INTERMEDIATE ACCOUNTING (Volume One)

Chapter 1: CASH AND CASH EQUIVALENTS

Definition of Cash
 Cash simply means MONEY
o Standard medium of exchange in business transactions
o Refers to currency and coins which are cirulation and legal tender
 Has special and broader meaning (connotes more than money)
 As conteplated in accounting, cash includes money and any other negotiable instrument that is payable in
money and acceptable by bannk for deposit and immediate credit
 Cash includes CHECKS, BANK DRAFTS and MONEY ORDERS (acceptable by bank for deposit or
immdiate encashment)
 Postadated checks received cannot be considered as cash (unacceptable by bank for deposit and
immediate credit or outright encashment)

Unrestricted Cash
 No specific standard
 An entity shall classify an asset as current when the asset is cash or a cash equivalent unless it is
restricted to settle a liability for more than 12 months after the end of reporting period
 Reported as cash, item must be unrestricted in use
 Cash must be available in payment of current obligations and not subject to any restrictions, contractual or
otherwise

Cash intems included in Cash

 Cash on hand – undeposited cash collections and other cash items awaiting deposit such as customers’
checks, cashier’s or manager’s checks, traveler’s checks, bank drafts and money order
 Cash in bank – demand deposits or checking account and saving deposit (unrestricted to withdrawal)
 Cash fund – set aside for current purpose, petty cash fund, payroll fund and dividend fund

Cash Equivalents
 Short-term and highly liquid invetsments (readily convertible into cash)
 Only highly liquid investments that are acquired three months before maturity can qualify as cash
equivalents
o 3 months BSP treasury bill
o 3 years BSP treasury bill, but purchased 3 months before maturity
o 3 months time deposit
o 3 months money market instruments or commercial paper
 Equity securities cannot qualify as cash equivalents (shares do not have a maturity date)
 Preference shares with specified redemption date and acquired 3 months before redemption date can
qualify as cash equivalents
 Impotant!!! DATE OF PURCHASE (3 months or less before maturity)

Investment of Excess Cash

 Control and proper cash use of cash (important aspect of cash management)
 Cash accumulated in excess, needed for current operatiions should be invested even temporarily in some
type of revenue earning invetsment
 Excess cash may be invested in time deposits (Money Market instruments and Treasury Bills)

Measurement of Cash
 Measured as Face Value
 Foreign Currency = Current Exchange Rate
 Bank or financial institution holding funds of an entity is in bankruptcy, cash should be written down to
 estimated realizable value if amount recoverable is estimated to be lower than face value
Financial Statement Presentation
 Cash and Cash Equivalents should be shown as first line item (current assets)
o Includes: all cash items (cash on hand, cash in bank, petty cash fund and cash equivalents)

Foreign Currency
 Should be translated to Philippine pesos using current exchange rate
 Deposits in foreign countries are not subjetced to any foreign exchange restriction
 Deposits in foreign bank which are subjected to foreign exchange restriction, if material, should be
classified separately among noncurrent assets and restriction should be stated clearly

Cash Fund for a Certain Purpose

 Cash set aside for use in current operations for payment of current obligations (current asset)
o Petty cash fund, payroll fund, travel fund, interest fund, dividend fund and tax fund
 Set aside for noncurrent purpose or payment of noncurrent obligation (long-term investment)
o Sinking fund, preference share, redemption fund, contingent fund, insurance fund and fund for
acquisition or construction of property, plant, and equipment

Classification of Cash Fund

 Cash fund as current or noncurrent should parallel to classification of the related liability
 Sinking fund for pay bond payable shall classified as current assets (bond due within 1 year)
 Cash fund set aside for acquisition of noncurrent asset should be classified as noncurrent regardless of
year of disbursement

Bank Overdraft
 Credit balance in bank account
 Classified as current liability and should not be offset against other bank accounts with debit balances

Exception to Rule on Overdraft

 Entity maintains 2 or more accounts in one bank and one account results in an overdraft (can be offset
against other bank account with debit balance)
 Net of bank overdratf or bank overdraft, net of other bank account
 Can be offset against other bank account if amount is not material
 IFRS, bank overdraft can be offset against other bank account when payable on demand and often
fluctuates from positive to negative as an integral part of cash management

Compensating Balance
 Minimum checking or demand deposit account balance that must be maintained
 Not legally restricted as to withdrawal by borrower because of an informal compensating balance
agreement
 Legally restricted because of formal compensating balance agreement, compensating balaance is classified
separately as “cash held as compensating balance” under current assets (loan is short term)
 Related loan is long term, compensating balance is noncurrent invetsment

Undelivered or Unreleased Check

 One that is merely drawn and recorded but not given to payee before ending of reporting period
 No payment when check is pending delivery to the payee at end or reporting period
 Undelivered check is still subject to entity’s control and may thus be cancelled anytime before delivery at
the discretion of entity
Cash xx
Accounts Payable / Appropriate Account xx
Postdated Check Delivered
 Check drawn, recorded and already given to payee but it bears a date subsequent to end of reporting
period
 No payment until check can be presented to bank for encashment or deposit

Stale Check or Check Long Outstanding

 Check not encashed by payee within relatively long period of time
 Negotiable Instruments Law – instrument is payable on demand, presentment must be made within a
reasonable time after issue
 Reasonable Time – consideration should be made regarding the nature of the instrument, the usage of
trade or business, if any, respect to such instrument and the facts of particular case
 Currently law does not specifiy a definite period within which checks must be presentated for encashment
 Check becomes stale if not encashed within six months from time of issuance (matter of entity policy)
 Even after three months, entity may issu a “stop payment order” to bank for cancelation of previoud
issued check
Cash xx
Miscellaneous Income xx

Accounting for Cash Shortage

 Cash count shows cash which is less than the balance per book, there is a cash shortage to be recorded
Cash shor or over xx
Cash xx

 Cash short or over account is only a temporary account. When FS are prepared it will be adjusted
Due from cashier xx
Cash short or over xx
*Cashier or cash custodian is held responsible for cash shortgage*
Loss from cash shortage xx
Cash short or over xx
*Resonable efforts fail to disclose the cause of shortage*

Accounting for cash overage

 Cash count shows which is more than the balance pero book, there is a cash overage to be recorded
Cash shor or over xx
Cash xx

 Whether it is a cash shortage or overage, the offsetting account is cash short or over.
Cash short or over xx
Miscellaneous Income xx
*Cash overage treated as miscellaneous income if there is no claim on the same*
Cash short or over xx
Payable to Cashier xx
*Cash overage is properly found to be the money of creditor*

Imprest System
 System of control of cash which requires that all cash receipts should be deposited intact and all cash
disbursement should be made be means of check
 Internal control ideally requires all payments should be made by means of check (sometimes impossible)
 Issuance of checks becomes impractical or inconvenient such as when small amounts are paid or things
are hurriedly bought or customers are entertained
 May be more economical and convenient to pay in cash rather than issue check
Petty Cash Fund: Money set aside to pay small expenses which cannot be paid conveniently by means of check

