INVENTORY COST FLOW

PAS 2, paragraph 25, expressly provides that the cost of inventories shall be determined by using
either:
1. First in, first out
Under this method, the goods first purchased are first sold and consequently,
goods at the end of the period are the most recently purchased or produced (current
replacement cost)
The objection to the method is that' there is improper matching of cost against
revenue because the goods sold are stated at earlier or older prices resulting in
understatement of cost of sales. Accordingly, in a period of inflation or rising prices, the
FIFO method would result to the highest net income.

ILLUSTRATION:

Units Unit Cost Total Cost Sales (in Units)

Jan 1 Beg. 800 200 160,000
8 Sale 500
18 Purchase 700 210 147,000
22 Sale 800
31 Purchase 500 220 110,000
Ending Inventory 700

FIFO - PERIODIC
Units Unit Cost Total Cost
From Jan. 18 Purchase 200 210 42,000
From Jan. 31 Purchase 500 220 110,000
700 152,000

Cost of Goods Sold = 160,0000 + 147,000 + 110,000 - 152,000

= 265,000

NOTE: Under FIFO periodic and perpetual method, inventory costs are the same.
FIFO - PERIODIC
Purchases Sales Balance (Purchase - Sales)
Unit Unit Total Unit Total
Units Cost Total Cost Units Cost Cost Units Cost Cost

Jan 1 Beg. - 800 200 160,000

8 - 500 200 100,000 300 200 60,000

300 200 60,000

18 700 210 147,000 - 700 210 147,000

22 - 300 200 60,000 -

500 210 105,000 200 210 42,000

200 210 42,000

31 500 220 110,000 500 220 110,000

2. Weighted average
a. Periodic - the cost of the inventory plus the total cost of purchases during the
period is divided by the total units purchased plus those in the beginning inventory
to get a weighted average unit cost.
Such weighted average unit cost is then multiplied by the units on hand to
derive the inventory value, i.e., the average unit cost is computed by dividing the
total cost of goods available for sale by the total number of units available for sale

Units Unit Cost Total Cost

Jan. 1 Beg. 800 200 160,000
18 Purchase 700 210 147,000
31 Purchase 500 220 110,000
Total Goods Available for sale 2,000 417,000

Weighted Ave. Unit Cost (417,000 / 2,000) 208.5

Inventory Cost (700 x 208.5) 145,950
Cost of Goods Sold (160,000 + 257,000 - 145,950) 271,050
 b. Perpetual (Moving Average Method) – PAS 2, paragraph 27, provides that the
weighted average may be calculated on a periodic basis or as each additional
shipment is received depending upon the circumstances of the entity.
Under this method, a new weighted average unit must computed after
every purchase and purchase return.

Units Unit Cost Total Cost

Jan 1 Balance 800 200 160,000
8 Sale -500 200 (100,000)
Balance 300 200 60,000
18 Purchase 700 210 147,000
Total 1000 207 207,000
22 Sale -800 207 (165,600)
Balance 200 207 41,400
31 Purchase 500 220 110,000
Total 700 216 151,400

We can obtain the Unit Cost by referring to the bold figures by dividing
total cost over number of units.
Under this method, Cost of goods sold shall be computed by adding
January 8 and 22 sales amount (100,000 + 165,600) or P265,600

Specific identification
• Specific identification means that specific costs are attributed to identified items of
inventory.
• The cost of the inventory is determined by simply multiplying the units on hand by their
actual unit cost. This requires records which will clearly determine the actual costs of
goods on hand.
• There is an actual determination of cost of units and on hand. The major argument against
this method is that itis very costly to implement even with high-speed computers.

PAS 2, paragraph 28, provides that this method is appropriate for inventories that are
segregated for a specific project and inventories that are not ordinarily interchangeable.

Standard Costs
• Are predetermined product established on the basis of normal levels of materials and
supplies, labor, efficiency and capacity utilization. Once determined, is applied to all
inventory movements - inventories, available for sale, purchases and or placed in
production.
PAS 2, paragraph 21, states that the standard cost method may be used for convenience if the
results approximate cost.

Relative price method

When different are purchased at a lump sum, the single cost is apportioned among the based on
their respective sales price.

