UNIT 6

PAS 2: INVENTORIES

LEARNING OBJECTIVES

1. Define inventory and identify the timing of its recognition.

2. Differentiate between the periodic and perpetual inventory systems.
3. Measure inventories and apply the cost formulas.
4. Account for inventory write-down and reversal thereof.

Inventories

Inventories are as assets:

a. Held for sale in the ordinary course of business (finished goods);

b. In the process of production for such sale (work in process); or
c. In the form of materials or supplies to be consumed in the production process or in the
rendering of services (raw materials and manufacturing supplies). (PAS 2.6)

Examples of inventories:

a. Merchandise purchased by a trading entity and held for resale.

b. Land and other property held for sale in the ordinary course of business.
c. Finished goods, goods undergoing production, and raw materials and supplies awaiting
use in the production process by a manufacturing entity.

Recognition

Inventories are recognized when they meet the definition of inventory and they qualify for
recognition as assets, such as when legal title is obtained by the buyer from the seller.

Ownership over inventories

Legal title normally passes when possession over of the goods is transferred.

However, there may be cases where the transfer of control (ownership) does not coincide with
the transfer of physical possession. Control may be transferred even before or after the transfer
of physical possession. All relevant facts and circumstances must be considered when
determining whether control over the inventory is transferred.

In daily transactions, strict adherence to the passing of legal title is not practicable. However,
proper inventory cut-off procedures should be made prior to the preparation of financial
statements for fair presentation. Regardless of location, an entity shall report in its financial
statements all inventories over which it holds legal title to or has obtained control of the
related economic benefits.

In this regard, proper consideration should be given to the following:

1. Goods in transit
2. Consigned goods
3. Inventory financing agreements
4. Sale with unusual right of return
5. Sale on trial or sale on approval
6. Installment sale
7. Bill and hold sale
8. Lay away sale

Goods in transit

Goods in transit pertain to goods already shipped by the seller but are not yet received by the
buyer. The lack of physical possession may pose a question on who owns the goods in transit.

Depending on the terms of the sale contract, goods in transit may form part of the inventories
of either the buyer or seller, but not both. Such terms are either FOB shipping point or FOB
destination. FOB stands for "free on board."

a. FOB shipping point, ownership over the goods is transferred upon shipment. Therefore, the
goods in transit form part of the buyer's inventories. The buyer records the purchase (and
accounts payable) upon shipment.
b. FOB destination, ownership over the goods is transferred only when the buyer receives the
goods. Therefore, the goods in transit still form part of the seller's inventories. The buyer
records the purchase (and accounts payable) only when the goods are received.

Sale contracts may also contain terms for shipping costs indicated by any of the following:

a. Freight collect - Freight is not yet paid upon shipment. The carrier collects shipping costs
from the buyer upon delivery. Thus, the buyer pays for the freight. However, this does not
mean that the buyer is the one who is supposed to pay for the freight.
b. Freight prepaid - The seller pays the freight in advance before shipment. However, this does
not mean that the seller is the one who is supposed to pay for the freight.
c. FAS (free alongside) - The seller assumes all expenses in delivering the goods to the dock
next to (alongside) the carrier on which the goods are to be shipped. The buyer assumes
loading and shipping costs. Title passes upon shipment to the carrier.
d. Ex-ship - The seller assumes all expenses until the goods are unloaded from the carrier, at
which time title passes to the buyer.
e. CIF (cost, insurance, and freight) - The buyer pays in lump sum the cost of the goods and
the insurance and freight costs.
f. CF (cost and freight) - The buyer pay in lump sum the cost of the goods and the freight
cost.

In either CIF or CF, the seller must deliver the goods to the carrier and pay the costs of
loading. Thus, title passes to the buyer upon delivery of the goods to the carrier.

The foregoing is meant only to define normal terms and usage. Actual contractual
arrangements between a buyer and a seller can vary widely.

As a rule, the entity who owns the goods being shipped should pay for the shipping costs.

