Review on Inventories

1.0 Concept

✓ Inventories are assets held for sale in the ordinary r business, in the process of
production for such sale or in the form of materials or supplies to be consumed
in the production pro 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 is the
production process.

2.0 Classes of inventories

✓ 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.

2.1 Goods includible in the inventory

✓ As a rule, all goods to which the entity has title shall be included.

✓ The phrase "passing of title" is a legal language which means Goods

includible in the inventory in the inventory, regardless of location. "the
point of time at which ownership changes."

2.1.1 Legal test

✓ Is the entity the owner of the goods to be inventoried?

✓ If the answer is in the affirmative, the goods shall be included in the

inventory. If the answer is in the negative, the goods shall be
excluded from the inventory.

✓ Applying the legal test, the following items are includible in inventory:

a. Goods owned and on hand

b. Goods in transit and sold FOB destination
c. Goods in transit and purchased FOB shipping point
d. Goods out on consignment
 e. Goods in the hands of salesmen or agents
f. Goods held by customers on approval or on trial

3.0 Who is the owner of goods in transit?

✓ This will depend on the terms, whether FOB destination or FOB shipping point. FOB
means free on board.

✓ FOB destination – seller

✓ FOB shipping point – buyer

4.0 Consigned Goods

✓ Consigned goods shall be included in the consignor's inventory and excluded

from the consignee's inventory.

✓ Freight and other handling charges on goods out on consignment are part of
the cost of goods consigned.

✓ When consigned goods are sold by the consignee, a report is made to the
consignor together with a cash remittance for the amount of sales minus
commission and other expenses chargeable to the consignor.

✓ For example, a consignee sells consigned goods for P100,000. This amount
is remitted to the consignor less commission of P15,000 and advertising of
P2,000.

The consignor simply records the cash remittance from the consignee as
follows:

Cash 83, 000

Commission 15, 000
Advertising 2, 000
Sales 100, 000

Incidentally, consigned goods are recorded by the consignor by means of a

memorandum entry.

5.0 Statement Presentation

Inventories are generally classified as current assets.

The inventories shall be presented as one line item in the statement of financial
position but the details of the inventories shall be disclosed in the notes to financial
statements.

For example, the note shall disclose the composition of the inventories of a
manufacturing entity as finished goods, goods in process, raw materials and
manufacturing supplies.
6.0 Accounting for Inventories

✓ Two systems are offered in accounting for inventories, namely periodic system
and perpetual system.

8.0 Trade Discounts and Cash Discounts

✓ Trade discounts are deductions from the list or catalog price in order to arrive
at the invoice price which is the amount actually charged to the buyer. Thus,
trade discounts are not recorded.

✓ Cash discounts are deductions from the invoice price when payment is made
within the discount period. The purpose of cash discounts is to encourage
prompt payment. Cash discounts are recorded as purchase discount by the
buyer and sales discount by the seller.

✓ Purchase discount is deducted from purchases to arrive at net purchases and

sales discount is deducted from sales to arrive at net sales revenue

9.0 Methods of recording purchases

1. Gross method- Purchases and accounts payable are recorded at gross.

2. Net method- Purchases and accounts payable are recorded at net.

9.2 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

✓ 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 these costs are 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 that do not contribute to bringing inventories
to their present location and condition.
d. Distribution or selling costs
Practice Problems
1. Hero Company reported inventory on December 31, 2019 at P6,000,000 based
on a physical count of goods priced at cost, and before any necessary year-
end adjustment relating to the following:

• Included in the physical count were goods billed to a customer FOB shipping
point on December 31, 2019.

These goods had a cost of P125,000 and were picked up by the carrier on
January 10, 2020.

• Goods shipped FOB shipping point on December 28, 2019 from a vendor to
Hero Company were received on January 4, 2020. The invoice cost was
P300,000.

What amount should be reported as inventory on December 31, 2019?

a. 5,875,000
b. 6,000,000
c. 6,175,000
d. 6,300,000

2. Dignity Company had the following consignment transactions during the current
year:

Inventory shipped on consignment to a consignee 600,000

Freight paid by Dignity Company 50,000
Inventory received on consignment from a consignor 800,000
Freight paid by consignor 50,000

No sales of consigned goods were made during the current year.

