Divine Word College of Calapan

INVENTORIES
Module Code: INTACCTNG1: INVENTORIES

OVERVIEW:

This module focuses on the discussion of Philippine Accounting Standard 2: Inventories.

LEARNING OUTCOMES:

The students should gain knowledge of the following topics:

1. Definition of inventories

2. Classes of inventories

3. Goods includible in inventory

4. Goods in transit

5. Freight collect and freight prepaid

6. FOB destination and FOB shipping point

7. Maritime shipping terms – FAS, CIF and Ex-ship

8. Statement of presentation of inventories

9. Periodic and perpetual system

10. Trade discount and cash discount

11. Gross method and net method of recording purchases

12. Cost of inventories cost of purchase, cost of conversion and other cost

13. Cost of inventories of a service provider

INTRODUCTION:

Inventory is one of the major and most used account in the entity’s books. In this module, we will dive-in deeper
into discussion and will learn how to properly account for inventory. We will walk-through different aspects of
inventory: the meaning of inventory; major classes of inventory; accounting for inventory transactions using
periodic and perpetual system; accounting for purchases using gross and net method; and identify the items
included in inventory cost.

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DISCUSSION OF THE TOPIC:

Definition
PAS 2, paragraph 6, defines inventories as follows:
"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 the rendering of services”.
Inventories encompass goods purchased and held for resale, for example:
1. Merchandise purchased by a retailer and held for resale; and
2. 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.
In case of service provider, inventories include the cost of the service for which the entity has not yet
recognized the related revenue.

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
Finished goods are completed products which are ready for sale.
Finished goods have been assigned their full share of manufacturing costs.
Goods in process or work in process are partially completed products which require further process
or work before they can be sold.
Raw materials are goods that are to be used in the production process.
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No work or process has been done on them as yet by the entity inventorying them.
Broadly, raw materials cover all materials used in the manufacturing operations
However, frequently raw materials are restricted to materials that will be physically incorporated in the
production of other goods and which can be traced directly to the end product of the production
process.
Factory or manufacturing supplies are similar to raw materials but their relationship to the end product
is indirect.
Factory or manufacturing supplies may be referred to as indirect materials.
It is indirect because they are not physically incorporated in the products being manufactured.
However, there are other manufacturing supplies like paint and nails which become part of the
finished product but since the amounts involved are insignificant it is impractical to attempt to allocate
their costs directly to the product.
These supplies find their way into the product cost as part of the manufacturing overhead.

Goods includible in the inventory

As a rule, all goods to which the entity has title shall be included in the inventory, regardless of
location. Where title has already passed from the seller to the buyer, the goods form part of the
inventory of the latter.
The phrase "passing of title" is a legal language which means "the point of time at which ownership
changes."

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:
1. Goods owned and on hand
2. Goods in transit and sold FOB destination,
3. Goods in transit and purchased FOB shipping point
4. Goods out on consignment
5. Goods in the hands of salesmen or agents
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 6. Goods held by customers on approval or on trial, are all includible in inventory

Exception to the legal test

Installment contracts may provide for retention of title by the seller until the selling price is fully
collected.
Following the legal test, the goods sold on installment basis are still the property of the seller and
therefore normally includible in his inventory.
However, in such a case, it is an accepted accounting procedure to record the installment sale as a
regular sale involving deferred income on the part of the seller and as a regular purchase on the part
of the buyer.
Thus, the goods sold on installment are included in the inventory of the buyer and excluded from that
of the seller, the legal test to the contrary notwithstanding.
This is a clear example of economic substance prevailing over legal form.

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.
Under FOB destination, ownership of goods purchased is transferred only upon receipt of the goods
by the buyer at the point of destination.
Thus, under FOB destination, the goods in transit are still the property of the seller.
Accordingly, the seller shall legally be responsible for freight charges and other expenses up to the
point of destination.
On the other hand, if the term is FOB shipping point, ownership is transferred upon shipment of the
goods and therefore, the goods in transit) are the property of the buyer.
Accordingly, the buyer shall legally be responsible for freight charges and other expenses from the
point of shipment to the point of destination.
In practice, during an accounting period, the accountant normally records purchases when goods are
received and sales when goods are shipped, regardless of the precise moment at which title passed.
This procedure is expedient and no material misstatements occur in the financial statements because
title usually-passes in the same accounting period.

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However, the accountant should carefully analyze the invoice terms of goods that are in transit at the
end of the accounting period to determine who has legal title.
Accordingly, adjustments are in order if errors are committed in recording purchases and sales.