No special accounting is necessary if the term of the sales contract is either "FOB shipping
point, Freight collect" or "FOB destination, Freight prepaid" because the owner of the goods in
transit is also the one who pays for the freight charges.
Illustration: Goods in Transit

ABC Co. purchased goods with invoice price of P1,000 on account on December 27, 2020. The
related shipping cost is amounted to P10. The seller shipped the goods on December 31, 2020.
ABC Co. received the goods on January 2, 2021 and settled the account on January 5, 2021.

a. FOB shipping point, freight collect

Dec. 31, 2020 Purchases 1,000
Accounts payable 1,000
To record purchases on account
Jan 2, 2021 Freight-in 10
Cash 10
To record the payment of freight to the carrier
Jan 5, 2021 Accounts payable 1,000
Cash 1,000
To record the settlement of accounts payable

b. FOB destination, freight prepaid

Dec. 31, 2020 NO ENTRY
Jan 2, 2021 Purchase 1,0000
Accounts payable 1,000
To record purchases on account
Jan 5, 2021 Accounts payable 1,000
Cash 1,000
To record the settlement of accounts payable

c. FOB shipping point, freight prepaid

Dec. 31, 2020 Purchases 1,000
Freight-in 10
Accounts payable 1,010
To record purchases on account and freight reimbursable to the seller
Jan 2, 2021 NO ENTRY
Jan 5, 2021 Accounts payable 1,010
Cash 1,010
To record the settlement of accounts payable inclusive of freight

d. FOB destination, freight collect

Dec. 31, 2020 NO ENTRY
Jan 2, 2021 Purchases 1,000
Accounts payable 1,000
To record purchases on account

Accounts payable 10
Cash 10
To record freight paid on behalf of the seller
Jan 5, 2021 Accounts payable 990
Cash 990
To record the settlement of accounts payable net of freight

Consigned Goods

A consignment involves a consignor transferring goods to a consignee who acts as agent of

the consignor in selling the goods.
Consigned goods are included in the consignor's inventory and are excluded from the
consignee's inventory. When goods are delivered to the consignee, the consignor retains
ownership over the consigned goods. The consigned goods remain the property of the
consignor and hence, included in his inventory.

Since ownership is not transferred, transfers of consigned goods between the consignor and
consignee are recorded only through memo entries.

Freight and other incidental costs of transferring consigned goods to the consignee form part
of the cost of the consigned goods. Repair costs for damages during shipment and storage and
other maintenance costs are charged as expense.

In a typical consignment, the consignee is entitled to a commission based on sales. In other

arrangements, the consignee "purchases" the goods simultaneously with their sale to the final
customer. In effect, the consignee's commission is based on the mark-up he made on the final
selling price. Commissions are accounted for as expense by the consignor and as income by
the consignee. Accordingly, commissions do not affect the cost of consigned goods.

Normally, the consignee deducts the commission he has earned from the amount that he
remits to the seller. In cases where commission is given to the consignee in advance, the
consignor records the advanced commission as receivable and not as cost of inventory.

Illustration 1: Total inventory

ABC Co. provided you the following information for the purpose of determining the amount of
its inventory as of December 31, 2020:

Goods located at the warehouse (physical count) 3,800,000

Goods located at the sales department (at cost) 13,600,000
Goods in-transit purchased FOB Destination 1,600,000
Goods in-transit purchased FOB Shipping Point 2,100,000
Freight incurred under "freight prepaid" for the goods purchased under FOB Shipping 60,000
Point
Goods held on consignment from XYZ, Inc. 1,800,000

Requirement: How much is the total inventory on December 31, 2020?

Solution:

Goods located at the warehouse (physical count) 3,800,000

Goods located at the sales department (at cost) 13,600,000
Goods in-transit purchased FOB Shipping Point 2,100,000
Freight under "freight prepaid" for purchases under FOB Shipping Point 60,000
Total Inventory on December 31, 2020 19,560,000

Illustration 2: Consigned goods

ABC Co. consigned goods costing P10,000 to XYZ, Inc. Transportation costs of delivering the
goods to XYZ totaled P2,000. Repair costs for goods damaged during transportation totaled
P500. To induce XYZ, Inc. in accepting the consigned goods, ABC Co. gave XYZ P1,000
representing an advance commission. How much is the cost of the consigned goods?