What amount should be reported as consigned inventory at year-end?

a. 700,000
b. 650,000
c. 850,000
d. 600,000

3. Kindness Company regularly buys sweaters and is allowed a trade discount of 20%
and 10%. The entity made a purchase on March 20 and received an invoice with a list
price of P900,000, a freight charge of P50,000, and payment terms of met 30 days.
What is the cost of the purchase?

a. 648,000
b. 630,000
c. 698.000
d. 680,000
4. On June 1, 2019 Compassion Company sold merchandise with a list price of
P1,000,000 to a customer.

The entity allowed trade discounts of 20% and 10%. Credit terms were 5/10, n/30 and
the sale was made FOB shipping point.

The entity prepaid P50,000 of delivery cost for the customer paid in full on June 11,
2019.

What amount is received from the customer as full remittance?

a. 684,000
b. 734,000
c. 720,000
d. 770,000

I. Inventory Cost Flow

1.0 Cost Formulas/Methods
1. Average cost
➢ Considers goods to be indistinguishable
➢ Goods are valued at an average of the costs incurred.
➢ Weighted average (periodic system) and moving average (perpetual
system).

2. FIFO (First in First out)

➢ The first goods purchased are first sold.
➢ Ending inventory is presumed to consist of the most recent costs.
➢ There is no proper matching of costs and revenues since old costs are
matched against current revenues.
➢ Favors the balance sheet because ending inventory approximates
replacement costs.

1.1 Other Cost Methods

3. LIFO (Last in First out) – the new standard prohibits the use of LIFO
inventory costing.
➢ The last goods purchased are first sold.
➢ The cost of good sold comes from the most recent purchases.
➢ Ending inventory is presumed to consist of the earlier costs.
➢ Favors the income statement because there is proper matching of
costs against revenue.

4. Specific identification
➢ Specific costs are attributed to identified items of inventory
➢ Applicable for inventory with a small number and are easily
distinguishable.
➢ Makes possible to manipulate net income
Practice Problem

Slack Company provide the following inventory information relating to television sets for the
current year:
UNITS UNIT COST
January 1 INVENTORY ON HAND 200 7,500
APRIL 5 PURCHASE 300 9,000
OCTOBER 1 PURCHASE 500 10,000

The entity sold 700TV sets during the year. A physical count on December 31 indicated that
300TV sets are on hand.
REQUIRED:
Assuming that the entity used the periodic inventory system, compute the cost of the ending
inventory and the cost of goods sold using FIFO and weighted average.

Lower of Cost and Net Realizable Value

1.0 Valuation of Inventory
1. Inventories shall be measured at the lower of cost or net realizable value.
➢ Net realizable 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.
2. The cost of inventories should be determined by using either the FIFO method
or weighted average method. The new standards prohibit the use of LIFO
inventory costing.
3. The cost of inventories that are not ordinarily interchangeable and inventories
that are segregated for specific projects should be determined by using specific
identification method.

2.0 Lower of Cost or Net Realizable Value

1. Inventories are recorded at their original cost.
2. Inventories that experience a decline in value shall be measured at lower of
cost or net realizable value. Hence, a loss should be recognized.
3. Net Realizable Value (NRV) = Estimated Selling Price - Estimated Cost of
Completion and Disposal
4. Lower of cost or net realizable value is applied on an item by item basis or
individual basis.
5. Inventory write down can be accounted either under allowance method or
direct method.
 3.0 Financial Statement Presentation

Loss on Inventory Write-down Added to cost of goods sold

Gain on Inventory Recovery Deducted from cost of goods sold
Allowance for Inventory Write- Contra account, deducted from
down Merchandise Inventory

Disclosures

1. The accounting policies adopted in measuring inventories including the cost

method used.
2. The total carrying amount of inventories and the carrying amount in
classifications appropriate to the enterprise.
3. The carrying amount of inventories at net realizable value.
4. The amount of reversal of any write-down that is recognized as income.
5. The circumstances or events that led to the reversal of a write-down of
inventories.
6. The carrying amount of inventories pledged as security for liabilities.
7. The amount of inventories recognized as an expense during the period.

