TOPIC: INVENTORIES

Key Terms and Concepts to Know

Ownership: Ownership includes all inventory owned by the purchaser, regardless of location or
possession. The following items are included in inventory:
 Owned inventory at the company’s location.
 Inventory purchased FOB Shipping Point and still in-transit from the seller.
 Inventory sold FOB Destination and still in-transit to the seller.
 Owned inventory on consignment to others

Physical Inventory:
 Inventory is physically counted to determine the actual quantity on hand.
 The units of inventory physical counted are then valued at cost to determine the value of
inventory that SHOULD be recorded in the general ledger.
 Any difference between the general ledger balance and the value of the physical inventory is
recorded as shrinkage.

Inventory Methods:
 There are two basic methods used to account for inventory: Periodic and Perpetual.
 Periodic Inventory:
 A separate general ledger account is used for each type of inventory transaction.
 Cost of goods sold transactions are ignored during the period and recorded only at the
end of the period.
 Merchandise inventory balance in the general ledger is not updated until the end of the
period and does NOT represent the value of inventory on hand.
 Perpetual Inventory:
 All inventory transactions are recorded in a single merchandise inventory account in the
general ledger.
 Cost of goods sold transactions are recorded as incurred throughout the period.
 l inventory transactions are recorded as incurred, constantly updating the value of
inventory in the general ledger which represents the value of inventory on hand.

Inventory Cost:
 Cost is the total resources given up acquiring inventory and move it to the purchaser’s place of
business.
 Cost may be assigned to units of inventory in one of four ways:
 Specific identification
 First-In, First Out (FIFO)
 Last-In, First-Out (LIFO)
 Weighted Average Cost
 The actual application of these methods will vary depending on whether a perpetual or periodic
inventory system is used.

Lower of Cost or Market:

 As with all assets, inventory is recorded at cost when acquired.
  Over time, however, the cost of replacing the inventory with the same type of inventory (market
cost) may fall below purchase cost.
 The lower-of-cost-or-market principle may be applied in one of three ways:
 To the entire inventory taken as a whole.
 By group or class or type of product.
 To each item individually.
 This situation requires a journal entry to record the decline in the value of the inventory on
hand:

Cost of Goods Sold xxx

Merchandise Inventory xxx

Inventory Turnover ratio and Days Sales in Inventory ratio

Key Topics to Know

Inventory Cost Flow Assumptions: Specific Identification

Specific Identification means that each item in inventory is retains its purchase cost throughout
the inventory and cost of goods sold cycle. This inventory method is appropriate for a low volume, high
value inventory, such as a new car dealer or a high-end jewelry store would have. Specific identification
is typically used with the perpetual inventory method. This method provided the “truest” value for both
ending inventory and cost of goods sold but is too cumbersome for many applications.

Inventory Cost Flow Assumptions: FIFO, LIFO and Average Cost

Under these three inventory methods, inventory items or units do not retain their unit purchase
cost after the purchase has been recorded. Instead, units sold during the accounting period and units
remaining in inventory at the end of the accounting period are assigned a cost according to the rules of
FIFO, LIFO or Average Cost.

How costs are assigned the units in ending inventory and units sold is controlled by two factors:

1. Whether the Periodic or Perpetual inventory method is used.

2. Whether FIFO, LIFO or Average Cost assumption is used for the flow of costs assigned to
inventory and cost of goods sold.

In summary:
 Under FIFO, unit costs are assigned to units sold in the order in which they were incurred,
regardless of which units were actually sold. The oldest or first-in unit costs are used to
calculate cost of goods sold; remaining unit costs are assigned to the units in ending inventory.
 Under LIFO, unit costs are assigned to units sold in the reverse order of which they were
incurred, regardless of which units were actually sold. The most recent or last-in unit costs are
used to calculate cost of goods sold; remaining unit costs are assigned to the units in ending
inventory.
 Under Average Cost, an average cost for all units cost for all units in inventory is calculated and
used to value the units in both cost of goods sold and ending inventory.
Following are examples of these methods under the periodic inventory method (Examples #1, #2 and
#3) and under the perpetual inventory method (Examples #4, #5 and #6). There are 50 units in ending
inventory.

Transaction Type # of Units Unit Cost

Beginning Inventory 10 120
Purchased 40 125
Sold 20
Purchased 50 130
Sold 20
Sold 30
Purchased 40 132
Sold 20

Example #1: FIFO/Periodic

Note that the costs of the 50 units purchased at $130 have been split between the units sold and the
units remaining in inventory.