Impreset Fund System

 One usually followed in handling petty cash fund
a. Check is drawn to establishe the fund
Petty Cash Fund xx
Cash xx
b. Payment of expenses out of the fund
*No formal journal entries are made*
c. Replenishment of petty cash payments
Exepenses xx
Cash xx
d. At the end of the accounting period, necessary to adjust unreplenished expenses in order to state
the correct petty cash balance
Exepenses xx
Cash xx
e. An increase in fund is recorded
Petty Cash Fund xx
Cash in Bank xx
f. A decrease in fund is recorded
Cash in Bank xx
Petty Cash Fund xx

~~~~~ Illustration ~~~~~

2019
Nov. 10 The entity established an imprest fund of P10,000.00
Petty Cash Fund 10,000.00
Cahs in Bank 10,000.00
29 Replenished fund. The petty cash items included the following:
Curreny and Coins 2,000.00
Supplies
5,000.00
Telephone
1,800.00
Postage
1,200.00
Supplies Expense 5,000.00
Telephone Expense 1,800.00
Postage Expense 1,200.00
Cash in Bank 8,000.00
Dec. 31 The Fund was not Replenished
The fund is composed of the following: currency and coins P7,000.00,
supplies P1,500.00, postage P500.00, miscellaneous expense P1,000.00
Supplies Expense 1,500.00
Postage Expense 500.00
Miscellaneous Expense 1,000.00
Petty Cash Fund 3,000.00
2020
Jan. 01 The adjustment made on December 31, 2019 is reversed
Petty Cash Fund 3,000.00
 Supplies Expense 1,500.00
Postage Expense 500.00
Miscellaneous Expense 1,000.00
Feb. 01 The fund is replenished and increased to P15,000.00
Cuureny and Coins 1,000.00
Supplies 4,500.00
Postage 3,000.00
Miscellaneous Expense 1,500.00
Petty Cash Fund 5,000.00
Supplies Expense 4,500.00
Postage Expense 3,000.00
Miscellaneous Expense 1,500.00
Cash in Bank 14,000.00
*The total amount of the check drawn is P14,000.00 representing the petty csh disbursements of P9,000.00 and the
fund increase of P5,000.00*

Fluctuating Fund System

 Because checks drawn to replenish the fund do not necessarily equal the petty cash disbursement
 Replenishment checks are simply drawn upon the request of the petty cashier
 Immediately recorded thus resulting in a fluctuating petty cash balance per book from time to time

Chapter 2: BANK RECONCILIATION

Bank Deposits
 Demand deposit
o Current account or checking account or commercial deposit where deposits are covered by
deposit slips
o Funds are withdrawable on demand
o Draiwng check against bank
o Non-interest bearing
 Saving deposit
o Depositer is given a passbook upon the initial deposit
o Passbook is required when making deposits ad withdrawals
o Withdrawawls are made anytime but bank sometimes may require notice of withdrawal
o Interest bearing
 Time deposit
o Similar to saving deposit
o Interest bearing
o Formal agreement enbodied in an instrument called certificate of deposit
o May be preterminated or withdrawn on demand or after a certain period of time agreed upon

Bank Reconciliation
 Necessary only for a demand deposit or checking account
 Person authorized to draw checks against the account wil required to sign cards furnished by bank
 Specimen signature will be filed by bank so that any teller who may be unfamiliar with a depositor’s
signature can test the authenticity of check by comparing signatures
 Accounit credited by bank is demand deposit account but the same is posted to subsidiary ledger of
company X
 Bank credits account of depositor, company x, recognizes its liability to depositor
 Deposit is made, there exists a debotor-creditor relationship between bank and depositor
 Account of depositor increased the sam is credited
 Depositor’s account is decreased, the same is debited
  Statement which brings into agreement the cash balance per book and cash balance per bank
 Usually prepared monthly because ethe bank provides depositor with bank statement at end of every
month
 Monthly report of bank to depositor
o Cash balance per bank at beginning
o Deposits made by depositor and acknowledged by bank
o Checks drawn by depositor and paid by bank
o Daily cash balance per bank during the month
 Exact copy of depositor’s ledger in records of bank
 Bank statement received, attached thereto are depositor’s canceled checks and any debit or credit
memoranda have affected depositor’s account
 Canceled checks are checks issued by depositor and paid by bank during the month
 It is called canceled checks because they are literally canceled by stamping or punching to show that they
have been paid
 Book reconciling items
o Credit memos: refers to items not representing deposists credited by bank to account of
depositor but not yet recorded by depositor as cash receipts
o Debit memos: refer to item not representing checks paid by bank which are charged or debited
by bank to account of the depositor but nt yet recorded by depositor as cash disbursement. Have
effect of decreasing bank balance
 Bank reconciling items
o Deposit in transit: collections already recorded by depositor as cash recipts but not yet recorded
on bank statement
o Outstanding checks: checks already recorded by depositor as cash disbursement but not yet
reflected on bank statement
o Errors

Forms of Bank Reconciliation

 Adjusted Balance Method: book balance and bank balance are brought to a correct cash balance that
must appear on balance sheet
~~~~~~~~~~Proforma Reconciliation~~~~~~~~~~
Book Balance Bank Balance
Add: Credit Memos Add: Deposit in Transit
Total Total
Less: Debit Memos Less: Outstanding Checks
Adjusted Book Balance Adjusted Bank Balance

 Book to Bank Method: book balance is reconciled with bank balance or book balance is adjusted to equal
the banks balance
Book Balance
Add: Credit Memos
Outstanding Checks
Total
Less: Debit Memos
Deposits in Transit
Bank Balance

 Bank to Book Method: bank balance is reconciled with book balance or bank balance is adjusted to equal
the book balance
Bank Balance
Add: Deposit in Transit
 Debit Memos
Total
Less: Outstanding Checks
Credit Memos
Book Balance
*The first method is preferred over the two*
 Errors are reconciling items of party which committed them
 Under adjusted balance method, credit memos are always added to book balance and debit memos are
always deudcted from book balance
 Deposit in transit are always added to bank balance and outstanding checks are always deducted from
bank balance
 Adjusted balance method – book balance and bank balance are adjusted equal the correct cash balance
 Credit memos always increase bank balance, no effect on book balance, because credit memos are not yet
recorded by depositor

Chapter 3: PROOF OF CASH

Two-date Bank Reconciliation
 It literally involves two dates
 Procedures followed for one date reconciliation are the same for two date reconciliation
 Becomes complicated only when certain facts or data are omitted (necessity for computing them)
 All facts are available, reconciliation statements will simply be prepared as of two date
o Book balance – beginning and ending
o Bank balance – beginning and ending
o Deposit in transit – beginning and ending
o Outstanding checks – beginning and ending
 Ending balances are not given
Balance per book – beginning of the month
Add: Book debits during the month
Total
Less: Book credits during the month
Balance per book – end of month
o Book debits refer to cash receipts or all items debited to the cash in bank account
o Book credits refer to cash disbursement or all items credited to cash in bank account
 Beginning balances are omitted, the formulas should simply be reserved or just work back
 Bank credits refer to all items credited to amount of depositor which include deposits acknowledged by
bank and credit memos
 Bank debits refer to all items debited to account of the depositor which include checks paid by bank and
debit memos
 Computation of Deposits in Transit
Deposit in Transit – beginning of month
Add: cash receipts deposited during the month
Total deposits to be acknowledged by bank
Less: deposits acknowledged by bank during month
Deposit in Transit – end of month

 Computation of Outstanding Checks

Outstanding checks – beginning of month
Add: checks drawn by depositor during the month
Total checks to be paid by bank
Less: checks paid by bank during the month
Outstanding checks – end of month
Proof of Cash
 Expanded reconciliation in that it includes proof of receipts and disbursements
 May be useful in discovering possible discrepancies in handling cash particularly when cash receipts have
been recorded but have not been deposited
o Ajusted balance method
o Book to bank method
o Bank to book method
 Four column worksheet is necessary
 Adjusted balance method, eight colun worksheet may be required

Chapter 4: ACCOUNTS RECEIVABLE

Definition
 Receivables – financial assets that represent a contractual right to receive cash or another financial asset
from another entity
 Retailers or manufacturers, receivables are classified into trade receivables and nontrade receivables

Trade and Nontrade Receivables

 Trade receivables – claims arising from sale of merchandise or services in ordinary course of business
 Trade receivabels include accounts receivables and notes receivable
 Accounts receivable – open accounts arising from sale of goods and services in ordinary course of
business and not supported by promissory notes
o Customers’ accounts
o Trade debtors
o Trade accounts receivable
 Notes receivable – supported by formal promises to pay in form of notes
 Nontrade receivables – claims arising from sources other than sale of merchandise or services in ordinary
course of business

