CHAPTER 10: PAS 2 - INVENTORIES

INVENTORIES

Inventories are assets held for sale in the ordinary course of business, In the process of production for such sale or in the
form of materials or supplies to be consumed in the production process or in the rendering of services.

Inventories encompass goods purchased and held for resale, for example:

a. Merchandise purchased by a retailer and held for resale

b. Land and other property held for resale by a subdivision entity and real estate developer.

Inventories also encompass finished goods produced, goods in process and materials and supplies awaiting use in the
production process.

Classes of inventories

Inventories are broadly classified into two, namely inventories of a trading concern and inventories of manufacturing
concern.

A trading concern is one that buys and sells goods in the same form purchased.

The term “merchandise inventory” is generally applied to goods held by a trading concern.

A manufacturing concern is one that buys goods which are altered or converted into another form before they are made
available for sale.

The inventories of a manufacturing concern are:

a. Finished goods
b. Goods in process
c. Raw materials
d. Factory or manufacturing supplies

Cost of inventories

The cost of inventories shall comprise:

a. Cost of purchase
b. Cost of conversion
c. Other cost incurred in bringing the inventories to their present location and condition

Cost of purchase

The cost of purchase of inventories comprises the purchase price, import duties and irrecoverable taxes, freight,
handling and other costs directly attributable to the acquisition of finished goods, materials and services.

Trade discounts, rebates and other similar items are deducted in determining the cost of purchase.

Cost of conversion

The cost of conversion of inventories includes cost directly related to the units of production such as direct labor.

It also includes a systematic allocation of fixed and variable production overhead that is incurred in converting materials
into finished goods.

Fixed production overhead is the indirect cost of production that remains relatively constant regardless of the volume of
production.
CHAPTER 10: PAS 2 - INVENTORIES

Examples are depreciation and maintenance of factory building and equipment, and the cost of factory management
and administration.

Variable production overhead is the indirect cost of production that varies directly with the volume of production.

Examples are indirect labor and indirect materials.

Other cost

Other cost is included in the cost of inventories only to the extent that it is incurred in bringing the inventories to their
present location and condition.

For example, it may be appropriate to include the cost of designing product for specific customers in the cost of
inventories.

However, the following costs are excluded from the cost of inventories and recognized as expenses in the period when
incurred:

a. Abnormal amounts of wasted materials, labor and other production costs.

b. Storage costs, unless necessary in the production process prior to a further production stage.

Thus, storage costs on goods in process are capitalized but storage costs on finished goods are expensed.

c. Administrative overheads d. Distribution or selling costs

Cost of inventories of a service provider

The cost of inventories of a service provider consists primarily of the labor and other costs of personnel directly engaged
in providing the service, including supervisory personnel and attributable overhead.

Labor and other costs relating to sales and general administrative personnel are not included but are recognized as
expenses in the period in which they incurred.

Cost formulas

PAS 2 paragraph 25, expressly provides that the cost of inventories shall be determined by using either:

a. First in, First out

b. Weighted average

The standard does not permit anymore the use of the last in, first out (LIFO) as an alternative formula in measuring cost
of inventories.

First in, First out (FIFO)

The FIFO method assumes that “the goods first purchased are first sold” and consequently the goods remaining in the
inventory at the end of the period are those most recently purchased or produced.

In other words, the FIFO is in accordance with the ordinary merchandising procedure that the goods are sold in the
order they are purchased.

The rule is “first come, first sold”.

The inventory is thus expressed in terms of recent or new prices while the cost of goods sold is representative of earlier or
old prices.

This method favors the statement of financial position in that the inventory is stated at current replacement cost.
CHAPTER 10: PAS 2 - INVENTORIES

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 goods sold.

Accordingly, in a period of inflation or rising prices, the FIFO method would result to the highest net income.

However, in a period of deflation or declining prices, the FIFO method would result to the lowest net income.

Illustration - FIFO

The following data pertain to an inventory item:

Unit Unit cost Total cost Sales (in units)

Jan. 1 Beginning balance 800 200 160,000

8 Sale 500

18 Purchase 700 210 147,000

22 Sale 800

31 Purchase 500 220 110,000

The ending inventory is 700 units.

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

Inventory - January 1 160,000

Purchases 257,000

Goods available for sale 417,000

Inventory – January 31 (152,000)

Cost of goods sold 265,000

Jan. 18 purchases 147,000

31 purchases 110,000

Total purchases 257,000

Weighted average

The cost of the beginning inventory plus the total cost of purchased, 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.
CHAPTER 10: PAS 2 - INVENTORIES

In other words, 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.

The preceding illustrative data are used.