Cost of Goods Sold Ending Inventory

Units Cost/unit Total Units Cost/unit Total
10 120 1,200
40 125 5,000
40 130 5,200 10 130 1,300
40 132 5,280
P11,400 P6,580

Example #2: LIFO/Periodic

Cost of Goods Sold Ending Inventory

Units Cost/unit Total Units Cost/unit Total
50 130 6,500 10 120 1,200
40 132 5,280 40 125 5,000
P11,780 P6,200
Example #3: Average Cost/Periodic

Transaction Type # of Units Unit Cost Value

Beginning Inventory 10 120 1,200
Purchased 40 125 5,000
Purchased 50 130 6,500
Purchased 40 132 5,280
Total 140 P128.43 P17,980

Average Cost: P17,980 / 140 total units = 128.43/unit (rounded).

Average cost is calculated at the end of the period.

Cost of Goods Sold Ending Inventory

Units Cost/unit Total Units Cost/unit Total
90 128.43 P11,558.50 50 128.43 P6,421.50
Example #4: FIFO/Perpetual

Transaction Type Purchases Cost of Goods Sold Balance

Beginning Inventory 10@120= 1,200

Purchased 40@125= 5,000 10@120= 1,200
40@125= 5,000
Sold 10@120= 1,200
10@125= 1,250 30@125= 3,750
Purchased 50@130= 6,500 30@125= 3,750
50@130= 6,500
Sold 20@125= 2,500 10@125= 1,250
50@130= 6,500
Sold 10@125= 1,250
20@130= 2,600 30@130= 3,900
Purchased 40@132= 5,280 30@130= 3,900
40@132= 5,280
Sold 20@130= 2,600 10@130= 1,300
40@132= 5,280
Total/Balance: P11,400 P6,580

Example #5: LIFO/Perpetual

Transaction Type Purchases Cost of Goods Sold Balance

Beginning Inventory 10@120= 1,200

Purchased 40@125= 5,000 10@120= 1,200
40@125= 5,000
Sold 20@125= 2,500 10@120= 1,200
20@125= 2,500
Purchased 50@130= 6,500 10@120= 1,200
20@125= 2,500
50@130= 6,500
Sold 20@130= 2,600 10@120= 1,200
20@125= 2,500
30@130= 3,900
Sold 30@130= 3,900 10@120= 1,200
20@125= 2,500
Purchased 40@132= 5,280 10@120= 1,200
20@125= 2,500
40@132= 5,280
Sold 20@132= 2,640 10@120= 1,200
20@125= 2,500
20@132= 2,640
Total/Balance: P11,640 P6,340
Example #6: Average Cost/Perpetual

Transaction Type Purchases Cost of Goods Sold Balance

Beginning Inventory 10@120= 1,200

Purchased 40@125= 5,000 50@124= 6,200
Sold 20@124= 2,480 30@124= 3,720
Purchased 50@130= 6,500 80@127.75= 10,220
Sold 20@127.75= 2,555 60@127.75= 7,665
Sold 30@127.75= 3,833 30@127.75= 3,833
Purchased 40@132= 5,280 70@130.19= 9,113
Sold 20@130.19= 2,603 50@130.19= 6,509
Total/Balance: P11, 471 P6, 509

Average cost (highlighted in red) is calculated after each purchase and is used to value both cost of
goods sold and inventory until the next purchase is made.

Summary of Examples #1 through #6:

Cost of Goods Sold Ending Inventory

Units Value Units Value
Periodic
Example #1 90 11,400 50 6,580
Example #2 90 11,780 50 6,200
Example #3 90 11,558 50 6,422
Perpetual
Example #4 90 11,400 50 6,580
Example #5 90 11,640 50 6,340
Example #6 90 11,471 50 6,509

*** Six different inventory methods, five different costs of goods sold and five different ending inventory
vales and all of them are GAAP. Periodic and perpetual FIFO will always produce the same cost of goods
sold and ending inventory.

Lower of Cost and Net Realizable Value

Like many other assets, inventory is recorded and reported at cost in accounting books following
historical cost principle following a certain cost flow assumption either FIFO, LIFO, AVCO or other
methods. Another way of measuring inventory value is based on net realizable value (NRV).

Under normal circumstances, cost of inventory is always lesser than the net amount business can earn
by selling the inventory, called net realizable value (NRV). Common sense dictates that cost has to be
lesser than NRV to make profit. But following a concept of conservatism, even if NRV is higher than cost,
value of inventory is kept at cost and gain is not recognized until the inventory actually sells.