Loans Receivable
 For bank and other financial institutions, receivables result primarily from loans to customers
 Made to heterogeneous customers and repayment periods are frequently longer or over several years

Classification
 Trade receivables are expected to be realized in cash within normal operating cycle or one year,
whichover is longer, current assets
 Nontrade receivables are expected to be realized in cash within one year, length of operating cycle
notwithstanding, current assets
o An entity shall classify an asset ash current when entity expects to realize asset or intends to sell
or consume it in entity’s normal operating cycle, when entity expects to realize asset within
twleve months after reporting period

Presentation
 Trade and nontrade receivbales which are currently collectible shall be presented on face of statement of
financial position as one line item called trade and other receivables

Examples of Nontrade Receivables

 Advances to or receivables from shareholders, directors, officers or employees. If collectible in one year,
such advances or receivables should be classified as current assets
o Otherwise, such advances or receivables are classified as noncurrent assets
 Advances to affiliates are usually treated as long term investment
  Advances to supplie for acquisition of merchandise are current assets
 Subscriptions receivable are current assets if collectible within one year. Otherwise, subscriptions
receivable should be shown preferably as a deduction from subscribed share capital
 Creditors’ accounts may have debit balances as a resuly of overpayment or returns and allowances. These
are classified as current assets
o If debit balances are not material, an offset may ba made against the creditors’ accounts with
credit balances and only the net accounts payable may be presented
 Special deposits on contract bids normally are classified as noncurrent assets because such deposits are
likely to remain outstanding for a considerable long period of time
o Deposits that are collectible currently should be classified as current assets
 Accrued income such as dividend receivable, accrued rent receivable, accrued royalties receivable and
accrued interest receivable on bond investemnt are usually classified as current assets
 Claims receviable such as claims against common carriers for losses or damages, claim for rebates and tax
refunds, claim from insurance entity, are normally classfied as current assets

Customers’ Creidt Balances

 Credit balances in accounts receivable resulting from overpayments, returns and allowances, and advance
payments from customers
 It is classified as current liabilities and are not offset against the debit balances in other customers’
accounts, except the sme is not materaial in which case only the net may be presented
Accounts Receivable xx
Customers’ Credit Balances xx

Initial Measurement of Accounts Receivable

 Financial asset shall be recognized initially at fair value plus transaction costs that directly attributable to
acquisition
 Fair value of financial asset is usually transaction price (fair value consideration given)
 For short term receivables fair value is equal to face amount or original invoice amount
 Cash flows relating to shrt term receivables are not discounted because effect of discounting is usually
immaterial
 Accounts receivable shall be measured initially at face amount or original invoice amount

Subsequent Measurement
 Accounts receivable shall be measured at amortized cost
 Amortized cost is actually net realizable value of accounts receivable
o Has more relevance in long term note receivable
o Net realizable value is preferable used in relation to accounts receivable
o Net realizable value is amount of cash expected to be collected or estimated recoverable amount

Net Realizable Value

 Initial amount recognized for accounts receivable shall be reduced by adjustments which in ordinary
course of business will reduce amount recoerable from customer
 Based on established basic principle that assets shall not be carried at above their recoverable amount
 Estimating net realizable value of trade accounts receivable
o Allowance for freight charge
o Allowance for sales return
o Allowance for sales discount
o Allowance doubtful accounts

Terms Related to Freight Charge

 Order to give proper accounting recognition to freight charge in relation to accounts receivable, the
 following terms should be understood
o FOB destination: ownership of goods purchased is vested in buyer upon receipt thereof
 Seller shall be responsible for freight charge up to point of destination
o FOB shipping point: ownership of goods purchased is vested in buyer upon shipment thereof
 Incumbent upon buyer to pay for transportation charge from point of shipment to point
of destination
o Freight collect: frieght charge on goods shipped is not yet paid. Common carrier shall collect the
same from buyer, freight charge is pad by buyer
o Freight prepaid: freight charge on goods shipped already paid by seller

Accounting for Freight Charge

 Goods are sold FOB destination but shipped freight collect with understanding that buyer will pay for
freight charge and deduct the same when remittance is made
 On part of seller, freight charge is recorded by debiting freight out and crediting allowances for freight
charge
 Entity has a P100,00.00 account receivable at end of accounting period
 Terms are 2/10, n/30, FOB destination and freight collect. The customer paid freight charge of P5,000.00
To record sales:
Accounts Receivable 100,000.00
Freight Out 5,000.00
Sales 100,000.00
Allowance for Freight Charge 5,000.00

To record collection within discount period:

Cash 93,000.00
Sales Discount 2,000.00
Allowance for Freight Charge 5,000.00
Accounts Receivable 100,000.00

Allowance for Sales Return

 Measurement of accounts receivable shall also recognize the probability that some customers will return
goods that unsatisfatory or will make other claims requiring reduction in amount due as in case of
shipment shortages and defects
 Amount of P50,000.00 of total accounts receivable at year-end represents selling price of goods that will
probably be returned. The journal entry to recognize the probable return:
Sales return 50,000.00
Allowance for sales return 50,000.00

Sales Discount
 Usually offer cash discounts to credit customers, cash discount is a reduction from an invoice price by
reason of prompt payment
 Cash discounts is known as sales discount on part of the seller and a purchase discount on part of buyer
 Cash discount may be expressed as 5/10, n/30 (customer is entitled 5% discount if payment is made in 10
days from the invoice date)
 Customer fails to pay within the 10-day disocunt period, gross amount of invoice price must be paid
within 30 days

