CONCEPTUAL FRAMEWORK AND ACCOUNTING STANDARDS (AE 14)

LEARNING MATERIAL

UNIT NUMBER/ HEADING: INVENTORIES

TOPIC 1: INVENTORIES – Basic Principles

Presentation of Content

Definition
The following are the terms you must be familiar with in discussion of
inventories:
o 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.
- It encompasses goods purchased and held for resale, for
example:
 Merchandise purchased by a retailer and held for resale
 Land and other property held for resale by a subdivision
entity and real estate developer
- It also includes finished goods produced, goods in process and
materials and supplies awaiting use in the production process
- Classes of inventories, namely inventories of:
 Trading concern is one that buys and sells goods in the
same form purchased
 Manufacturing concern is one that buys goods which are
altered or converted into another form before they are made
available for sale
o Finished goods are completed products which are ready for resale
o Goods in process or work in process are partially completed products
which require further process or work before they can be sold
o Raw materials are goods that are to be used in the production process.
No work or process has been done on them as yet by the entity
inventorying them
o Factory or manufacturing supplies are similar to raw materials but
their relationship to the end product is indirect. Often called as indirect
materials.

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GOODS INCLUDIBLE IN THE INVENTORY
 As a rule, all goods to which the entity ha title shall be included in the
inventory, regardless of location. The phrase “passing of title” is a legal
language which means “the point of time at which ownership changes”
 The following items are includible in inventory:
 Goods owned and on hand
 Goods in transit and sold FOB destination
 Goods in transit and purchased FOB shipping point
 Goods out on consignment
 Goods in the hands of salesmen or agents
 Goods held by customers on approval or trial

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.
a. FOB Destination
- ownership of goods purchased is transferred only upon receipt of
the goods by the buyer at the point of destination
-the goods in transit are still the property of the SELLER. Thus, the
seller shall legally be responsible for freight charges and other
expenses up to the point of destination

b. FOB Shipping Point

- ownership is transferred upon shipment of the goods and therefore,
the good in transit are the property of the BUYER.
Freight terms
o Freight collect – freight charges on the goods shipped is not yet paid.
It shall be collected from the buyer. Thus, under this, freight charge is
actually paid by the buyer
o Freight prepaid – freight charge on the goods shipped is already paid
by the seller.

** The term “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 term “freight collect” and “freight prepaid” determine the party who
actually paid the freight charge

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 Who
Freight Who owns Who should
FOB Terms actually
Terms the goods? pay freight?
pay?
FOB Freight
Seller Seller Seller
Destination prepaid
FOB Freight
Seller Seller Buyer
Destination collect
FOB
Freight
Shipping Buyer Buyer Buyer
collect
Point
FOB
Freight
Shipping Buyer Buyer Seller
prepaid
Point

CONSIGNED GOODS
o 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

FINANCIAL 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

ACCOUNTING FOR INVENTORIES

1. Periodic Inventory System
- calls for the physical counting of goods on hand at the end of the
accounting period to determine quantities
- gives actual or physical inventories
- usually used when the individual inventory items have small peso
investment, such as groceries , hardware and autoparts

2. Perpetual Inventory System

- requires the maintenance of records called stock cards that usually
offer a running summary of the inventory inflow and outflow
- gives book or perpetual inventories
- commonly used where the inventory items treated individually
represent a relatively large peso investment such as jewelry and cars

o 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

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 the buyer. Thus, it is not recorded. The purpose of trade discounts is
to encourage buyers to buy in bulk or wholesale
o Cash discounts are deductions from the invoice price when payment
is made within the discount period. Its purpose is to encourage prompt
payment. It is recorded as:
 Purchase discount by the buyer; and
 Sales discount by the seller

Illustration:
The list price of a merchandise purchased is P500,000 less 20% and 10%,
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 within 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 P500,000

First trade discount (20% x P500,000) (P100,000)
P400,000
Second trade discount (10% x P400,000) (P 40,000)
Invoice Price P360,000
Cash discount (5% x P360,000) (P 18,000)
Payment within the discount period P342,000