Freight terms
Freight collect — This means that the freight charge on the goods shipped is not yet paid. The
common carrier shall collect the same from the buyer. Thus, under this, the freight charge actually
paid by the buyer.
Freight prepaid — This means that the freight charge on the goods shipped is already paid by the
seller.
The terms "FOB destination" and "FOB shipping point" determine ownership of the goods in transit
and the party who is supposed to pay the freight charge and other expenses from the point of
shipment to the point of destination.
The terms "freight collect" and "freight prepaid" determine the party who actually paid the freight
charge but not the party who is supposed to legally pay the freight charge.

Maritime shipping terms

FAS or free alongside — A seller who ships FAS must bear all expenses and 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.
CIF or Cost, insurance and freight — Under this shipping contract, the buyer agrees to pay in a
lump sum the cost of the goods, insurance cost and freight charge. The shipping contract may be
modified as CF which means that the buyer agrees to pay in a lump sum the cost of the goods and
freight charge only.
In either case (CIF or CF), 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.
Ex-ship — A seller who delivers the goods ex-ship bears all expenses and risk of loss until the goods
are unloaded at which time title and risk of loss shall pass to the buyer.

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Consigned goods
A consignment is a method of marketing 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.
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 P 100,000. This amount is remitted to the
consignor less commission of P 15,000 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.
Thus, it may be necessary for the consignor to maintain subsidiary ledger for various consignees.

Statement presentation
Since inventories are acquired for production, sale or consumption and acquisitions normally
approximate the entity's peed for the current operating cycle, these are generally 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.

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Accounting for inventories
Two systems are offered in accounting for inventories, namely periodic system and perpetual system.
The periodic system calls for the physical counting of goods on hand at the end of the accounting
period to determine quantities.
The quantities are then multiplied by the corresponding unit costs to get the inventory value for
balance sheet purposes. This approach gives actual or physical inventories.
The periodic inventory is generally used when the individual items have small peso investment, such
as groceries, hardware and auto parts.
On the other hand, the perpetual system requires the maintenance of records called stock cards that
usually offer a running summary of the inventory inflow and outflow.
Inventory increases and decreases are reflected in the stock cards and the resulting balance
represents the inventory. This. approach gives book or perpetual inventories.
The perpetual inventory procedure is commonly used where the inventory items treated individually
represent a relatively large peso investment such as jewelry and cars.
In an ideal perpetual system, the stock cards are kept to reflect and control both units and costs.
Consequently, the entity would be able to know the inventory on hand at a particular moment in time.
In recent years, the widespread use of computers has enabled practically all large trading and
manufacturing entities to maintain a perpetual inventory system.
With computers, the entities can conveniently and effectively store and retrieve large amount of
inventory data.
When the perpetual system is used, a physical count of the units on hand should at least be made
once a year or at frequent intervals to confirm the balances appearing on the stock cards.

Illustration — Periodic system

1. Purchase of merchandise on account, P300,000.
Purchases 300,000
Accounts payable 300,000

2. Payment of freight on the purchase, P20,000.

Freight in 20,000
Cash 20,000

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 3. Return of merchandise purchased to supplier, P30,000.
Accounts payable 30,000
Purchase return 30,000

4. Sale of merchandise on account, P400,000, at 40% gross profit.

Accounts receivable 400,000
Sales 400,000

5. Return of merchandise sold from customer, P25,000.

Sales return 25,000
Accounts receivable 25,000

6. Adjustment of ending inventory, P65,000.

Merchandise inventory-end 65,000
Income summary 65,000

Illustration — Perpetual system

1. Purchase of merchandise on account, P300,000.
Merchandise Inventory 300,000
Accounts payable 300,000

2. Payment of freight on the purchase, P20,000.

Merchandise Inventory 20,000
Cash 20,000

3. Return of merchandise purchased to supplier, P30,000.

Accounts payable 30,000
Merchandise Inventory 30,000

4. Sale of merchandise on account, P400,000, at 40% gross profit. The cost o merchandise sold
is 60% or P240,000.
Accounts receivable 400,000
Sales 400,000

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 Cost of Goods Sold 240,000
Merchandise Inventory 240,000

5. Return of merchandise sold from customer, P25,000.

Sales return 25,000
Accounts receivable 25,000

Merchandise Inventory 25,000

Cost of Goods Sold 25,000

Under the perpetual system, the cost of merchandise sold is immediately recorded because
this is clearly determinable from the stock card.

6. Adjustment of ending inventory.

As a rule, the ending merchandise inventory is not adjusted. The balance of the merchandise
inventory account represents the ending inventory.