For example, products A, B, and C are purchased at "basket price" of P3,000,000. Assume the
following sales price and allocation:

Allocation / Lump
Sales Price Ratio
Sum Price
Product A 500,000 (500,000/5,000,000) x 3,000,000 300,000
Product B 1,500,000 (500,000/5,000,000) x 3,000,000 900,000
Product C 3,000,000 (500,000/5,000,000) x 3,000,000 1,800,000
5,000,000 3,000,000

LOWER OF COST AND NET REALIZABLE VALUE

Measurement of inventory

PAS 2, paragraph 9, provides that inventories shall be measured at the lower of cost and net
realizable value (LCNRV).
This is consistent with the view that assets shall not be carried in excess of amounts
expected to be realized from their sale or use

Net realizable value (NRV)

Is the estimated selling price in the ordinary course of business less the estimated cost of
completion and the estimated of disposal.

The cost of inventories may not be recoverable under the following circumstances:
a. inventories are damaged.
b. The inventories have wholly or partially obsolete.
c. The selling prices have declined
3. The estimated cost of completion or the estimated cost of disposal has increased.

Determination of net realizable value

• Inventories are usually written down net realizable value on an item by item or individual
basis (and not based on classification – ex. finished goods or inventories in a particular
industry)
• Materials held for use in production 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 (replacement cost).

Accounting for inventory write-down

• COST < NRV = In order and no accounting problem arises

• NRV < COST = Inventory write-down (decrease in value) is recognized

Methods of accounting for the inventory write-down

a. Direct method or cost of goods sold method

• Inventory is recorded at LCNRV
• Any loss on inventory write-down or gain on reversal of inventory write-down is
not accounted for separately but “buried” in the cost of goods sold.

b. Allowance method or loss method

• Inventory is recorded at cost, any loss on inventory write-down (debit) is
accounted for separately.
• Allowance account (credit) is adjusted upward or downward depending on the
difference between the cost and NRV of the inventory at year-end

PAS 2, par. 36, requires disclosure of the amount of any inventory write-down and the amount
of any reversal of inventory write-down. Therefore, allowance method is preferred.

ILLUSTRATION – INVENTORY DATA ON DEC. 31, 2020

COST NRV LCNRV

Category 1
A 110,000 100,000 100,000
B 690,000 750,000 690,000
C 600,000 640,000 600,000
1,400,000 1,490,000 1,390,000

Category 2
D 2,000,000 1,900,000 1,900,000
E 1,500,000 1,560,000 1,500,000
3,500,000 3,460,000 3,400,000

Category 3
F 1,500,000 1,460,000 1,460,000
G 1,600,000 1,690,000 1,600,000
3,100,000 3,150,000 3,060,000
 TOTAL 8,000,000 8,100,000 7,850,000

LCNRV - Item by item 7,850,000

COST NRV LCNRV

Category 1 1,400,000 1,490,000 1,400,000
Category 2 3,500,000 3,460,000 3,460,000
Category 3 3,100,000 3,150,000 3,100,000
LCNRV by Category 7,960,000

COST NRV LCNRV

LCNRV by Total 8,000,000 8,100,000 8,000,000

The inventory is measured at LCNRV applied on an item by item or individual basis.

Cost - Dec. 31, 2020 8,000,000
NRV 7,850,000
Inventory write-down 150,000

The allowance for inventory write-down is presented as a deduction from the inventory
Inventory- Dec. 31, 2020, at cost 8,000,000
Allowance for Inventory write-down -150,000
Inventory write-down 7,850,000

ASSUME: On Dec. 31, 2021 the total cost of the inventory is P8,500,000 and the NRV is
P8,400,000
*Gain on reversal is presented as a deduction from the cost of goods sold and is computed as
follows:
Cost -Dec. 31, 2021 8,500,000
NRV 8,400,000
Required allowance - Dec. 31, 2021 100,000
Less: Allowance balance - Dec. 31, 2020 150,000
Decrease in allowance -50,000

PAS 2, paragraph 34, provides that the amount of any reversal of any write-down of inventory
arising from an increase in net realizable value shall recognized as a reduction in the amount of
inventory recognized as an expense in the period in which the reversal occurs.

The amount of inventory recognized as an expense of the period is actually the cost of
goods sold during the period.

REFERENCE: INTERMEDIATE ACCOUNTING VOLUME 1 BY CONTADO T. VALIX