overstated. The ending
inventory is an asset and is, therefore, directly related to profit. Thus, if ending inventory is understated,
the profit for the period is also understated; if ending inventory is overstated, the profit for the period is
also overstated. To illustrate the effects of errors relating to purchases and inventories, consider the
following illustrations: A. A purchase on credit towards the end of 2019 is omitted from both purchases
account and ending inventory. The purchase is recorded in 2020 only when the goods are received. 1.
Statement of Comprehensive Income 2019: Profit is correct. Purchases are understated understating
cost of goods sold; however, ending inventory is understated, overstating cost of goods sold. The effect
of errors in purchases and in ending inventory offset each other. 2020: Profit is correct. Purchases are
overstated overstating cost of goods sold; however, beginning inventory is understated, understating
cost of goods sold. The effect of errors in purchases and in beginning inventory offset each other. 2.
Statement of Financial Position December 31, 2019 - Ending inventory and accounts payable are both
understated. December 31, 2020 - No error exists anymore in the statement of financial position.

Chapter 1 Inventories share on his mind from the rewarded punase in in de are propriately included in
the ending inventory 1 Statement of Comprehensive Income because cost of goods sold understated
because purchases overstated and, therefore, cost of gods sold is overstated Statement of Financial
Position December 31, 2019 Accounts payable are understated because a purchase has been amitted,
The balance of retained earnings in overstated because profit is overstated December 31, 2020 No error
exists anymore in the statement of financial position. The overstatement in profit previous year
counterbalanced by the understatement in profit of this year. Ending inventory is overstated because
some goods were counted Iwice, but purchases are correct Statement of Comprehensive Income 2019:
Profit is overstated because cost of goods sold is understated resulting from overstated ending
inventory 2020: Profit is understated because beginning inventory is overstated, and therefore cost of
goods sold is overstated. Statement of Financial Position December 31, 2019: Ending inventory and
retained earnings are overstated. December 31, 2020: All balances are correct because the errors in
inventory and retained earnings in the previous year were counterbalanced this year. Note that if
income taxes had been considered the effect of the error on profit would be reduced. For example, if
the ending inventory is overstated by P100,000 and the company had an income tax rate of 30%, the
inventory would still be overstated by P100,000 but profit would be

overstated by only P70,000 and income taxes payable would increase buy shall be recognized as an
expense in the period in which the related When inventories are sold, the carrying amount of those
inventories Chapter 1 - Inventories P30,000. Recognition as an Expense revenue is recognized. consists
of (a) costs of goods that have been sold during the period, (b) unallocated production overheads, (c)
abnormal amounts of production costs of inventories, and (d) write-down from cost to net realizable
value of unsold goods, These expenses are reported in a manner that reflects the method adopted by
the entity for reporting expenses (nature of expense method or function of expense method) and the
method for reporting the effects of applying the lower of cost and net realizable value (direct inventory
reduction method or allowance method). DISCLOSURE REQUIREMENTS The financial statements shall
disclose (IAS 2, paragraph 26): the accounting policies adopted in measuring inventories, including the
cost formula used; the total carrying amount of inventories and the carrying amount in classifications
appropriate to the entity; the carrying amount of inventories carried at fair value less costs to sell; the
amount of inventories recognized as an expense during the period; the amount of any write-down of
inventories recognized as an expense in the period; the amount of any reversal of any write-down that is
recognized as expense in the period; the circumstances or events that led to the reversal of a write-
down of inventories; and the carrying amount of inventories pledged as security for liabilities.

Chapter 1 - Inventories A sample disclosure relating to inventories of a fictitious company is presented

below. From summary of significant accounting policies: Raw materials and purchased finished goods
are valued at purchase cost. Work in progress and manufactured finished goods are valued at
production cost Production cost includes direct production costs and an appropriate proportion of
production overheads and factory depreciation Raw materials inventories and purchased finished goods
are accounted for using the FIFO (first in, first out) method. The weighted average cast method is used
for other inventories. An allowance is established when the net realizable value of any inventory item is
lower than the value calculated above. From supporting schedules (in millions of PHPs) Raw materials,
work in progress and sundry supplies Finished goods Allowance for write off at net realizable value Total
2018 3 904 5 488 (137) 9 255 2018 3 243 4812 (130) 7925 Inventories amounting to PHP 227 million
(2017: PHP 169 million) are pledged as security for financial liabilities.

Abnormal Inventory loss. Loss in inventory units and/or amount due to unforeseen circumstances (such
as theft and accidents and lons that beyond tolerable limits. Cash discount. An incentive for early
payment of amounts owing on credit transactions, normally quoted as a percentage: also calles
settlement discount. Consigned goods. Inventory that is physically located at (consignee) but whose
ownership is retained by the shipper (consignor until the dealer sells the inventory. Cost, Insurance and
Freight (CIF). Term of sale where the selle pays the cost and freight necessary to bring the goods to the
named port of destination. The seller contracts for insurance and pays the insurance premium This term
of sale requires the seller to clear the goods for export. Fair value. It is the price that would be received
to sell an asset or paid to transfer liability in orderly transaction between marker participants the
measurement date (IFRS 13, Fiar Measurement, paragraph 9). Finished goods. Manufactured products
for which the manufacturing process is complete. First-in, first-out method. A method of allocating cost
to inventory items that assumes that the items first purchased will be the items first sold. FOB (free on
board) destination. Terms of sale under which title of goods passes to the purchaser at the point of
destination; a condition of sale under which the seller pays all freight costs. FOB destination, freight
collect. Term of sale under which title of goods passes to the buyer that pays the freight cost at the
point of destination. This amount paid by the buyer for freight is deductible from the amount payable to
the seller. FOB (free on board) shipping point. Terms of sale under which title of goods passes to the
purchaser at the point of shipment; a condition of sale under which freight costs incurred from the point
of shipment are paid by the buyer. FOB shipping point, freight prepaid. Term of sale under which title of
goods passes to the buyer at the shipping point but the seller pays freight cost that should be borne by
the buyer. The amount paid by the seller for freight is an addition to the amount receivable from the
buyer. Free alongside (FAS). Term of shipment where the risk of loss shifts from the seller to the buyer
to a named port alongside a vessel designated by the buyer; Used for sea or inland waterway
transportation. Goods in process. Inventory of a manufacturer that are partly processed and require
further work before they can be sold; also called work in process. Gross method. A method of inventory
accounting that records inventory cost before considering cash discounts, also called gross price
method.