Methods of Recording Credit Sales

 Gross Method – accounts receivable and sales are recorded at gross amount of invoice. This is common
and widely used method because it is simple to apply
 Net Method – accounts receivable and sales are recorded at net amount of invoice, meaning invoice price
 minus cash discount

~~~~~ Illustration ~~~~~

 Gross Method
Accounts Receivable 100,000.00
Sales 100,000.00
Cash 95,000.00
Sales Discount 5,000.00
Accounts Receivable 100,000.00
Cash 100,000.00
Accounts Receivable 100,000.00

 Net Method
Accounts Receivable 95,000.00
Sales 95,000.00
Cash 95,000.00
Accounts Receivable 95,000.00
Cash 100,000.00
Accounts Receivable 95,000.00
Sales Discount Forfeited 5,000.00 *Other Income*

Allowance for Sales Discount

 Customers are granted cash discounts for prompt payment, then conceptually estimates cash discounts on
open accounts at end of the period based on past experience shall be made
 Adjustment may be reversed at beginning of next period in order that discounts can then be charged
normally to sales discount account

Accounting for Bad Debts

 Business entities sell on credit rather than only for cash to increase total sales and thereby increase income
 Entity that selss n credit assumes the risk that some customers will not pay their accounts
 When an account becomes uncollectible, the entity has sustained a bad debt loss. (loss is simply one of the
costs of doing business on credit)
 Two methods:
o Allowance method: requires recognition of bad debt loss if accounts are doubtful of collection
Doubtful Accounts xx
Allowance for Doubtful Accounts xx
 “Allowance for doubtful accounts” is deduction from accounts receivable
 Doubtful accounts are qsubsequently found to be worthless or uncollectible, accounts
are writtenoff as follows:
Allowance for doubtful accounts xx
Accounts Receivable xx
 Generally accepted accounting principles require the use of the allowance method
because it conforms with matching principle
 Accounts receivable would be properly measured at NRV
o Direct writeoff method: required recognition of a bad debt loss only when the accounts proved
to be worthless or uncollectible
 Worthless accounts are recorded by debiting bad debts and crediting accounts
receivable. Accounts are only oubtful of collection, no adjustment is necessary
 Matter of fact the BIR recognizes only this method for income tax purposes
 Direct writeoff method violates the matching principle because the bad debts loss is
often recognized in later accounting period than period in which sales revenue is
 recognized.
NO ENTRY IS NECESSARY
Bad Debts 30,000.00
Accounts Receivable 30,000.00
Accounts Receivable 30,000.00
Bad Debts 30,000.00
Cash 30,000.00
Accounts Receivable 30,000.00
o Recoveries of Accounts Written off: collection is made on account previously written off as
uncollectible, the customary procedure is first to recharge the customer’s account with the
amount collected and possibly with entrie amount previously charged off if it is now expected
that collection will be received in full
 Collection is recorded normally be debiting cash and crediting accounts receivable
 Recharging of customer’s account is usually followed because it is an evidence of
attempt of customer to reestablish his credit with entity
 Generally accepted approach is to simply reserve the original entry of writeoff
regardless of wheher the recovery is during the year of writeoff or subsequent thereto
Doubtful Accounts xx
Allowance for Doubtful Accounts xx
Allowance for Doubtful Accounts xx
Accounts Receivable xx
Accounts Receivable xx
Allowance for Doubtful Accounts xx
Cash xx
Accounts Receivable xx

Doubtful Accounts in the Income Statement

 Distribution Cost
o Granting credit and collection of accounts are under the charge of sales manager, doubtful
accounts shall be considered as distribution cost
 Administrative Cost
o Granting of credit and collection of accounts are under charge of an officer other than sales
manager, doubtful accounts shall be considered as administrative expense

Chapter 5: ESTIMATION OF DOUBTFUL ACCOUNTS

Methods of Estimating Doubtful Accounts
 Three methods of estimating doubtful accounts
o Aging accounts receivable or “statement of financial position approach”
o Percent of acounts receivable or also statement of financial position approach
o Percent of sales or “income statement approach”

Aging of Accounts Receivable

Not due 91 to 120 days past due
1 to 30 days past due 121 to 180 days past due
31 to 60 days past due 181 to 365 days past due
61 to 90 days past due More than 1 year past due

 Allowance is then determined by multiplying total of each classification by rate or percent of loss
experienced by entity for each category
 Major argument for use of this method is more than accurate and scientific computation of allowance for
doubtful accounts
  Method has the advantage of presenting fairly accounts receivbale in statemnet of financial position at
NRV
 Objection to aging method is that it violates matching process
 Method could become prohibitively time consuming if a large number of accounts are involved

Balance Experience Rate Required Allowance

Not due 500,000 0.01 5,000
1 to 30 days past due 300,000 0.02 6,000
31 to 60 days past due 200,000 0.04 8,000
61 to 90 days past due 100,000 0.07 7,000
91 to 180 days past due 50,000 0.10 5,000
181 to 365 days past due 30,000 0.30 9,000
More than 1 year past due 20,000 0.50 10,000
1,200,000.00 50,000.00

Percent of Accounts Receivable

 Certain rate is multiplied by open accounts at end of the period in order to get required allowance balance
 Rate used is usually determined from past experience of entity
 Procedure has advantage of presenting accounts receivable at estimated NRV (approach is simply applied)
 Application of approach violates the principle of matching bad debt loss against sales revenue
 Loss experience rate may be difficult to obtain and may not be reliable

Percent of Sales
 Amount of sales for year is multiplied by certain rate to get doubtful accounts expense (rate may be
applied on credit sales or total sales)
 Rate to be used is computed by dividing bad debts losses in prior years by charge sales of prior years
 Rate thus obtained is multiplied by current year’s charge slaes to arrive at doubtful accounts expense
 No substantial difference if in computation of rate, the basis is total sales of the prior period
 Rate thus obtained is multiplied by current year’s total slales to get doubtful accounts expense
 Procedure of determining rate has advantage of eliminating exta work of making a record of cash sales
and credit sales
 This apprach may prove unsatisfactory when there is a considerable fluctuation in proportion of cash and
credit sales
 Argument for Percent of Sales Method
o Is used in computing doubtful accounts, proper matching of cost against revenue is achieved
o Bad debt loss is directly related to sales and reported in year of sale
o This method is an income statement approach because it favors income statement
 Argument against Percent of Sales Method
o Accounts receivable may not be shown at estimated realizable value bacaause allowance for
doubtful accounts may prove excessive or inadequate
o It is necessary that from time to time accounts hsould be aged to ascertain probable loss
o Rate applied on sales should be revided accordingly

~~~~~ Illustration ~~~~~

Accounts Receivable 1,000,000.00
Sales 5,050,000.00
Sales Return 50,000.00
Allowance for Doubtful Accounts 20,000.00

 If doubtful accounts are estimated at 1% of net sales, doubtful accounts expense is P50,000.00 (5,000,000
* 0.01) and recorded as follows
 Doubtful Accounts 50,000.00
Allowance for Doubtful Accounts 50,000.00
 Resulting amount of computation is already the amount of doubtful accounts expense and not required
allowance, in contradistinction with aging method and percent of accounts receivable method
 Allowance balance before adjustment is ignored in determining doubtful accounts expense to be recorded
 Allowance for doubtful accounts should have an adjusted balance of P70,000 beginning allowance of
P20,000 plus adjustment P50,000
 Correction in Allowance for Doubtful Accounts
o Percent of sales method os estimating doubtful accounts has disadvantage of allowance for
doubtful accounts being inadequate or excessive
o Aging accounts is necessary to test reasonableness of allowance
o Allowance is inadequate or excessive, question: proper treatment of discrepancy, whethe consider
it as an error or component of profit or loss
o Correction is to be reported in income statement (addition to or substraction from doubtful
accounts expense)
o Inadequate allowance is adjusted as follows
Doubtful Accounts xx
Allowance for Doubtful Accounts xx
o Excessive allowance is recorded as follows
Allowance for Doubtful Accounts xx
Doubtful Accounts xx
o Allowance is excessive, corollary problem when discrepancy is more than debit balance in
doubtful accounts expense account

Debit Balance in Allowance Account

 Allowance in doubtful accounts normally has a credit balance
 Certain instances, may have a debit balance because it may be policy of entity to adjust allowance at end
of period and record accounts written off during the year

Chapter 6: NOTES RECEIVABLE

Definition
 Claims supported by formal promises to pay usually in form of notes
 Negotiable Promissory Note – unconditional promise in writing made by one person to another, signed by
maker, engaging to pay on demand or at fixed determinable future time a sum certain in money to order or
to bearer
 Promissory note is a written contract which one person, maker, promises to pay another person, payee,
definite sum of money
 Not may be payable on demand or at definite future date
 Notes receivable represents only claims arising from sale of merchandise or service in ordinary course of
business
 Notes recevied from officers, employees, shareholder and affiliates shall be designated separately

Dishonored Notes
 Promissory note matures and is not paid, it is said to be dishonored
 Dishonored notes receivable should be removed from notes receivable account and transferred to accounts
receivable
 Amount debited to accounts receivable should include face amount, interest and other charges
 Such approach is defended pn ground that overdue note has loast part of its statues as a negotiable
instrument and really represents only ordinary claim against the maker

Initial Measurement of Notes Receivable

  Notes receivable shall be measured initially at present value
 Present value is sum of all future cash flows discounted using prevailing market rate of interest for similar
notes
 Prevailing market rate of interest is actually effective interest rate
 Short term notes receivable shall be measured at face value
 Cash flows relating to short term notes receivable are not discounted because effect of discounting is
usually not material
 Interest Bearing Notes Receivable
o Initial measuremnet of long term notes will depend on whether the notes are interest-bearing or
noninterest-bearing
o Measured at face value which is actually the present value upon issuance
 Noninterest Bearing Notes Receivable
o Measured at present value which is discounted value of future cash flows using effective interest
rates
o It is misnomer because all notes implicitly contain interest
o Interest bearing included in face amount rather than being stated as a separate rate