Units Unit cost Total cost

Jan. 1 Beginning balance 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 average unit cost (417,000 / 2,000) 208.50

Inventory cost (700 x 208.50) 145,950

Cost of goods sold

Inventory January 1 160,000

Purchases 257,000

Goods available for sale 417,000

Inventory January 31 (145,950)

Cost of goods sold 271,050

The argument for the weighted average method is that it is relatively easy to apply, especially with computers.

Moreover, the weighted average method produces inventory valuation that approximates current value if there is a
rapid turnover of inventory.

The argument against the weighted average method is that there may be a considerable lag between the current cost
and inventory valuation since the average unit cost involves early purchases.

Last in, First out (LIFO)

The LIFO method assumes that the goods last purchased are first sold and consequently the goods remaining in the
inventory at the end of the period are those first purchased or produced.

The inventory is thus expressed in terms of earlier or old prices and the cost of goods sold is representative of recent or
new prices.

The LIFO favors the income statement because there is matching of current cost against current revenue, the cost of
goods sold being expressed in terms of current or recent cost.

The objection of the LIFO is that the inventory is stated at earlier or older prices and therefore there may be a significant
lag between inventory valuation and current replacement cost.

Actually, in a period of rising prices, the LIFO method would result to the lowest net income. In a period of declining
prices, the LIFO method would result to the highest net income.
CHAPTER 10: PAS 2 - INVENTORIES

Illustration LIFO

In the preceding illustration, the cost of 700 units under the LIFO is computed as follows:

Units Unit cost Total cost

From January 1 balance 700 200 140,000

Inventory - January 160,000

Purchases 257,000

Goods available for sale 417,000

Inventory January 31 (140,000)

Cost of goods sold 277,000

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 the actual unit cost.

PAS 2, paragraph 23, provides that this method is appropriate for inventories that are segregated for a specific project
and inventories that are not ordinarily interchangeable.

Measurement of inventory

PAS 2, paragraph 9, provides that inventories shall be measured at the lower of cost and net realizable value.

The cost of inventory is determined using either FIFO cost or average cost.

The measurement of inventory at the lower of cost and net realizable value is known as LCNRV.

Net realizable value

Net realizable value or NRV is the estimated selling price in the ordinary course of business less the estimated cost of
completion and the estimated cost of disposal.

The cost of inventories may not be recoverable under the following circumstances:

a. The inventories are damaged.

b. The inventories have become wholly or partially obsolete.
c. The selling prices have declined.
d. The estimated cost of completion or the estimated cost of disposal has increased.

Inventories are usually written down to net realizable value on an item by item or individual basis.

Accounting for inventory writedown

If the cost is lower than net realizable value, there is no accounting problem because the inventory is stated at cost and
the increase in value is not recognized.

If the net realizable value is lower than cost, the inventory is measured at net realizable value.

In this case, the problem is the proper treatment of the writedown of the inventory to net realizable value.
CHAPTER 10: PAS 2 - INVENTORIES

The writedown of inventory to net realizable value is accounted for using the allowance method.

Allowance method

The inventory is recorded at cost and any loss on inventory writedown is accounted for separately.

This method is also known as loss method because a loss account "loss on inventory writedown" is debited and a
valuation account "allowance for inventory writedown" is credited.

In subsequent years, this allowance account is adjusted upward or downward depending on the difference between the
cost and net realizable value of the inventory at year-end.

If the required allowance i increases, an additional loss is recognized.

If the required allowance decreases, a gain on reversal of inventory writedown is recorded.

However, the gain is limited only to the extent of the allowance balance.

The allowance method is used in order that the effects of writedown and reversal of writedown can be clearly identified.

As a matter of fact, PAS 2, paragraph 36, requires disclosure of the amount of: any inventory writedown and the amount
of any reversal of inventory writedown.

Illustration Inventory data on December 31, 2019

Inventory item Total cost NRV LCNRV

A 2,000,000 1,900,000 1,900,000

B 1,500,000 1,550,000 1,500,000

C 2,600,000 2,100,000 2,100,000

D 3,000,000 3,200,000 3,000,000

Total 9,000,000 8,750,000 8,500,000

The measurement of the inventory at LCNRV is applied on an item by item or individual basis or P8,500,000.

Total cost 9,000,000

LCNRV 8,500,000

Inventory writedown 500,000

Journal entries

The inventory on December 31, 2019 is recorded at cost.

Inventory December 31, 2019 9,000,000

Income summary 9,000,000

The loss on inventory writedown is accounted for separately.

Loss on inventory writedown 500,000

Allowance for inventory writedown 500,000

CHAPTER 10: PAS 2 - INVENTORIES

The loss on inventory writedown is included in the computation of cost of goods sold.

The allowance for inventory writedown is presented as a deduction from the inventory.

Inventory December 31, 2019, at cost 9,000,000

Allowance for inventory writedown (500,000)

Net realizable value 8,500,000