However, if NRV of inventory falls below the cost of inventory, following the same concept of
conservatism, entity must write down the value of inventory to the amount that can be realized. Hence
the recognition of loss to the extent expenditure on inventory are not expected to be recovered. It does
not make sense to report an asset at any value higher than the amount it can recover and may overstate
the assets materially. Therefore, entity must switch to NRV basis from historical cost basis of
measurement if recoverable amount falls below cost of asset.

Reasons for lower NRV

NRV may falls below cost for two main reasons; either cost has increased or sales price has dropped.
Some of the examples include:

 Goods are now obsolete. With newer products in the market offered at competitive rates, entity
is unable to make sales or at least at profitable rate.
 Goods are damaged. Though price is good, but the cost to repair the goods renders recoverable
or realisable amount lesser than the cost itself.
 Seasonal effects can alter prices significantly, though can be temporary.
 Wrong sales strategy of entity may cause oversaturation of goods in the market. This can cause
prices to plummet below original cost. Entity has to maintain appropriate levels of supply
against demand.
 If entity is minting profits, sooner or later competitors in the market will jump in as well offering
similar products and it may be the case that they start offering products with same utility at
prices lower than the production cost of entity.
 Production cost has increased. May be because of increase in raw material cost or other direct
expenses such as royalty that is paid in foreign currency and exchange rate has fluctuated
unfavourably for entity.
 It might be possible that entity can produce units at lower cost but has to spend a lot of carriage
cost to move inventory to market before it can be sold.

Biological Assets
 Active market – a market in which items traded are homogeneous, willing buyers and sellers
can normally be found at any time and prices are available to the public.
 Biological transformation – quantitative and qualitative processes of growth, degeneration, and
procreation of biological assets and harvesting of agricultural produce.
 Biological assets – plants and animals.
 Net realisable 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.
 Acquisition (production) cost – the amount of cash or cash equivalents paid or payable, or the
value of other consideration given or consumed to acquire an asset at the time of its acquisition
or production.
 Point-of-sale costs – payments to intermediaries, assessors, sales agents, as well as taxes, levies,
and similar costs.
 Harvest – the detachment of produce from a biological asset (e.g. picking of apples) or the
cessation of a biological asset’s life processes (e.g. threshing grains, slaughtering livestock).
 Fair value – the amount for which an asset or a service could be exchanged, or a liability settled,
between knowledgeable, willing parties in an arm’s length transaction.
 Agricultural produce – the harvested product of the entity’s biological assets.
 Agricultural activities – activities that comprise production and treatment of agricultural
produce, processing of agricultural produce produced and treated by the entity, production and
realisation of foodstuff, and rendering services for agriculture. Production of foodstuff from
 agricultural produce other than grown and treated in own farm and realisation of this produce
are not regarded as an agricultural activity.

An entity shall recognise a biological asset and agricultural produce in accounting records only when:

 it manages and uses the asset and (or) controls it as a result of past events;
 It is probable that it will get future economic benefits from this asset;
 It is possible to measure reliably the value of the asset.

All biological assets shall be measured on initial recognition (at the time of procreation, germination
of crops, tree planting, etc.) and at subsequent balance sheet dates; and all agricultural produce
harvested of the biological assets shall be measured at the point of harvest applying one of these
methods:

 At the fair value less point-of-sale costs;

 At the acquisition (production) costs.

If the fair value less point-of-sale costs method is chosen for measuring biological assets and
agricultural produce harvested of these assets upon the first-time application of this Standard, the
change in accounting policies is applied prospectively.

Gross Profit Method

Gross Profit Method—estimating inventory by using the previous years’ percentage of gross
profit on operations
 A business that keeps periodic inventory and prepares interim monthly financial statements
needs a cost to use for monthly ending inventory.
 Assumes that a continuing relationship exists between gross profit and net sales.
 ESTIMATE—not absolutely accurate .

Retail Inventory Method

Retail Method—estimating inventory using a percentage based on both cost and retail prices.

Business must keep separate records of both cost and retail prices for net purchases, net sales,
and beginning merchandise inventory

Merchandise Available ÷ Merchandise Available = Percentage for Sale at Cost for Sale at Retail

Many business used the gross profit method because it does not require keeping separate cost
and retail price records.

Businesses that keep a perpetual inventory or has a computerized inventory system may have
the figures needed for the retail method readily available.