Subsequent Measurement
 Initial recognition, long term notes receivable shall be measured at amortized cost using effective interest
method

Meaning of Amortized Cost

 Amount at which note receivable is measure initially:
o Minus principal repayment
o Plus or minus cumulative amortization of any difference between the initial carrying amount and
principal maturity amount
o Minus reduction for impairment or uncollectibility
 Long term noninterest bearing notes receivable, amortized cost is present value plus amortization of
discount or face value minus unamortized unearned interest income
 only long term notes receivable will be discussed in conjunction with present value concept

Chpater 7: LOAN RECEIVABLE

Definition
 financial asset arising from loan granted by bank or other financial institution to borrower or client
 term of loan may be short term but in most cases, repayment periods cover several years

Initial Measuremnet of Loan Receivable

 entity shall measure a loan receivable at fair value plus transaction costs that are directly attributable to
acquisition of financial asset
 fair value of loan receivable at initial recognition is normall transaction price, meaning, the amount of loan
granted
 transaction costs that are directly attributable to loan recceivable includes direct origination costs
o should be included in initial measurement of loan receivable
 indirect origination costs hsould be treated as outright expense

Subsequent Measurement of Loan Receivable

 financial asset is to collect contractual cash flows on specified dates and contractual cash flows are solely
payments of principal and interest, financial asset shall be measured at amortized cost
 loan receivable is measured at amortized cost using effective interest method

Origination Fees
  Lending activities usually precede actual disbursement of funds and generally include efforts to indentify
and attract potential borrowers and to originate a loan
 Fees charged by bank against borrower for creation of loan are known as “origination fees”
 Origination fees include compensation for following activties:
o Evaluating borrower’s financial condition
o Evaluating guarantees, collateral and other security
o Negotiating terms of the loan
o Preparing and processing documents related to loan
o Closing and approving loan transaction

Accounting for Origination Fees

 Origination fees received from borrower are recognized as unearned interest income and amortized over
term of loan
 Origination fees are not chargeable against the borrower, fees are known as “direct origination costs”
o Deferred and also amortized over term of loan
o Offset directly against any unearned origination fees received
o Received exceed direct origination costs, difference is unearned interest income and amortization
will increase interest income
o Exceed origination fees received, difference is charged to “direct origination costs” and
amortization will decrease interest income
o Originatiion fees received and direct origination costs are included in measurement of loan
receivable

Measurement of Impairment
 Expected credit losses, and entity should consider:
o Probability weighted outcome: estimated should reflect possibility that credit loss occurs and
possibility that no credit loss occurs
o Time value of money: expected credit losses should be discounted
o Reasonable and supportable information: available without undue cost or effort
 Does not prescribe particular method of measuring expected credit losses
 Entity may use various sources of data both internal or entity-specific and external measuring expected
credit losses
 Amount of impairment loss can be measured as difference between carrying amount and present value of
estimated future cash flows discounted at original effective rate
 Carrying amount of loan receivable shall be reduced either directly or through use of an allowance
account

Meaning of Credit Risk

 Risk that one party to a financial instrument will cause a financial loss for other party by failing to
discharge an obligation
 Risk contemplated risk that issuer will fail to perform a particular obligation
 Risk does not necessarily relate to credit worthiness of issuer
 Entity issued a collateralized liability and noncollateralized liability that are otherwise identical, credit risk
of two liabilities will de different
 Credit risk of collateralized liability is surely less than credit risk of noncollateralized liability
 Credit risk for collateralized liability may be zero

Three Stage Impairment Approach

 Stage 1 – Low Credit Risk
o Stage covers debt instruments that have not declined significantly in credit quality since initial
 recognition
 Stage 2 – Significant Increase in Credit Risk but no Objective Evidence of Impairment
o Stage covers debt instruments have declined significantly in credit quality since initial
recognition but do not have objective evidence of impairment
 Stage 3 – Objective Evidence of Impairment
o Stage covers debt instruments that have objective evidence of impairment at reporting date (life
time expected cedit loass is recognized)

12 – Month Expected Credit Loss

 Defined as portion of lifetime expected credit loss from default events that are possible within 12 months
after reporting period

Life Time Expected Credit Loss

 Defined as expected credit loss results from all default events over expected life of instruments
 Shall always be recognized for trade receivables through aging, percentage of accounts receivable and
percentage of sales

Interest Income
 Under stage 1 and 2 interest income is computed based on gross carryikng amount or face amount
 Under stage 3, interest income is computed based on net carrying amount which is equal to gross carrying
amount or face amount minus allowance for credit loss

Chapter 8: RECEIVABLE FINANCING (Pledge, Assignment and Factoring)

Concept of Receivable Financing
 Receivable financing is financial flexibility or capability of an entity to raise monet out of its receivables
 During general business decline, entity may find itself in tight cash position because sales decrease and
customers are not paying their accounts on time
 Entity’s current accounts and notes payable must continue to be paid if its credit standing is not to suffer
 Entity then would be in a financial distress as collections of receivable are delayed but cash payments for
obligations must be maintained
 Situation becomes very critical, entity may be forced to look for cash by financing its receivable
Forms of Receivable Financing
 Pledge of accounts receivable
o Loans are obtained from bank or any lending institution, accounts receivable may ba pledged as
collateral security for payment of loan
o Borrowng entity makes collections of pledged accounts but may required to turn over collections
to bank in satisfaction for loan
o No complex problems are involved in this form of financing except amounting for loan
o Loan is recorded by debiting cash and discount on note payable if loan is discounted, and
crediting note payable
o Subsequent payment of loan is recorded by debiting note payable and crediting cash
o With respect to pledged accounts, no entry would be necessary (sufficient that disclosure thereof
is made in a note to financial statement)
 Assignment of accounts receivable
o Means a borrower called assignor transfers rights in some accounts receivable to a lender called
assignee in consideration for loan
o Assignment is a more formal type of pledging of accounts receivable
o Secured borrowing evidence by financing agreement nad a promissory note both of which
assignor signs
o Pledging is general because all accounts receivable serve as collateral security of loan
 o Assignment is specific because specific accounts receivable serve as collateral security of loan
o Accounts are assigned on nonnotification basis, customers are not informed that their accounts
have been assigned
o Customers continue to make payments to assignor, who in turn remits collectiions to assignee
o Asignee usually lends only certain percentage of face value of accounts assigned because
assigned accounts may not be fully realized by reason of such factors as sales discount, sales
return and allowances and uncollectible accounts
o Perentage maybe 70%, 80%, or 90% depending on quality of accounts
o Assignee usually charges interest for loan that makes and requires a service or financing charge
or commission for assignment agreement
 Factoring of accounts receivable
o Sale of accounts receivable on a without recourse notification basis
o Entity sells accounts reecivable to bank or finance entity called factor
o Gain or loss is recognized for difference between proceeds received and net carrying amount of
receivables factored
o Differs from an assignment in an entity actually transfers ownership of accounts receivable to
factor
o Assumes responsibility for uncollectible factored accounts
o Assignor retains ownership of accounts assigned
o Nature of transaction, customers whose accounts are factored are notified and required to pay
directly to factor
o Has responsibility of keeping receivable records and collecting accounts
o Factoring may take form of following
 Casual Factoring
 Entity finds itself in a critical cash position, it may be forced to factor some or
all of its account receivable at substantial discount to bank or finance entity to
obtain much needed cash
 Factoring as a Continuing Agreement
 Involve a continuing arrangement where a finance entity purchases all of
accounts receivable of certain entity
 Before a merchandise is shipped to a customer, selling entity requests factor’s
credit approval (set-up)
 Account is sold immediately to factor after shipment of goods (approved)
 Assumed credit function as well as collection function
 Typically factor cahrges a commission or factoring fee of 5% to 20% for its
services of credit approval, billing, collecting and assuming uncollectible
factored accounts
 Withhold a predetermined amount as protection against customer returns and
allowances and other special adjustments
 Amount withheld is known as “factor’s holdback”
 Actually a receivable from factor and classified as current assets
 Final settlement: made after factored receivables have been fully
collected
 Discounting of accounts receivable – CHAPTER 9