Inventory shortage or overage

In the illustration, the merchandise inventory account has debit balance of P65,000. If at the end of the
accounting period, a physical count indicates a different amount, an adjustment is necessary to
recognize any inventory shortage or average.
For example, if the physical count shows inventory on hand of P55,000, the following adjustment is
necessary:
Inventory shortage 10,000
Merchandise inventory (65,000 - 55,000) 10,000
The inventory shortage is usually closed to cost of goods sold because this is often the result of
normal shrinkage and breakage in inventory.
However, abnormal and material shortage shall be separately classified and presented as other
expense.

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.

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The purpose of trade discounts is to encourage trading or increase sales. Trade discounts also
suggest to the buyer the price at which the goods may be resold.
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.

Illustration
The list price of a merchandise purchased is P500,000 less 20% and 10% and with credit terms of
5/10, n/30.
This means that trade discounts are 20% and 10%, and the cash discount is 5% if payment is made in
10 days.
The full amount of the invoice is paid if the payment is made after 10 days and within the credit period
of 30 days.
List price 500,000
First trade discount (20% x 500,000) (160,000)
400,000
Second trade discount (10% x 400,000) (40,000)
Invoice price 360,000
Cash discount (5% x 360,000) (18,000)
Payment within the discount period 342,000
The journal entry to record the purchase is:
Purchases 360,000
Accounts payable 360,000
Note that the trade discounts are not recorded. The journal entry to record the payment of the
invoice within the discount period is:
Accounts payable 360,000
Cash 342,000
Purchase discounts 18,000

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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.

Illustration — Gross method

1. Purchase on account, P200,000, 2/10, n/30.
Purchases 200,000
Accounts Payable 200,000

2. Assume payment is made within the discount period.

Accounts Payable 200,000
Cash 196,000
Purchase Discount 4,000

3. Assume payment is made beyond the discount period.

Accounts Payable 200,000
Cash 200,000

Illustration — Net Method

1. Purchase on account, P200,000, 2/10, n/30.
Purchases 196,000
Accounts Payable 196,000

2. Assume payment is made within the discount period.

Accounts Payable 196,000
Cash 196,000

3. Assume payment is made beyond the discount period.

Accounts Payable 196,000
Purchase Discount Lost (other expense) 4,000
Cash 200,000

4. Assume it is the end of accounting period, no payment is made and the discount period has
expired.
Purchase Discount Lost 4,000
Accounts Payable 4,000

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Gross method vs. net method
The cost measured under the net method represents the cash equivalent price on the, date of
payment and therefore the theoretically correct historical cost.
However, in practice, most entities record purchases at gross invoice amount.
Technically, the gross method violates the matching principle because discounts are recorded only'
when taken or when cash is paid rather than when purchases that give rise to the discounts are made.
Moreover, this procedure does not allocate discounts taken between goods sold and goods on hand.
Despite its theoretical shortcomings, the gross method is supported on practical grounds.
The gross method is more convenient than the net method from a bookkeeping standpoint.
Moreover, if applied consistently over time, it usually produces no material errors in the financial
statements.

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.
The cost of purchase shall not include foreign exchange differences which arise directly from the
recent acquisition of inventories involving a foreign currency.
Moreover, when inventories are 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.

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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.
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.

Allocation of fixed production overhead

The allocation of fixed production overhead to the cost of conversion is based on the normal
capacity of the production facilities.
Normal capacity is the production expected to be achieved on average over a number of periods or
seasons under normal circumstances taking into account the loss of capacity resulting from planned
maintenance.
The amount of fixed overhead allocated to each unit of production is not increased as consequence of
low production or idle plant.
Unallocated fixed overhead is recognized as expense in the period in which it is incurred.

Allocation of variable production overhead

Variable production overhead is allocated to each unit of production on the basis of the actual use of
the production facilities.
A production process may result in more than one product being produced simultaneously.
This is the case, for example, when joint products are produced or where there is a main product and
a by-product.

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When the costs of conversion are not separately identifiable, they are allocated between the products
on a rational and consistent basis, for example, on the basis of the relative sales value of each
product.
Most by-products by their nature are not material.
By-products are measured at net realizable value and this value is deducted from the cost of the main
product.

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 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.

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.
The inventories of a service provider may simply be described as work in progress.
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.

END OF DISCUSSION
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REFERENCES:

1. Intermediate Accounting Volume 1 2019 Edition

Chapter 10

LEARNING ACTIVITIES:

To be uploaded soon via google forms.

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SYNTHESIS:

What am I learning from this module?

What am I finding hard or challenging about the topic?

What was the most important thing I learned from this module?

Be positive even if others are not. Work hard even if others have quit. Continue to
dream big even if others have given up on theirs – Tamthewise

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