Answer: 12,000 = 10,000 cost + 2,000 Transportation cost

Illustration 3: Correct inventory and accounts payable

On December 31, 2020, ABC Co. has a balance of P160,000 in its inventory account determined
through physical count and a balance of P100,000 in its accounts payable account. The
balances were determined before any necessary adjustment for the following:
a. Merchandise costing P10,000, shipped FOB shipping point from a vendor on December 30,
2020, was received and recorded on January 5, 2021.
b. A package containing a product costing P50,000 was standing in the shipping area when
the physical inventory was conducted. This was not included in the inventory because it
was marked "Hold for shipping instructions." The sale order was dated December 17 but
the package was shipped and the customer was billed on January 3, 2021.
c. Goods in the shipping area were included in inventory because shipment was not made
until January 4, 2021. The goods, billed to the customer FOB shipping point on December
30, 2020, had a cost of P20,000.
d. Goods shipped F.O.B. destination on December 27, 2020, from a vendor to ABC Co. were
received on January 6, 20?2. The invoice cost of P30,000 was recorded on December 31,
2020 and included in the count as "goods in-transit."

Requirement: Determine the adjusted balances of (1) inventory and (2) accounts payable as of
December 31, 2020.

Inventory Accounts Payable

Unadjusted balances 160,000 100,000
Purchase on FOB shipping pt. 10,000 10,000
Unshipped goods not counted 50,000 -
Unshipped goods counted - -
FOB destination improperly included (30,000) (30,000)
Adjusted balances 190,000 80,000

Inventory financing agreements

Inventories may be acquired or sold under various forms of financing agreements, which may
include the following:

a. Product financing agreement - a seller sells inventory to a buyer but assumes an obligation
to repurchase it at a later date. This arrangement does not result to the transfer of control
over the asset. Therefore, the seller retains ownership over the inventory.

b. Pledge of inventory - a borrower uses its inventory as collateral security for a loan. This
arrangement does not result to the transfer of control over the asset. Therefore, the
borrower retains ownership over the inventory.

Warehouse financing - under this arrangement, a third party (e.g., a public warehouse)
holds the inventory and acts as the creditor's agent. The public warehouse then furnishes
the creditor the warehouse receipts evidencing rights to the inventory.

c. Loan of inventory - an entity borrows inventory from another entity to be replaced with the
same kind of inventory. This arrangement results to transfer of control over the asset.
Accordingly, the borrower includes the loaned goods in its inventory.
Sale with unusual right of return

The buyer normally recognizes goods purchased under a sale with right of return at the time of
sale, unless the goods purchased does not qualify for recognition as asset. For example, the
buyer does not recognize any inventory when:

a. the buyer assesses that no economic benefits will be derived from the goods, such as when
they are defective or unsalable; or
b. the buyer intends to return the goods to the seller within the time limit allowed under the
sale agreement.

Sale on trial

Under a "sale on trial" (or "sale on approval), a seller allows a prospective customer to use a
good for a given period of time. At the end of that time, if the prospective customer is satisfied
with the good, he purchases it. If not, he returns it to the seller.

Under this type of arrangement, the legal title over the good does not pass to the prospective
customer until he approves it and purchases it. Therefore, the good remains in the seller's
inventory during the trial period. Accordingly, the prospective customer does not include the
good in his inventory until he purchases it.

In some arrangements, the good is considered sold if it is not returned within a reasonable
period of time after the trial period has lapsed.

Installment sale

An installment sale where the possession of the goods is transferred to the buyer but the seller
retains legal title solely to protect the collectability of the amount due is considered as a
regular sale. Therefore, the goods are excluded from the seller's inventory and included in the
buyer's inventory at the point of sale.

