Lesson 4: Accounting For Inventories

Document no.
INTERNATIONAL SCHOOL OF ASIA AND THE PACIFIC ISAP-QMS-DCO-ILG (AE 15)

Effective Date:
TITLE: INTERMEDIATE ACCOUNTING 1 September 2020
Revision No. 00
LESSON 4
ACCOUNTING FOR INVENTORIES (12 Hours)
INVENTORIES are assets which are held for sale in the ordinary course of business, in the process of
production for such sale or in the form of materials or supplies to be consumed in the production
process or in rendering of services.
MEASUREMENT OF INVENTORY
Initial Measurement = Cost*
Subsequent Measurement = Lower of Cost or Net Realizable Value**
TEACHER’S INSIGHT
 **Net Realizable Value (NRV) is the estimated selling price in the ordinary course
of business less estimated cost of completion and the estimated cost necessary to
make the sale.
Measurement of Cost*
Purchase
 Purchase price
 Import dutes
 Irrevocable Taxes
 Freight
 Handling
 Other Cost Directly attributable to the purchase
Deduct
 Trade Discounts
 Rebates
 Other Similar Items
TEACHER’S INSIGHT
 When purchased with deferred settlement terms, the difference between the purchase price
for normal credit terms and the amount paid is recognized as interest expense over the
period of financing.
Conversion
 Direct materials
 Direct Labor
 Fixed and variable production overhead
 Abnormal amounts of waste and spoilage
 Storage costs
 Administrative Overheads
 Selling Costs
FREIGHT ON BOARD (FOB) TERMS

a. FOB destination – ownership of goods purchased is transferred only upon the receipt of goods by
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the buyer at the point of destination. The seller shall be responsible for the freight charges and other
charges up to the point of destination.
b. FOB shipping point – ownership is transferred upon shipment of the goods. The buyer shall be
responsible for the freight charges and other charges up to the point of destination.
c. Freight collect – freight charge is paid by the buyer.
d. Freight prepaid – freight charge is paid by the seller.
MARITIME SHIPPING TERMS

a. Free alongside (FAS) – seller must bear the risk involved in delivering the goods to the dock next
to or alongside the vessel on which the goods are to be shipped. The buyer bears the cost of loading
and shipment and thus, title passes to the buyer when the carrier takes possession of the goods.
b. Cost, insurance, and freight (CIS) – buyer agrees to pay in a lump sum the cost of the goods,
insurance cost and freight charges. The seller must pay for the cost of loading. Thus, title and risk of
loss shall pass to the buyer upon delivery of the goods to the carrier.
c. Ex-ship (super FOB destnaton) – seller bears all expenses and risk of loss until the goods are
unloaded at which time and risk of loss shall pass to the buyer.
CONSIGNED GOODS
Consignment –method of marketing of goods in which the owner called the consignor transfers
physical possession of certain goods to an agent called the consignee who sells them on the owner’s
behalf.
TEACHER’S INSIGHT
 Consigned goods shall be included in the consignor’s inventory and excluded from the
consignee’s inventory. Freight and other charges on goods out on consignment are part of
the cost of goods consigned.
PERIODIC SYSTEM AND PERPETUAL SYSTEM

Periodic System – calls for the physical counting of goods on hand at the end of the accounting
period to determine quantities. This procedure is generally used when the individual inventory items
turn over rapidly and have small peso investment such that it may prove impractical or inconvenient to
record inventory inflow and outflow, such as groceries, hardware and auto parts.
Perpetual System – requires the maintenance of records called stock cards that usually offer a
running summary of the inventory inflow and outflow. This procedure is commonly used where the
inventory items
treated individually represent a relatively large peso investment. This is designed for control purposes.
TRADE DISCOUNTS AND CASH DISCOUNTS

Trade discounts
 deductions from the list catalog price in order to arrive at the invoice price which is the amount
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actually charged to the buyer

 to encourage trading or increase sale.
Cash discounts
 deductions from the invoice price when payment is made within the discount period
 to encourage prompt payment.
INVENTORY COSTING METHODS