MEASUREMENT OF INVENTORIES
 The standard states that inventories shall be measured at the lower of
cost and net realizable value (LCNRV)
 Net realizable value (NRV) is the estimated selling price in the
ordinary course of business less the estimated costs of completion and
the estimated costs of disposal.
 Situations in which NRV is likely to be less than cost, (i.e where there
has been:
 an increase in costs or a fall in selling price
 a physical deterioration in the condition of inventory
 obsolescence of products
 a decision as part of the company’s marketing strategy to
manufacture and sell products at a loss
 errors in production or purchasing
 Inventories are usually written down to net realizable value on an item
by item or individual basis

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COST OF INVENTORIES
The cost of inventories shall comprise:
a. Cost of Purchase
- 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
- shall not include foreign exchange differences which arise directly
from the recent acquisition of inventories involving a foreign currency

b. Cost of conversion
- includes cost directly related to the units of production such as direct
labor
- 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
- variable production overhead is the indirect cost of production that
varies directly with the volume of production

c. Other costs
- include all other costs 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:
 Abnormal amounts of wasted materials, labor and other
production costs
 Storage costs, unless these costs are necessary in the
production process prior to a further production stage
 Administrative overheads that do not contribute to bringing
inventories to their present location and condition
 Distribution or selling costs

Techniques for the Measurement of Cost

Two techniques are mentioned by the standard, both of which produce results
which approximate to cost, and so both of which may be used for
inconvenience:
a. Standard costs are set up to take account of normal production values:
Amount of raw materials used, labor time etc. They are reviewed and
revised on a regular basis.

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 b. Retail method: this is often used in the retail industry where there is a
large turnover of inventory items, which nevertheless have similar profit
margins.

Cost Formulas
Cost of inventories should be assigned by specific identification of their
individual costs for:
a. Items that are not ordinarily interchangeable
b. Goods or services produced and segregated for specific projects

**Specific costs should be attributed to individual items of inventory when

they are segregated for a specific project, but not where inventories consist of
a large number of interchangeable (i.e. identical or very similar) items.
**For interchangeable items, under the weighted average cost method, a
recalculation can be made after each purchase, or alternatively only at the
period end.

ILLUSTRATIVE EXAMPLES
Illustration 1:
Myriad Company revealed the following purchase transactions occurred
during the last few days of the fiscal year, which ends December 31, and in
the first few days after that date.
a. An invoice for P500,000, FOB shipping point, was received and recorded
on December 27. The shipment was received in satisfactory condition
on January 2. The merchandise was not included in the inventory.
b. An invoice for P75,000, FOB destination, was received and recorded on
December 28. The shipment was received in satisfactory condition on
January 3. The merchandise was not included in the inventory.
c. An invoice for P300,000, FOB shipping point, was received and recorded
on January 4. The invoice shows that the goods had been shipped on
December 28 and the receiving report indicates that the goods had been
received on January 4. The merchandise was excluded from inventory.
d. An invoice for P90,000, FOB shipping point, was received on December
15. The receiving report indicates that the goods were received on
December 18 but across the face of the report is the notation
“merchandise not of the same quality as ordered – returned for credit,
December 19”. The merchandise was included in the inventory.
e. An invoice for P140,000, FOB destination, was received and recorded
on January 4. The receiving report indicates that the goods were
received on December 29. The merchandise was not included in
inventory.
What is the amount of inventory that should be reported in the financial
statements?

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Computation:
Invoice, FOB shipping point P50,000
Invoice, FOB shipping point P30,000
Invoice, FOB shipping point but credit memo (P90,000)
Invoice, P140,000
Total Inventory P130,000

Illustration 2:
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
P125,00 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?

Computation:
Physical count P6,000,000
Included inventory of customer, FOB SP (P 125,000)
Goods purchased, FOB shipping point P 300,000
Total inventory P6,175,000

Illustration 3:
Dignity Company had the following consignment transactions during the
current year:
Inventory shipped on consignment to a consignee P600,000
Freight paid by Dignity Company P 50,000
Inventory received on consignment from a consignor P800,000
Freight paid by consignor P 50,000

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

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

Computation:
Consigned inventory to consignee P600,000
Freight paid P 50,000
Total P650,000