Bill and hold arrangement

A bill-and-hold arrangement is a contract (of sale) under which a seller bills a customer but
retains physical possession of the goods until it is transferred to the customer at a future date.

The goods are excluded from the seller's inventory and included in the buyer's inventory upon
billing, provided:

a. the reason for the bill-and-hold arrangement is substantive (e.g ., the customer has
requested for the arrangement);
b. the goods are identified separately as belonging to the customer;
c. the goods are available for immediate transfer to the customer; and
d. the seller cannot use the goods or sell them to another customer.

Lay away sale

Lay away sale is a type of sale in which goods are delivered only when the buyer makes the
final payment in a series of installments. This is different from a regular installment sale
wherein goods are delivered to the buyer at the time of sale.

The goods sold under a lay away sale are included in the seller's inventory until the goods are
delivered to the buyer. Delivery is made after the final installment payment is paid. However,
when significant payments have already been made, the goods may be included in the buyer's
inventory, provided delivery is probable.

Remember the following:

Type of arrangement Included in the inventory of

1. FOB shipping point Buyer
2. FOB destination Seller
3. Consigned goods Consignor
4. Inventory financing Borrower
5. Sale with unusual right of return Buyer, except when unsalable
6. Sale on trial (approval) Seller
7. Bill and hold Buyer
8. Lay away Seller

Illustration 1: Recognition of inventory

The records of ABC Co. show the following:

a. Goods sold on an installment basis to XYZ, Inc., title to the goods is 750,000
retained by ABC Co. until full payment is made. XYZ, Inc. took
possession of goods.
b. Goods sold to Alpha Co ., for which ABC Co. has signed an agreement to 680,000
repurchase the goods sold at a set price that covers all costs related to
the inventory
c. Goods sold where large returns are predictable. 270,000
d. Goods received from Beta Co. for which an agreement was signed 580,000
requiring ABC Co. to replace such goods in the near future.

Requirement: How much is included as part of ABC Co.’s inventory?

Answer: 1,260,000 (680,000 + 580,000)

Illustration 2: Bill and hold and Lay away

The following are among the transactions of ABC Co. during the year:

 Purchased goods costing P10,000 from XYZ, Inc. Billing was received although delivery was
delayed per request of ABC Co. The goods purchased were segregated and ready for
delivery on demand.
 Purchased goods costing P25,000 from Alpha Corp. on a lay away sale agreement. The
goods were not yet delivered until after ABC makes the final payment on the purchase
price. ABC Co. made total payments of P15,000 during the year.

Requirement: How much of the goods purchased above will be included in ABC's year-end
inventory?

Answer: 10,000 - inventory purchased on a "bill and hold" arrangement.

Financial statement presentation

All items that meet the definition of inventory are presented on the statement of financial
position as one line item under the caption "Inventories." The breakdown (i.e ., finished goods,
work in process, and raw materials and manufacturing supplies) is disclosed in the notes.
Inventories are classified as current assets.
Accounting for inventories

The major objectives of inventory accounting are:

a. Proper determination of periodic income through the recognition of appropriate costs

which are matched with revenue.
b. Proper representation of inventories recognized as assets in the financial statements.

Inventories are accounted for either through: (a) perpetual inventory system or (b) periodic
inventory system

Perpetual inventory system

Under the perpetual inventory system, the "Inventory" account is updated each time a
purchase or sale is made. Thus, the "Inventory" account shows a continuing or running balance
of the goods on hand.

Moreover, records called "stock cards" and "stock ledger cards" are maintained under this
system, from which the quantities and balances of goods on hand and goods sold can be
determined at any given point of time without the need of performing a physical count of
inventories. Physical count is performed only as an internal control to determine the accuracy
of the balance per records.

All increases and decreases in inventory, such as purchases, freight-in, purchase returns,
purchase discounts, cost of goods sold, and sales returns are recorded in the "Inventory"
account. "Cost of goods sold" is also updated each time a sale or sale return is made.