First in, First out (FIFO) Method
 Goods first purchased are first sold
 Inventory is stated at current replacement cost.
 In the period of inflation, FIFO method would result to the highest net income.
 In a period of deflation or declining prices, FIFO method would result to the lowest net income.
TEACHER’S INSIGHT
 Under FIFO-periodic and FIFO-perpetual, the inventory costs are the same.
Weighted Average – Periodic

 The cost of beginning inventory plus the total costs of purchases during the period is divided by the
total number of units purchased plus those in the beginning inventory to get the weighted average unit
cost. Such weighted average unit cost is then multiplied by the units on hand to derive the inventory
value.
Weighted Average – Perpetual (moving average method)

 A new weighted average unit cost must be computed every after purchase. Such weighted average
unit cost is then multiplied by the units on hand to get the inventory cost.
Specific Identification
 The cost of inventory is determined by simply multiplying the units on hand by their actual unit cost.
 Appropriate for inventories that are segregated for a specific project and inventories that are not
ordinarily interchangeable.
ACCOUNTING FOR INVENTORY WRITE-DOWN

Direct Method
 Loss on inventory write-down is not accounted for separately but buried in the cost of goods sold.
Allowance Method
 Loss on inventory write-down is accounted for separately and credited to “allowance for inventory
write-down
 The loss on inventory write down and gain on reversal is included in the computation of COGS
TEACHER’S INSIGHT
 Gain on reversal of inventory write-down is limited only to the extent of the allowance
balance.
RELATIVE SALE PRICE METHOD

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When different commodities are purchased at a lump sum, the single cost is apportioned among the
commodities based on their respective sale price.
PURCHASE COMMITMENTS
Purchase commitments are obligations of the entity to acquire certain goods sometime in the future at
a fixed price and fixed quantity.
market price = gain on purchase commitment
market price = loss on purchase commitment
AGRICULTURAL, FOREST AND MINERAL PRODUCTS

 measured at net realizable value at certain stages of production(PAS 2, par 4)
 This occurs when agricultural crops have been harvested or mineral products have been harvested
and a sale is assured under a forward contract or a government guarantee, or when a homogenous
market exists and there is a negligible risk of failure to sell.
COMMODITIES OF BROKER-TRADERS
 measured at fair value less cost to sell.
TEACHER’S INSIGHT
 Broker-traders are those who buy and sell commodities for others or on their own account
for the purpose of selling them in the near future and generating a profit from fluctuations
in price or broker-traders’ margin.
INVENTORY ESTIMATION
Reasons:
 inventory is destroyed by fire and other catastrophe, or theft
 to prove the correctness or reasonableness of physical count
 for interim financial statements
GROSS PROFIT METHOD

This method is based on the assumption that the rate of gross profit remains approximately the same
from period to period and therefore the ratio of cost of goods sold to net sales is relatively constant
from period to period.
1. Gross proft rate “based on sales”
2. Gross proft rate “based on cost”
TEACHER’S INSIGHT
 Sales Allowances and Sales Discounts are ignored in computing the net sales for purposes
of using gross profit rate method in computing COGS
RETAIL INVENTORY METHOD

This method is generally employed by department stores, supermarkets and other retail concerns
where there is a wide variety of goods because keeping track of unit cost at all times is difficult.
1. Conservative Cost Approach (conventional or lower of average cost or market approach)
Include mark-up, exclude mark-down
2. Average Cost Approach

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Mark-up and mark-down are included

3. FIFO Approach
4. LIFO Approach
TEACHER’S INSIGHT
 PAS 2 requires either the FIFO or Average Cost Approach
Cost ratio = Goods available for sale at cost_______

Goods available for sale at selling price
TERMINOLOGIES:
Initial Mark-up - Original mark-up on the cost of goods
Original Retail - Sales price at which the goods are first offered for sale
Additional mark-up - Increase in sales price above the original sales price
Mark-up Cancelation - Decrease in sales price that does not decrease the sales price below the
original
sales price
Net additional mark-up or net mark-up - Mark-up minus mark-up cancelation
Markdown - Decrease in sales price below the original sales price
Markdown Cancelation - Increase in sales price that does not increase the sales price above the
original sales price
Net Markdown - Markdown minus markdown cancelation
Maintained Mark-up or mark-on - Difference between cost and sales price after adjustment for all
the above items
TREATMENT OF OTHER ITEMS:

Purchase Discount – deducted from purchases at cost only
Purchase Return – deducted from purchases at cost and at retail
Purchase Allowance – deducted from purchases at cost only
Freight in – addition to purchases at cost only
Departmental transfer in or debit – addition to purchases at cost and at retail
Departmental transfer out or credit – deduction from purchases at cost and at retail
Sales discount and sale allowance – disregarded, meaning, not deducted from sales
Sales return – deducted from sales. If the account is “sales return and allowances”, the same should
be
deducted from sales.
Employee discounts – added to sales.
Normal shortage, shrinkage, spoilage and
breakage – this are deducted from goods available for sale at retail.

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ILLUSTRATIVE PROBLEMS
On July 1, Dash Company purchased a tract of land for P12, 000, 000. Dash incurred additional cost
of P3, 000, 000 during the remainder of the year in preparing the land for sale. The tract was
subdivided into residential lots as follows:
Lot class Number of lots Sale price per lot
A 100 240, 000
B 100 160, 000
C 200 100, 000
Using the relative sales price method, what amount of cost should be allocated to Class A lots?
CLASS SALES PRICE FRACTON ALLOCATED COST

A (100 X 240, 000) 24, 000, 000 24/60 6, 000, 000
B (100 X 160, 000) 16, 000, 000 16/60 4, 000, 000
C (200 X 100, 000) 20, 000, 000 20/60 5, 000, 000
60, 000, 000 15, 000, 000
The following data are gathered for the current year:
Inventory beginning 600, 000
Purchases 2, 530, 000
Purchase return 15, 000
Purchase allowance 5, 000
Purchase discount 10, 000
Freight in 50, 000
Sales 3, 100, 000
Sales return 100, 000
Sales allowance 50, 000
Sales discount 150, 000
Gross profit is computed under each of the following assumptions:
a. Gross proft rate is 25% based on sales
b. Gross proft rate is 25% based on cost
Gross profit rate “based on sales”

Inventory beginning 600, 000
Purchases 2, 530, 000
Freight in ___50, 000
Total 2, 580, 000
Less: Purchase return 15, 000
Purchase allowance 5, 000
Purchase discount 10, 000 30, 000 2, 500, 000
Goods available for sale 3, 150, 000
Less: Cost of sales:
Sales 3, 100, 000
Less: Sales return 100, 000
Net Sales 3, 000, 000
Multiply by cost ratio 75% 2, 250, 000
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Ending inventory 900, 000
Gross profit rate “based on cost”
Goods available for sale 3, 150, 000

Less: Cost of sales:
Sales 3, 100, 000
Less: Sales return 100, 000
Net Sales 3, 000, 000
Divided by sales ratio 125% 2, 250, 000
Ending inventory 750, 000
Note: Sales allowance and sales discount are ignored, that is, not deducted from sales. While these items decrease the
amount of sales, they do not affect the physical volume of goods sold. They do not increase the physical inventory
of goods, unlike sales return where there is an actual addition to goods on hand.
. Cost Retail
Beginning Inventory 180, 000 250, 000
Net purchases 1, 020, 000 1, 575, 000
Additonal mark up 200, 000
Mark up cancelaton 25, 000
Markdown 140, 000
Markdown cancelaton 15, 000
Sales 1, 450, 000
Sales return 50, 000
Sales allowance 10, 000
Sales discount 20, 000
Employee discount 40, 000
Spoilage and breakage 35, 000
Retail method – Conservative and Average Cost Approach
Cost Retail
Beginning inventory 180, 000 250, 000
Net Purchases 1, 202, 000 1, 575, 000
Additional Mark-up 200, 000
Mark-up cancelation (25,000)
GAS – Conservative 1, 200, 000 2,000,000
Cost ratio (1, 200, 000 / 2, 000, 000) 60%
Markdown (140,000)
Markdown cancelation 15,000
GAS – Average 1,200,000 1,875,000
Cost rato (1, 200, 000 / 1, 875, 000) 64%
Less: Sales 1, 450, 000
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Sales return (50, 000)

