PRACTICAL ACCOUNTING 1

INVENTORIES – Lecture

1. Definition of Inventories – these are assets that are

a. Held for sale in the normal course of business, or
b. In the process of production for such sale, or
c. In the form of materials or supplies to be consumed in the production process or in the rendering of
services

2. Classification of Inventories:

a. Merchandising business
1. Merchandise Inventory or Inventory – goods purchased by a trading company for the resale in the
enterprise’s ordinary course of business
b. Manufacturing business:
1. Raw materials inventory – tangible goods purchased for direct use in the manufacture of goods for
sale
2. Work in process inventory – manufactured items requiring further processing
3. Finished goods inventory – manufactured goods completed and ready for sale
4. Manufacturing supplies inventory – items purchased for indirect used in the manufacture of goods for
resale
c. Service provider business
1. Work in process inventory – the cost of the service

3. Measurement of inventories

A. Initial measurement – inventories are initially measured at historical cost. The cost of inventories should include
all costs of purchase, cost of conversion and other cost incurred in bringing the inventories to their present
location and condition.

1. Cost of purchase includes the purchase price, import duties and other taxes (other than those subsequently
recoverable by the enterprise from the taxing authorities), 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 cost of purchase.

2. Cost of conversion – includes costs directly related to the units of production, such as direct labor and
systematic allocation of fixed and variable production overheads that are incurred in the production
process.

3. Cost of agricultural produce harvested from biological assets – are measured on initial recognition at their
fair value less estimated point of sale costs at the point of harvest.

4. Cost of inventories of a service provider – the labor and other costs of personnel directly engaged in
providing the service, including supervisory personnel and attributable overhead cost excluding any profit
margins or non-attributable overheads.

The following are excluded from the cost of inventories:

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

b. Storage costs, unless these costs are necessary in the production process prior to a further production stage
c. Administrative overheads that do not contribute to bringing inventories to their present location and
condition, and
d. Selling costs

B. Balance sheet measurement – should be measured at the lower of cost or net realizable value. The net
realizable value is the net selling price in the course of business less the estimated cost of completion and the
estimated costs necessary to make the sale. Inventories are usually written down to net realizable value on an
individual basis. In some cases, however, it may be appropriate to group similar or related items that can be
properly valued on aggregate.

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 cost 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. (PAS 2 par.32)

PRACTICAL ACCOUNTING 1
 When an item of inventory has been written-down to its net realizable value, and if in subsequent balance sheet
period the same item of the inventory still on hand, a new assessment of net realizable value should be made. If
there is a clear evidence of an increase in net realizable value because of change in economic condition the
amount of the write-down should be reversed. The amount of reversal should not exceed the original amount of
write-down that was recognized previously.

5. Establishment of the year-end inventory – the periodic system of recording inventories calls for the physical
Counting of goods while the perpetual system provides a record of the cost and units remaining as of a particular
date, however, physical counting is necessary to determine the reasonableness of the records.

However, when physical count is not possible or practicable it would be necessary to estimate the value of the
Inventory.

Include the year-end inventory, all item of inventories own and controlled by the enterprise that are in good,
Usable and salable condition within the enterprise’s premises and adjust the count by including those items of
Inventories that are also own and controlled by the entity. Therefore, the following items of inventories should Be
considered:

a. Merchandise in transit – if the term of shipment is shipping point, include as inventory of the buyer but if the
term is destination, include as inventory of the seller.

b. Goods on consignment – include as inventory of the consignor

c. Sales on approval – goods sent on approval to a potential buyer should remain as inventory on the seller until
payment is received for items kept by the buyer

d. Special sales contract:

1. Product-financing (Sale with a buyback agreement) – also known as a park sale because the seller parks
(transfers) its inventory in the buyer’s premises thru sales contract that clearly specifies to purchase back
the same inventory over a specified period of time at a specified amount. Include as inventory of the seller.

2. Sale but buyer given the right to return – the revenue from the sales transaction shall be recognized at of
the sale only if all the following conditions are met: (a) the seller’s price to the buyer is substantially fixed
or determinable at the date of sale, (b) the buyer has paid the seller, or the buyer is obligated to pay the
seller and the obligation is not contingent on resale of the product, (c) the buyer’s obligation to the seller
would not be changed in the event of theft or physical destruction or damage of the product, (d) the buyer
acquiring the product for resale has economic substance apart from that provided by the seller, (e) the
seller does not have significant obligations for future performance to directly about the resale of the
product by the buyer, and (f) the amount of future returns can be reasonably estimated.

If the above conditions are not met, the seller should continue to recognize the inventory.

3. Installment Sales – goods should be considered sold or removed from inventory, even though legal title
has yet to pass to the buyer. Include as inventory of the buyer.

e. Segregated goods – mere segregation does not exclude such inventory, however, if the segregation is due to
sales contract such as special orders, such inventory is excluded in the inventory of the seller.

6. Techniques for the measurement of Cost:

the retail method or standard cost method may be used for convenience if the results approximate cost. Standard
costs take into account normal levels of materials and supplies, labor efficiency and capacity utilization, but a
regular review is a requirement and if necessary, revised in the light of current conditions.

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 inventory is determined by reducing the sales value of the inventory by the appropriate
percentage of gross margin.

7. The cost formulas for inventory:

The cost of inventory that are not ordinary interchangeable and goods or services produced and segregated for
specific projects shall be assigned using specific identification of their individual costs.

The cost of inventories that are ordinarily interchangeable shall be assigned by using the FIFO or weighted average
method.

An entity shall use the same cost formula for all inventories having a similar nature and use. For inventories with
a different nature or use, different cost formulas maybe justified.

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Comparison between Full PFRS and PFRS for SME’s – the PFRS for SMEs is drafted in simple language and includes
significantly less guidance on how to apply the principles. PAS 23 borrowing costs requires borrowing costs directly
attributable to the acquisition, construction or production of a qualifying asset (including some inventories) to be
capitalized as part of the cost of the asset, for cost benefit reason borrowing costs of the PFRS for SMEs requires
such costs to be charged to expense.