The perpetual inventory system is commonly used for inventories that are specifically
identifiable and are relatively high valued, such as cars, machineries, furniture and heavy
equipment.

Periodic Inventory System

Under the periodic inventory system, the "Inventory" account is updated only when a physical
count is performed. Thus, the amounts of inventory and cost of goods sold are determined
only periodically.

Under this system, the entity does not maintain records that show the running balances of
inventory on hand and cost of goods sold as at any given point of time. To determine this
information, a physical count of the quantity of goods on hand must be performed periodically
(e.g ., on a daily, weekly, monthly, or annual basis). The quantity counted is then multiplied by
the unit cost to get the balance of the "Inventory" account. This amount is then used to
compute for the "Cost of goods sold," which is the residual amount in the formula below.

Beginning inventory Pxxx

Add: Net purchases xxx
Total Goods Available for Sale xxx
Less: Ending inventory (physical count) (xxx)
Cost of goods sold Pxxx

Net purchases is computed as follows:

Purchases Pxxx
Add: Freight-in xxx
 Less: Purchase returns and discounts (xxx)
Net Purchases Pxxx

Under the periodic inventory system, purchases of inventory are debited to the "Purchases"
account, shipping costs are debited to the "Freight-in" account, purchase returns are credited
to the "Purchase returns" account, and purchase discounts are credited to the "Purchase
discounts" account. No entry is made to recognize cost of goods sold when inventory is sold.

Since the "Inventory" account is updated only after a physical count, prior to the count, the
balance of the inventory account represents the beginning balance or the balance from the
last physical count. Consequently, the balance of "Cost of goods sold" prior to a physical count
is zero. The periodic inventory system is commonly used for inventories that are normally
interchangeable, relatively low valued, and has a fast turnover rate, such as grocery items,
medicines, electrical parts, and office supplies

Illustration: Perpetual vs. Periodic (Journal Entries)

Perpetual system Periodic system

1. You purchased goods worth P10,000 on account
Inventory 10,000 Purchases 10,000
Accounts payable 10,000 Accounts payable 10,000

2. You paid shipping costs of P1,000 on the purchase above

Inventory 1,000 Freight-In 1,000
Cash 1,000 Cash 1,000

3. You returned damaged goods worth P2,000 to the supplier

Accounts payable 2,000 Accounts payable 2,000
Inventory 2,000 Purchase returns 2,000

4. You sold goods costing P5,000 for P20,000 on account

Accounts receivable 20,000 Accounts receivable 20,000
Sales 20,000 Sales 20,000

Cost of goods sold 5,000 NO ENTRY

Inventory 5,000
5. A customer returned goods with sale price of P800 and cost of P200
Sales returns 800 Sales returns 800
Accounts receivable 800 Accounts receivable 800

Inventory 200 NO ENTRY

Cost of goods sold 200

 Under the perpetual inventory system, all increases and decreases in inventory are
recorded in the "Inventory" account. Also, cost of goods sold is debited when inventory is
sold and credited when there is a sales return.
 Under the periodic inventory system, increases and decreases in inventory are recorded
through the purchases, freight-in, purchase returns, and purchase discounts accounts. Cost
of goods sold is not recorded.
 Under the perpetual inventory system, the balances of inventory on hand and cost of
goods sold are readily determinable from the ledger. P4,800 = P5,000 - 200
 Under the periodic inventory system, the balances of inventory on hand and cost of goods
sold are not readily determinable without performing first a physical count of the quantity
of goods on hand.
Assume that a physical count revealed inventory on hand of 105 units costing P40 per unit. The
inventory on hand and cost of goods sold under the periodic inventory system are determined
as follows:

Beginning inventory P 0
Purchases (1) P10,000
Freight-in (2) 1,000
Purchase returns (2,000)
Net purchases 9,000
Total Goods Available for Sale 9,000
Less: Ending inventory (physical count) (4,200)
Cost of goods sold P4,800

Variation: Shortages/Overages

When an entity uses a perpetual inventory system and a difference exists between the
perpetual inventory balance and the physical inventory count, there is inventory shortage or
overage.