Credit Card
 Plastic card which enables holder to obtain credit up to predetermined lmit from issuer of card for
purchase of goods and services
 Enabled retailers and other businesses to continue to sell goods and services where customers obtain
possession of goods immediately but do not have to pay for goods about one month
  Generally responsible for approving credit of customers and collecting receivables for service fee from
1% to 5% of credit service charge
 Two entries are necessary, one entry at time of sale and another entry when payment is received from card
issuer

Chapter 9: RECEIVABLE FINANCING (Discounting of Note Receivable)

Concept of Discounting
 Form of receivable
 Discounting specifically pertains to note receivable
 Promissory note, original parties (maker and payee)
 Maker is liable and oayee is one entitled to payment on date of maturity
 Note is negotiable, payee may obtain cash before maturity date by discounting note at bank or other
financing company
 Discount the note, payee must endorse
 Legally, payee becomes an endorser and bank becomes endorsee

Endorsement
 Transfer of right to a negotiable instrument by simplt signing at back of instruments
 May be with recourse which means endorser shall pay the endorsee if maker dishonors the note
 Legal parlance, secondary liability of endorser
 Accounting parlance, contingent liability of endorser
 Without recourse means endorser avoids future liability even if maker reuses to pay endorsee on date of
maturity
 Absence of any evidence to contrary, endorsement is assumed to be with recourse

Terms Related to Discounting of Note

 Net proceeds - discounted value of note received by endorser from endorsee (Net proceeds = Maturity
value minus discount)
 Maturity value – amount due on note at date of maturity (Principal + Interest = Maturity Value)
 Maturity date – date on which note should be paid
 Principal – amount appearing on face of note (a.k.a face value)
 Interest – amount of interest for full term of note (Principal * Rate * Time)
 Interest Rate – rate appearing on face of note
 Time – period within which interest shall accrue (discounting purpose, period from date of note to
maturity date)
 Discount – amount of interest deducted by bank in advance. (Discount = Maturity Date * Discount Rate *
Discount Period)
 Discount Rate – rate used by bank in computing discount, should not be confused with interest rate
(discount rate and interest rate is different from each other)
 Discount period – period of time from date of discounting to maturity date (discount period = term of note
– expired portion up to date of discounting), unexpried term of note

Accounting for Notes Receivable Discounting

 Depends on whether discounting is with or without recourse
 Discounting without recourse, meaning, sale of note receivable is absolute and therefore no contingent
liability
 Note receivable account is credited directly (sale of note receivable without recourse or absolute)
 Interest income is credited for actual interest earned on date of discounting

Conditional Sale
 Note receivable discounted account is deducted from total notes receivable when preparing statement of
 financial position with disclousre of contingent liability

Secure Borrowing
 Note receivable is not derecognized but instead an accounting liability is recorded at amount equal to face
amount of note receivable discounted
Conditional Sale or Secured Borrowing
 Contractual rights to cash flows of financial asset have expired
 Financial asset has been transferred and tranfer qualifies for derecognition based on extent of transfer
of risks and rewards of ownership
 First criterion
o Easy to apply
o Contractual rights to cash flows may expire (note receivable from a customer is fully collected)
 Second criterion
o Often complex
o Relies on assessment of extent of transfer of risks and rewards of ownership
 If entity has transferred substantially all risks and rewards, financial asset shall be recognized
 entity has retained substantially all risks and rewards, financial asset shall not be derecognized
 entity has neither transferred nor retained substantially all risks and rewards, derecognition depends on
whether entity has retained control of asset
o entity has lost control of asset, financial asset is derecognized in its entirely
o entity has retained control over asset, financial asset is not derecognized

Evaluation
 contractual rights to ash flows of note receivable discounted with recourse have not yet expired (first
criterion does not apply)
 discounting of note with recourse does not also fall squarely within a single guideline in second criterion
“transfer of risks and rewards of ownership”
o entity has substantially transferred all rewards
o entity has retained substantially all risk
o entity has lost control of note receivable

Chapter 10: INVENTORIES

Definition
 Inventories are assets held for sale in ordinary course of business, in process of production of such sale or
in form of materials or supplies to be consumed in production process or in rendering of services
 encompass goods purchased and held for resale
o Merchandise purchased by retailer and held for resale
o Land and other property held for resale by subdivision entity and real estate developer
 Also encompass finished goods, goods in process and materials and supplies awaiting in process

Classes of Inventories
 Inventories of a Trading Concern
o One that buys and sells goods in same form purchased
o Merchandise inventory – generally applied to goods held by trading concern
 Inventories of Manufacturing Concern
o One that buys goods which are altered or converted into another form before they are made
available for sale
o Concerns are:
 Finished goods
 Completed products which are ready for sale
  Haven been assigned their full share of manufacturing costs
 Goods in process
 Work in process
 Partially completed products which require further process or work before they
can be sold
 Raw materials
 Goods that are to be used in production process
 No work or process has been done on them as yet by entity inventorying them
 Cover all materials used in manufacturing operations
 Restricted to materials that will be physically incorporated in production of
other goods and which can be traced directly to end product of production
process
 Factory or manufacturing supplies
 Similar to raw materials but their relationship to end product is indirect
 May be referred to indirect materials
 Indirect because they are not physically incorporated in products being
manufactured

Goods Includible in the Inventory

 All goods to which entity has title shall be included in inventory, regardless of location
 Passing title – legal language which means “point of time at which ownership changes”

Legal Test
 Entity the ownder of goods to be inventoried?
o Answer: affirmative, goods shall be included in inventory
o Answer: negative, goods shall be excluded from inventory
 Following items are includible in inventory
o Goods owned and on hand
o Goods in transit and sold FOB destination
o Goods in transit and purchased FOB shipping point
o Goods out on consignment
o Goods in hands of salesmen or agents
o Goods held by customers on approval or on trial

Exception to the Legal Test

 Installment contracts may provide for retention of title by seller until selling price is fully collected
 Legal test, goods sold on installment basis are still property of seller and therefore normally includible in
invetory
 In such case, accepted accounting procedure to record installemnt sales as regular sale involving deferred
income on part of seller and regular purchase on part of buyer
 Thus, goods sold on installment are included in inventory of buyer and excluded from seller, legal test to
contrary notwithstanding
 Clear example of economic substance prevailing over legal form

Who is the Owner of Goods in Transit?