Practice Problem

1. Based on a physical inventory at the year-end, Cherry Company determined the

chocolate inventory on a FIFO basis at P2,600,000 with replacement cost of
P2,500,000. Cherry Company estimated that, after further processing costs of
P1,200,000, the chocolate could be sold as finished candy bars for P4,000,000. The
normal profit margin is 10% of sales.

Under the lower of cost and net realizable value, what amount should be reported as
chocolate inventory in the year-end statement of financial position?

a. 2,800,000
b. 2,600,000
c. 2,400,000
d. 2,500,000

2. Starstruck Company is a retailer of Italian furniture and has five major product
lines. At year-end, the entity provided the following data:

Units Unit cost NRV per unit

Sofas 100 1,000 1,020

Dining tables 200 500 450
Beds 300 1,500 1,600
Closets 400 750 770
Lounge chains 500 250 200

What is the inventory at the year-end using the lower of cost and net realizable
value?
a. 1,040,000
b. 1,075,000
c. 1,998,000
d. 2,033,000

I. Inventory Estimation

1.0 Inventory Estimation Techniques

Inventory estimation techniques are necessary when -
➢ It is too costly to conduct a physical count (as in the case for interim reports).
➢ It is no longer possible to physically count the inventory like when the goods
are destroyed by a natural disaster.

2.0 Two Estimation Techniques

➢ Gross Profit Method or Gross Margin Method
Gross profit may be expressed as
 a percentage of sales – gross profit / sales
 a percentage of cost of goods sold – gross profit / cost of goods sold

➢ Retail Inventory Method

 Based on an assumed relationship between cost and price
 Widely used by retail stores
 Records are maintained at two amounts – cost and retail.

Special Notes: Computation of Net Sales When Estimating Ending Inventory

1. For purposes of estimating ending inventory, sales allowances and sales
discounts are ignored when computing net sales. Sales allowance and sales
discount do not affect the physical inventory of goods. These are mere reductions
in the sales price.

2. For purposes of estimating ending inventory, sales returns is deducted from

gross sales when computing net sales. Sales returns cause an actual addition to
goods on hand.

3. When the account is Sales Returns and Allowances, this is deducted from gross
sales to arrive at net sales.
 Practice Problems

1. On June 30, a fire destroyed Intense Company’s entire inventory. The inventory on
January 1 totaled P6,600,000. From January 1 through the time of the fire, the entity
made purchases of P3,000,000, incurred freight in of P300,000, and had sales of
P7,800,000. The rate of gross profit on selling price is 30%. What is the approximate
cost of the inventory that was destroyed?
a. 3,600,000
b. 4,140,000
c. 4,440,000
d. 3,900,000

2. Keepsake Company estimated the cost of its physical inventory on March 31 for
use in interim financial statement. The rate of markup on cost is 25%. The inventory
on January 1 to March 31 was P4,700,000, the entity had purchases of P4,300,000,
purchase returns of P200,000 and sales of P7,500,000. What is the estimated cost of
inventory on March 31?
a. 2,100,000
b. 3,600,000
c. 3,975,000
d. 2,800,000

3. Empress Company used the retail inventory method to approximate the ending
inventory.

The following information is available for the current year:

Cost Retail
Beginning inventory 650,000 1,200,000
Purchases 9,000,000 14,700,000
Freight In 200,000
Purchase returns 300,000 500,000
Purchase allowances 150,000
Departmental transfer in 200,000 300,000
Net mark up 300,000
Net mark down 1,000,000
Sales 9,500,000
Sales discount 100,000
Employee discounts 500,000
Estimated normal shoplifting losses 600,000
Estimated normal shrinkage 400,000

What is the estimated cost of ending inventory using the conservative approach?
a. 2,400,000
b. 2,460,000
c. 3,060,000
d. 2,700,000
What is the estimated cost of ending inventory using the average cost approach?
a. 2,560,000
b. 2,624,000
c. 3,264,000
d. 2,880,000