Multiple Choice
1. The cost of purchase of inventory does not include
a. Purchase Price
b. Import duties and irrecoverable taxes
c. Freight and handling costs
d. Trade discounts, rebates and other similar items

2. Fixed production overheads include all, except

a. Indirect materials and indirect labor
b. Depreciation of factory building
c. Maintenance of factory equipment
d. Cost of factory management and administration

3. The inventories of a service provider may simply be describes as

a. Work in progress
b. Unbilled services
c. Billed services
d. Services inventory

4. Which of the following costs should be included in inventory valuation?

a. Administration cost
b. Abnormal material usage
c. Storage cost relating to finished goods
d. Fixed production overhead

5. Which of the following would be included in the balance sheet of a merchandiser?

a. Finished Goods Inventory.
b. Raw Materials Inventory.
c. Merchandise Inventory.
d. Work in Process Inventory.

6. Which of the following accounts does not exist in a perpetual inventory system?
a. Purchases.
b. Inventory.
c. Cost of Goods Sold.
d. Sales Returns and Allowances.

7. All of the following accounts are used under a perpetual inventory system except:
a. Sales.
b. Purchase Discounts Lost.
c. Inventory.
d. Cost of Goods Sold.

8. If the beginning inventory is overstated:

a. The current ratio is overstated.
b. Cost of goods sold is understated.
c. Retained earnings is understated.
d. Working capital is understated.
9. The buyer would report the inventory in its balance sheet for items:
a. Purchased with a buyback agreement.
b. Shipped f.o.b. destination and in transit.
c. Purchased f.o.b. shipping point and in transit.
d. Received on consignment.

10. Which of the following should be not included in a company's ending inventory?
a. Goods held on consignment.
b. Goods out on consignment.
c. In-transit goods purchased and shipped FOB shipping point.
d. In-transit goods sold and shipped FOB destination.

11. Freight charges on goods sold are accounted for as:

a. Manufacturing costs.
b. Product costs.
c. Variable costs.
d. Period costs.

12. An inventory pricing procedure in which the oldest costs incurred rarely have an effect on the
ending inventory valuation is
a. Base stock.
b. FIFO.
c. LIFO.
d. Weighted-average.

13. An inventory method that makes it possible to manipulate net income is the:
a. Specific identification method.
b. LIFO method.
c. FIFO method.
d. Average cost method.

14. An erosion of LIFO inventory layers is referred to as a LIFO

a. Allowance,
b. Effect.
c. Liquidation.
d. Reserve.

15. Which of the following is not considered an advantage of LIFO when prices are rising?
a. The more recent costs are matched against current revenues.
b. There will be a deferral of income tax.
c. The inventory will be overstated.
d. A company's future reported earnings will not be affected substantially by future price
declines.

16. Under a perpetual which accounts should be debited the each time a sale on account is made?
a. Accounts Payable and Purchases.
b. Accounts Receivable and Purchases.
 c. Accounts Receivable and Cost of Goods Sold.
d. Inventory and Cost of Goods Sold.

17. In a periodic inventory system the ending inventory and cost of goods sold must be determined
by:
a. External auditors.
b. Physical count.
c. A certification of inventory.
d. Reference to a running inventory balance.

18. A periodic system of inventory

a. Reduces record keeping.
b. Increases record keeping.
c. Increases the cost of maintaining inventory.
d. Eliminates the need for a physical count.

19. Goods held on consignment are included in the inventory valuation of

a. The consignor.
b. The consignee.
c. Both the consignor and the consignee. 
d. Neither the consignor nor the consignee

20. Variable costing is also referred to as

a. Direct costing.
b. Full costing.
c. Variable costing.
d. Fixed costing.

Problem Solving

1. Smiley Manufacturing Company has the following account balances at year end:

Office supplies 3,000

Raw materials 21,000
Work-in-process 32,000
Finished goods 46,000
Prepaid insurance 5,000

What amount should Smiley report as inventories in its balance sheet?

a. P46, 000.
b. P99, 000.
c. P104, 000.
d. P78, 000.

* P21, 000 + P32, 000 + P46, 000 = P99, 000

2. Hemply Corporation uses the FIFO method for internal reporting purposes and LIFO for external
reporting purposes. The balance in the LIFO Reserve account at the end of 2012 was P60, 000.
The balance in the same account at the end of 2017 is P90, 000. Hemply's Cost of Goods Sold
account has a balance of P450, 000 from sales transactions recorded during the year. What
amount should Hemply report as Cost of Goods Sold in the 2017 income statement?

a. P480, 000.
b. P450, 000.
c. P420, 000.
d. P540, 000.