 Depend on terms, whether FOB destination or FOB shipping point. (FOB – free on board)
 FOB destination – ownership of goods purchased is transferred upon receipt of goods by buyer at point of
destination (goods in transit are still the property of seller)
 FOB shipping point – ownership is transferred upon shipment of goods and therefore, goods in transit are
property of buyer
 Buyer shall legally be responsible for freight charges and other expenses from point of destination
  During accounting period, accountant normally records purchases when goods are received and sales
when goods are shipped, regardless of precise moment at which title passed
 Procedure is expedient and no material misstatements occur in financial statements because title usually
passes in same accounting period
 Accountant should carefully analyze invoice terms of goods that are in transit at end of accounting period
to determine who has legal title
 Adjustments are in order if errors are committed in recording purchases and sales

Freight Terms
 Freight collect – freight charge on goods shipped is not yet paid. Common carrier shall collect same from
buyer, freight charge is actually paid by buyer
 Freight prepaid – freight charge on goods shipped is already paid by seller
 FOB destination and FOB shipping point determin ownership of goods in transit and party who supposed
to pay freight charge and other expenses from point of shipment to point of destination
 Freight collect and Freight prepaid determine party who actually paid the freight charge but not party who
is supposed to legally pay the freight charge

Maritime Shipping Terms

 FAS or Free Alongside – seller who ships FAS must bear all expense and risk involved in delivering
goods to dock next to or alongside the vessel on which goods are to be shipped
o Buyer bears cost of loading and shipment, title passes to buyer when carrier takes possession of
goods
 CIR or Cost, Insurance and Freight – buyer agrees to pay in a lump sum cost of goods, insurance cost
and freight charge
o May be modified as CF means that buyer agrees to pay in lump sum cost of goods and freight
charge only
o Seller must pay for cost of loading, title and risk of loss shall pass to buyer upon delivery of
goods to carrier
 Ex-ship – seller who delivers goods ex-ship bears all expenses and risk of loss until goods are unloaded
at which time title and risk of loss shall pass to buyer

Consigned Goods
 Consignment is a method of marketing goods in which the owner called consignor transfers physical
possession of certain goods to an agent called conignee who sells them on owner’s behalf
 Consigned goods shall be included in consignor’s inventory and excluded from consignee’s inventory
 Freight and other handling charges on goods out on consignment are part of cost of goods consigned
 When goods are sold by consignee, report is made to consignor together with cash remittance for amount
of sales – commission and other expenses chargeable to consignor

Statement Presentation
 Inventories are generally classified as current assets
 Inventories shall be presented as one line item in statement of financial position but details of inventories
shall be disclosed in notes to financial statements
 Note shall disclose the composition of inventories of manufacturing entity as finished goods, goods in
process, raw materials and manufacturing supplies

Accounting for Inventories

 Two systems are offered in accounting for inventories
o Periodic system
 Calls for physical counting of goods on hand at end of accounting period to determine
quantities
  Quantities are multiplied by corresponding unit costs to get inventory value for balance
sheet purposes
 Actual or physical inventories
 Procedure is genreally used when individual inventory items have small peso investment
such as groceries, hardware and auto parts
o Perpetual system
 Maintenance of records called stock cards that usually offer a running summary of
inventory inflow and outflow
 Increase and decrease are reflected in stock cards and resulting balance represents
inventory
 Book or perpetual inventories
 Procedure is commonly used where inventory items treated individually represent a
relatively large peso investment such as jewelry and cars
 Stock cards are kept to reflect and control both units and costs
 Entity would be able to know inventory on hand at particular moment in time
 Widespread use of computers has enabled practically all large trading and
manufacturing entities to maintain perpetual inventory system
 Entities can conveniently and effectively store and retrive large amount of inventory
data
 Physcial count of units on hand should at least be made once a year to confirm the
balances appearing on stock cards

Inventory Shortage or Overage

 Merchandise inventory account has debit balance
 At end of accounting period, physical count indicates different amount, an adjustment is necessary to
recognize any inventory shortgae or overage
 Inventory shortage is usually closed to cost of goods sold because the result if normal shrinkage and
breakage in inventory
 Abnormal and material shortage shall be separately classified and presentad as other expenses

Trade Discount and Cash Discounts

 Deductions from the list or catalog price in order to arrive at invoice price which is the amount actually
charged to buyer
 Trade discounts are not recorded
 Encourage trading or increase sales. Trade discounts also suggest to buyer the price at which goods may
be resold
 Cash discounts are deductions from invoice price when payment is made within the disocunt period
 Purpose of cash discounts is to encourage prompt payment
 Cash discounts are recorded as purchase discount by buyer and sales discounts by seller
 Purchase discount is deducted from purchases to arrive at net purchases and sales disocunt is deducted
from sales to arrive net sales revenue

Methods of Recording Purchases

 Gross method – purchase and accounts payable are recorded at gross
o Supportedd on practical grounds
o More convenient than net method from bookkeeping standpoint
o Violates matching principle because discounts are recorded only when taken or when cash is paid
rather than when purchases give rise to discounts are made
o Most of the entities used in recording purchases
 Net method – purchases and accounts payable are recorded at net
o Represents cash equivalent price on date of payment and therefore the theoretically correct
 historical cost

Cost of Inventories
 Cost of purhcase
o Inventories comprise purchase price, imprt duties and irrecoverable taxes, freight, handling and
other costs directly attributable to acquisition of finished goods, materials and services
o Trade discounts, rebates and other similar items are deducted in determining cost of purchase
o Cost of purchase shall not include foreign exchange differences which arise directly from recent
acquisition o inventories involving a foreign currency
o Inventories are purchased with deferred settlement terms, difference between purchase price for
normal credit terms and amount paid is recognized as interest expense over period of financing
 Cost of conversion
o Inventories includes cost directly related to units of production such as direct labor
o Includes a systematic allocation of fixed and variable production overhead that is incurred in
converting materials into finished goods
o are not separately identifiable, they are allocated between products on rational and consistent
basis
o Fixed production overhead – indirect cost of production, relatively constant regardless of
volume of production
 Allocation: cost of conversion is based on normal capacity of production facilities
 Production expected to be achieved on average over a number of periods or
seasons under normal circumstances taking into account the loss of
capacityresult from planned maintanance
 Amount of FPO to each unit of production is not increased as consequences of
low production or idle plant
 Unallocated fixed overhead is recognized as expense in period in which it is
incurred
o Variable production overhead – indirect cost of production that varies directly with volume of
production
 Allocation: each unit of production on basis of actual use of production facilities
 Production process may result in more than one product being produced simultaneously

 Other cost incurred in bringing inventories to their present location and condition
o Included in cost of inventories only to extent that it is incurred in beinging the inventories to
present location and codition
o May be appropriate to include cost of designing product for specific customers in cost of
inventories
o Following costs are excluded from costs of inventories and recognized as expenses in period
when incurred:
 Abnormal amounts – wasted materials, labor and other production costs
 Storage costs – unless these costs are necessary in production process prior to further
production stage (goods in proces are capitalized but on finished goods are expenses)
 Administrative overheads – do not contribute to bringing inventories to present
loacation and condition
 Distribution or Selling Costs

Cost of Inventories of service provider

 Service provider consist primarily of labor and other costs or personnel directly engaged in providing
service, iincluding 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 period in which they incurred

Chapter 11: INVENTORY COST FLOW

Cost Formulas
 Expressly provides cost of inventories shall be deteremined by using either:
 FIRST IN FIRST OUT
o Assumes “the goods first purchased are first sold”, consequently goods remaining in inventory at
end of period are those most recently ppurchased or produced
o In accordance with ordinary merchandising procedure that goods are sold in order they are
purchased
o First come, first sold
o Inventory is thus expressed in terms of reccent or new prices while cost of goods sold is
representative of earlier or old prices
o Statement of financial positiion in inventory stated at current placement cost
o Objection to method is that there is improper matching of cost against revenue because goods
sold are stated earlier or older prices resulting in understatement of cost of sales
o Period of inflation or rising prices, FIFO method would resuly to highest net income
o Period of deflation or declining prices FIFO method would result to lower net income
 WEIGHTED AVERAGE
o Periodic
 Cost of beginning inventory + total cost of purchases of the period is divided by total
units purchased + beginning inventory to get weighted average
 Unit cost * units on hand derive inventory value
 Average unit cost = total cost of goods available for ssale / total number of units
available for sale
o Perpetual
 Used in conjunction with perpetul system, weighted average method is popularly known
as moving average method
 Weighted average may be calculated on periodic basis or each additional shipment is
received depends upon the circumstances of entity
 New weighted average unit cost must be computed after every purchase and purchase
return
 Total cost of goods available after every purhcase and purchase return is divided by total
units available for sale at time to get new weighted average unit cost
 LAST IN FIRST OUT
o Assume that “goods last purchased are first sold”, consequently goods remaining in inventory at
end of period are those first purchased or produced
o Expressed in terms of earlier or old prices and the cost of goods sold is representative of recent
or new prices
o Favors in income statement (matching of current cost against current revenue, cost of goods sold
being expressed in terms of current or recent cost)
o Inventory is stated at earlier or older prices and therefore may be significant lag between
inventory valuation and current replacement cost
o Permits income manipulation, making year-end purchases designed to perserve existing
inventories layers (purchases may not even be in best economic interest of entity)
o Period of rising prices, result to lowest net income, declining prices result to highest net income
 Standard does not permit anymore the use of LIFO as alternative formula in measuring cost of inventories