Employee discount 40, 000
Spoilage and breakage 35, 000 1,475,000
Ending Inventory at retail 400,000
Conservative cost (400, 000 x 60%) 240, 000
Average Cost (400, 000 x 64%) 256, 000

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TEACHER’S INSIGHTS
 Under FOB shipping point, ownership over the goods
transferred upon shipment. Therefore, the goods in transit
are included in the buyer's inventories.
 Under FOB destination, ownership over the goods is
transferred only upon receipt of the goods by the buyer.
Therefore, the goods in transit are excluded from the buyer's
inventories.
 Consigned goods are included in the consignor's inventory
and are excluded from the consignee's inventory. Costs
incurred in transferring the consigned goods to the consignee
are included as cost of the consigned goods.
 Goods sold under a product financing agreement whereby
the seller is obligated to repurchase the goods sold at a future date is not considered sale.
Therefore, the goods are included in the seller's inventory.
 Inventories sold under installment sale whereby the seller retains title solely to protect the
collectability of the amount due are included in the buyer's inventory (and are excluded from
the seller's inventory) at the time of sale.
 The objectives of inventory accounting are: (a) proper determination of income and (b)
proper representation of costs in the statement of financial position.
 The two systems of accounting for inventories are (a) perpetual and (b) periodic. Inventories
are measured at the lower of cost and net realizable value (NRV).
 The cost of inventories comprises all costs of purchase, costs of conversion and other costs
incurred in bringing the inventories to their present location and condition.
 Non-refundable purchase taxes are included as costs of inventories, while refundable
purchase taxes are excluded. Cash discounts are recorded, while trade discounts are not.
 The following costs are excluded from the cost of inventory: Abnormal costs, Selling costs,
Administrative costs, and Storage costs, unless necessary.
 The cost formulas permitted under PAS 2 are (a) specific identification, (b) FIFO, and (c)
weighted average.
 Specific identification is used for inventories that are not ordinarily interchangeable (i.e., are
individually unique). Net realizable value (NRV) is estimated selling price less estimated costs
of completion and estimated costs to sell.
 Inventories are usually written down to NRV on an item by item basis.
 Raw materials and manufacturing supplies held for use in the production of inventories are
not written down below cost the finished products in which they will be incorporated are
expected to be sold at or above cost.
 Reversals of inventory write-downs should not exceed the amount of write-downs previously
recognized.


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INTERNATIONAL SCHOOL OF ASIA AND THE PACIFIC ISAP-QMS-DCO-ILG (AE 15)

FREIGHT ON BOARD (FOB) TERMS

c. Freight collect – freight charge is paid by the buyer.

d. Freight prepaid – freight charge is paid by the seller.

MARITIME SHIPPING TERMS

PERIODIC SYSTEM AND PERPETUAL SYSTEM

TRADE DISCOUNTS AND CASH DISCOUNTS

actually charged to the buyer

INVENTORY COSTING METHODS

Weighted Average – Periodic

Weighted Average – Perpetual (moving average method)

ACCOUNTING FOR INVENTORY WRITE-DOWN

RELATIVE SALE PRICE METHOD

AGRICULTURAL, FOREST AND MINERAL PRODUCTS

GROSS PROFIT METHOD

RETAIL INVENTORY METHOD

Revision No. Details Organizer Reviewer Approving Date Page No.

Mark-up and mark-down are included

Cost ratio = Goods available for sale at cost_______

TREATMENT OF OTHER ITEMS:

Revision No. Details Organizer Reviewer Approving Date Page No.

CLASS SALES PRICE FRACTON ALLOCATED COST

Gross profit rate “based on sales”

Ending inventory 900, 000

Gross profit rate “based on cost”

Goods available for sale 3, 150, 000

Retail method – Conservative and Average Cost Approach

Sales return (50, 000)

Revision No. Details Organizer Reviewer Approving Date Page No.

Revision No. Details Organizer Reviewer Approving Date Page No.

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