*450,000 + (90,000 - 60,000) = P480, 000

3. Dragau Inc. is a calendar-year corporation. Its financial statements for the years 2017 and 2018
contained errors as follows:

2018:  2017: 
Ending inventory P6,000 overstated  Ending inventory P12,000 overstated 
Depreciation expense P4,000 understated Depreciation expense P9,000 overstated

Assume that the proper correcting entries were made at December 31, 2017. By how much will
2018 income before taxes be overstated or understated? 

a. P10, 000 overstated

b. P2,000 understated
c. P5,000 overstated
d. P7,000 overstated

* Overstating ending inventory by P6, 000 plus the understatement of depreciation expense by
P4, 000 overstates net income by P10, 000. The 2017 errors are contained in retained earnings.

4. Joelle Corporation uses the perpetual inventory method. On May 1, it purchased P22, 000 of
inventory, terms 2/10, n/30. On May 3, Joelle returned goods that cost P2, 000. On May 9, Joelle
paid the supplier. On May 9, the company should credit
a. Purchase discounts for P440.
b. Inventory for P440.
c. Inventory for P400.
d. Purchase discounts for P400.

* (P22, 000 - P2, 000) X 2% = P400.

5. Barashari Manufacturing Company has the following account balances at year end:

Office supplies P6, 000 

Raw materials 21,000 
Work-in-process 44,000 
Finished goods 52,000 
Prepaid insurance 8,000 
 What amount should Jamison report as inventories in its balance sheet?

a. P123, 000.
b. P52, 000.
c. P117, 000.
d. P96, 000.

* P21, 000 + P44, 000 + P52, 000 = P117, 000

6. Ernesto Company had January 1 inventory of P150, 000 when it adopted dollar-value LIFO.
During the year, purchases were P900, 000 and sales were P1, 500,000. December 31 inventory
at year-end prices was P189, 750, and the price index was 110. What is Ernesto Company's gross
profit?
a. P624, 750.
b. P450, 000.
c. P550, 250.
d. P600, 000.

* P1, 500,000 - [{(P150, 000 * 110%) + P900, 000} - P189, 750] = P624, 750

7. Under the principle of lower-of-cost-or-market, when a company has 10 units of inventory A

with market value of P50 and a cost of P60, what is the adjustment?
a. Debit Inventory P100; credit Cost of Goods Sold P100.
b. Debit Inventory P500; credit Cost of Goods Sold P500.
c. Debit Cost of Goods Sold P100; Credit Inventory P100.
d. Debit Cost of Goods Sold P500; credit Inventory P500.

8. Nel Company has the following information for their inventories A, B, C, and D:

The necessary adjustment associated with the lower-of-cost-or- market method would be:
a. Inventory 675
Cost of Goods Sold 675
b. Cost of Goods Sold 675
Inventory 675
c. Inventory 475
Cost of Goods Sold 475
d. Cost of Goods Sold 475
Inventory 475

9. Inventory records for Drazzle Incorporated revealed the following:

DATE TRANSACTION NUMBER OF UNITS UNIT COST
 Apr. 01 Beginning Inventory 500 P2.40
Apr. 20 Purchase 400 2.50

Drazzle sold 700 units of inventory during the month. Cost of goods sold assuming LIFO would
be:

a. P1,730
b. P1,700
c. P1,720
d. P1,710

10. If the merchandise costs P6, 000, insurance in transit costs P500, tariff costs P50, processing the
purchase order by the purchasing department costs P35, and the company receiving dock
personnel costs P15, what is the total cost charged to the merchandise?
a. P6,000
b. P6,500
c. P6,550
d. P6,600

SOLUTION MANUAL

Multiple Choice Multiple Choice – Problem Solving

1. D 1. B
2. A 2. A
3. A 3. A
4. C 4. C
5. C 5. C
6. A 6. A
7. B 7. C
8. C 8. D
9. C 9. C
10. A 10. C
11. D
12. B
13. A
14. C
15. C
16. C
17. B
18. A
19. A
20. A
FINANCIAL ACCOUNTING 1
W/F | 1:00PM – 4:00PM
Requirement: Synopsis

Topic covered: INVENTORIES

CHAPTER 16: Inventories

CHAPTER 17: Inventory Cost Flow
CHAPTER 18: Lower of Cost & Net Realizable Value
CHAPTER 19: Biological Assets
CHAPTER 20: Gross Profit Method
CHAPTER 21: Retail Inventory Method

Submitted by:

Trevias, Marinel P.
BSAT – II

Submitted to:

Dean Roma Salvador, CPA, MBM

Professor