Specific Identification
 Specific costs are attributed to identified items of inventory
  Cost of inventory is determined by simply multiplying units on hand by their actual unit cost
 Requires records which will clearly determine actual cost of goods on hand
 Segregated for specific project and inventories are not ordinarily interchangeable
 May be used either priodic or perpetual inventory system
 Major argument: flow of the inventory cost corresponds with actual physical flow of goods
 Actual determination of cost of units units sold and on hand

Standard Costs
 Predetermined product costs established on basis of normal levels of materials and supplies, labor,
efficiency and capacity utilization
 Predetermined and once deteremined, is applied to all inventory movements – inventories, goods available
for sale, purchases and goods sold or placed in production
 Standard set should be realistically attainable and reviewed and revised regularly in light of current
conditions

Relative Sales Price Methods

 Different commodities are purchased at lump sum, single cost is appropriated among commodities based
on sales price
 Based on philosophy cost is proportionate to selling price

Chapter 12: LOWER OF COST AND NET REALIZABLE VALUE

Measurement of Inventory
 Inventories shall be measuremen at lower of coast and net realizable value
 Also known as LCNRV

Net Realizable Value

 Estimated selling price in ordinary course of business – estimated cost of completion and estimated cost of
disposal
 Cost of inventoriees may not be recoverable under following circumstances
o Inventories are damaged
o Inventories have become wholly or partially obsolete
o Selling price have declined
o Estimated cost of completion or estimated cost of disposal has increased

Determination of Net Realizable Value

 Inventories are usually written down to NRV (item by item , individual basis)
 Not appropriate to write down inventories based on classification of inventory
 May be appropriate to group similar or related items
 May be the case with items of inventory relating to same product line that have similar purposes, are
produced and marketed in same geographical area and cannot be pratically evaluated separately
 Materials held for use in production are not written down below cost if finished products in which they
will incorporated are expected to be sold at or above cost
 Decline in price of materials indicates cost of finished products exceeds net realizable value, material are
written down to net realizable value
 Replacement cost of materials may be best evidence of net reliazable value

Accounting for Inventory Writedown

 Cost is lower than net realizable value, no accounting problem because inventory measured at cost and
increase in value is not recognized
 Net realizable value is lower than cost, inventory is measured at net realizable value and decrease in value
is recognized
Methods of Accounting for the Inventory Writedown
 Direct method or cost of goods sold method
o Inventory is needed at lower of cost or net realizable value
o Also known as cost of goods sold method, any loss on inventory writedown is not accounted for
separately but buried in cost of goods sold
 Allowance method or loss method
o Recorded at cost and any loss on inventory writedown is accounted for separately
o Also known as loss method, loss account (loss on inventory writedown, debited and valuation
account, allowance for inventory writedown is credited)
o Adjusted upwards or downward depending on difference between cost and net realizable value of
inventory at year end
o Required allowance increases, additional loss is recognized
o Required allowance decreases, gain or reversal of inventory writedown
o Gain is limited only to extent allowance balance
o Order that effects of writedown and reversal of writedown can be clearly identified

Purchase Commitments
 Obligations of entity to acquire certain goods sometime in future at fixed price and fixed quantity
 Purchase contract has already been made for future delivery goods fixed in price and quantity
 Significant or unusual, disclosure is required in accompanying notes to financial statements
 Losses are expected to arise from firm and noncancelable commitments shall be recognized
 There is a decline in purchase price after a purchase commitment has been made, loss is reccorded in
period of price decline
 Must be noncencelable in order that a loss purchase commitment can be recognized
 End of reporting period, purchase price falls below agreed price the difference between accounted for
debit to loss on purchase commitments and credit estimated liability

LCNRV Adaptation
 Recognition of loss on purchase commitment is adaptation of measurement at lower of cost or net
realizable value
 If market price rises by time the entity makes purchase, gain on purchase commitment would be recorded
 Amount of gain be recognized is limited to loss on purchase commitment previously recorded

Disclosures
1. Accounting policies – adopted in measuring inventories, including cost formula used
2. Total carrying amount – inventories and carrying amount in classifications appropriate to entity (common
classifications of inventories are merchandise, production supplies, goods in process and finished goods)
3. Carrying amount of inventories carried @ fair value – cost of disposal
4. Amount of inventories recognized as expense during period
5. Amount of any writedown of inventories recognized as expense during period
6. Amount of reversal of writedown is recognized as income
7. Circumstances or events led to reversal of writedown of inventories
8. Carrying amount of inventories pledged as security for liabilities

Agricultural, Forest and Mineral Products

 Provides that inventories of agricultural forest and mineral products are measured at net realizable value at
certain stages of production
 Agricultural crops have been harvested or mineral products have been extracted are measured at net
realizable value
 o Sales is assured under forwards contract or government guarantee
o Homogeneous market exists and there is a negliable risk of failure to sell

Commodities of Broker-Traders
 Measured at fair value miuns cost of disposal
 Brokers-Traders – who buy and sell commodities for others or on their own account
 Inventories of brokers-traders are principally acquired with purpose of selling them in near future and
generating a profit from fluctuations in price or margin

Chapter 13: GROSS PROFIT METHOD

Use of Estimate in Inventory Valuation
 Necessary to know the approximate value of inventory when not possible to take physical count
 Physical count is possible, same may prove costly, difficulty or incovenient at moment
 Two widely accepted procedures, gross profit method and retail inventory method
 Most common reasons for making an estimate of cost of goods on hand are:
o Inventory is destroyed by fire and other catastrophe or theft of merchandise has occurred and
amount of inventory is required for insurance purposes
o Physical count of goods on hand is made and necessary to prove correctness or reasonableness of
such count by making estimation (gross profit test)
o Interim financial statements are prepared and physical count of goods on hand is not necessary ,
it may take time to do the same
 Estimate is required to fairly present financial position and financial performance of
entity for inerim reporting purposes

Gross Profit Method

 Based on assumption that rate of gross profit remains approximately the same from period to period and
therefore ratio of cost of goods sold to net sales is relatively constant from period to period
 Basic formula:
GOODS AVAILABLE FOR SALE
Less: COST OF GOODS SOLD
ENDING INVENTORY
 Goods Available for Sale
Beginning Inventory
Purchases
Add: Freight In
Total
Less: Purchase Return, Allowance and Discount
Goods Available for Sale
 Cost of Goods Sold
o Groos profit method is called cost of goods sold is computed through use of gross profit rate
 Net sales * cost ratio: gross profit rate is based on sales
 Net sales / sales ratio: gross profit rate is based on cost

Sales Allowance ad Sales Discount

 Not deducted from sales
 Items decrease the amount of sales, do not affect physical volume of goods sold
 Do not increase physical inventory of goods, unlike sales return where there is an actual addition to goods
on hand
 Overstatement of inventory with consequent understatement of cost of goods sold and overstatement of
gross income