Gross profit method. An inventory estimation technique based on the relationship between grossprofit
and sales. the gross profit percentage is used to estimaye cost of good sold which in turn is used to
estimate the value of the inventory not yet sold. Inventories. Assets held for sale in the ordinary course
of business, inthe process of production for such sale or in the form of materiala or supplies to be
consumed in the production process or in the rendering of services. Lay away sales. A retails sales
promotion scheme where a customer cannot buy at the present time. merchandise until Usually, the
store holds the certain date or completes the payment and takes the delivery. before which the
customer Markup. An increase in the selling price over the original retail price. Markup cancellation. A
decrease in the selling price which does not bring the new selling price below the original retail.
Markdown. Decrease in the selling price below the original retail price. Markdown cancellation. Increase
in the selling price which does not bring the new selling price above the original retail price. Moving
average method. The weighted average inventory costing method applicable to perpetual inventory
system, where a new weighted average unit cost of goods is computed after each purchase or receipt.
Net method. A method of recording purchases at the invoice price less any cash discounts offered by the
seller; also called net price method. Net realizable value. The estimated selling price in the ordinary
course of business less the estimated costs of completion and the estimated costs necessary to make
the sale. Normal inventory loss. Loss in inventory units and/or amount due to foreseen events and loss
considered within tolerable limit. Periodic inventory system. A method of accounting for inventory in
which cost of goods sold is determined and inventory is adjusted to the proper balance at the end of the
accounting period. Purchases are recorded in the purchases account, and ending inventory is
determined by a physical count. Perpetual inventory system. A method of accounting for inventory in
which detailed records of each inventory purchase and sale are maintained. This system provides a
current record of inventory on hand and cost of goods sold to date. Raw materials. Inventory acquired
by a manufacturer for use in the production process. Retail inventory method. A method used by
companies in retail industry where the estimated cost of inventory is based on assumed relationship
between cost and retail prices after considering the changes in the original retail prices. Specific
identification. A method of allocating cost to inventory based on identifying and aggregating all costs
directly related to each individual inventory item.
Trade discount. A reduction in the list price of an item which is the amount actually charged to the
customer; generally, trade discounts are dependent on the volume of business or size of order from the
customer. Weighted average. A method of allocating cost to inventory items based on 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.

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ordinary course of business; in the process of production for such Chapter 1 - Inventories CHAPTER
SUMMARY are assets of an enterprise that are held for sale in the the production process or in the
rendering of services. The costs of inventories include all costs of purchase, costs of conversion and
other costs incurred in bringing the inventories to their present location and condition. * The basic
criterion for including items in inventory is economie, control rather than physical possession. There are
two main objectives for accounting for inventories (a) to measure the amount of inventory to be
recognized as asset in the statement of financial position, and (b) to measure the amount of inventory
that will be recognized as expense in the statement of comprehensive income. or Two alternative
accounting systems for inventories may be adopted by business enterprises, the periodic inventory
system and the perpetual inventory system. A company using periodic inventory system does not
maintain a continuous record of physical quantities cost of inventory on hand. Net costs of purchases
are summarized in nominal accounts and a physical count is conducted at year-end to establish the
quantities and cost of inventories. A company using the perpetual inventory system maintains a
continuous record of inventory quantities and cost. A physical count is conducted at least once a year
only to confirm the inventory balance per books. The cost of inventories is computed using a derived
cost formula. The cost of inventories that are not ordinarily interchangeable is determined using the
specific identification method. The cost of goods that are ordinarily interchangeable is determined using
either the first in, first out (FIFO) method or the weighted average method. IAS 2 does not allow the use
of the last in, first out (LIFO) method as an inventory costing procedure. • Inventories on the statement
of financial position are measured at the lower of cost and net realizable value, their cost being
computed using a derived formula (specific identification, FIFO method, or weighted average method).
Net realizable value is estimated sales price reduced by cost to complete and sell the goods. Any write
down of inventories from cost to lower of cost and net realizable value is taken up as an expense on the
statement of comprehensive income.

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Chapter 1 Inventortes An error in recording purchases and inventories may affect the well as the
financial statements of the subsequent period. financial statements of the period in which the error is
committed as Estimating procedures may be used to determine the cost of inventories destroyed by
catastrophe, to inventories for interim financial statement purposes and to validate the inventory cost
determined through physical count. alternative estimating procedures may be used: method and the
retail inventory method. method is not allowed for annual financial statement purposes, IAS 2 allows
the use of the retail inventory method to approximate the cost of inventory for annual financial
statement purposes. measure the cost of the gross profit While the gross profit ADDED LEARNING
APPLICABLE TO SMALL ENTITIES AND MEDIUM-SIZED ENTITIES There are no significant differences
between accounting for inventories for entities using full PFRS/IFRS and entities using PFRS/IFRS for
Small and Medium-sized Entities. Entities that report based on PFRS for Small Entities measure
inventories in their statement of financial position at the lower of cost or market value. Market value is
determined as the probable settling price to willing buyers as of reporting date.