Assume in the illustration above that the physical count revealed a balance of P4,000. The
inventory shortage is determined as follows:

Balance per count 4,000

Balance per records 4,200
Difference - Shortage (200)

Adjusting entry under:

Loss on inventory shortage 200

(or Inventory shortage or overage)
Inventory 200

Measurement

Inventories are measured at the lower of cost and net realizable value.

Cost

The cost of inventories comprises the following:

a. Purchase cost - this includes the purchase price (net of trade discounts and other rebates),
import duties, non-refundable or non-recoverable purchase taxes, and transport, handling
and other costs directly attributable to the acquisition of the inventory.

Purchase cost does not include refundable or recoverable taxes. For example, Value-Added
Taxes (VAT) paid by VAT payers are not included as cost of inventory but rather recognized
as "Input VAT" and treated as reduction to VAT payments to the Bureau of Internal
Revenue (BIR).

Trade discounts, rebates and other similar items are deducted in determining the purchase
cost.

b. Conversion costs - these refer to the costs necessary in converting raw materials into
finished goods. Conversion costs include direct labor and production overhead costs.
c. Other costs necessary in bringing the inventories to their present location and condition.

The following are excluded from the cost of inventories and are expensed in the period in
which they are incurred:

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

b. Selling costs, e.g ., advertising and promotion costs and delivery expense or freight out;
c. Administrative overheads that do not contribute to bringing inventories to their present
location and condition; and Storage costs, unless those costs are necessary in the
production process before a further production stage. (PAS 2.16)

For example, warehousing costs and other costs of storing inventories before they are sold
are expensed in the period they are incurred.

However, the storage cost of wine during fermentation is a necessary cost that can be
capitalized as cost of inventory by a wine producer.

Also, the storage costs of partly finished goods may be capitalized as cost of inventory, but
the storage costs of completed goods are expensed.

Illustration: Cost of purchase

ABC Co., a VAT taxpayer, imported goods from a foreign supplier and incurred the following
costs:

Purchase price 100,000

Import duties 10,000
Value added tax 13,000
Transportation and handling costs 5,000
Commission to broker 2,000
130,000

Requirement: How much is the cost of purchase of the imported goods?

Answer: P117,000 = (100,000 + 10,000 + 5,000 + 2,000)

The entry to record the purchase is as follows:

Inventory 117,000
Input VAT 13,000
Cash 130,000

Note: If the purchaser is a non-VAT taxpayer, the VAT paid forms part of the cost of inventory.
For a non-VAT business, any AT paid is considered non-refundable.

Trade Discounts and Cash Discounts

1. Trade discounts are given to encourage orders in large quantities. Trade discounts do not
form part of the cost of inventory. They are deducted from the list price in order to
determine the invoice price. Trade discounts are not recorded in the books of either the
buyer or seller.
2. Cash discounts are given to encourage prompt payment. They are deducted from the
invoice price in order to determine the amount of net payment required within the
discount period.
Accounting for cash discounts

1. Gross Method - The cost of inventory and accounts payable are recorded gross of cash
discounts. Purchase discounts are recorded under the "Purchase discounts" account only
when taken. Purchase discounts is deducted from gross purchases when computing for net
purchases.

2. Net Method - The cost of inventory and accounts payable are initially recorded net of cash
discounts, regardless of whether such discounts are taken or not. Purchase discounts not
taken are recorded under the "Purchase discounts lost" account and included as part of
"other expense" or as "finance cost" (interest expense).

Cash discounts not taken reflect penalties added to an established price to encourage
prompt payment. That is, the seller offers sales on account at a slightly higher price than if
selling for cash. The cash discount offered offsets the increase. Thus, customers who pay
within the discount period actually purchase at the cash price. Those who pay after
expiration of the discount period pay a penalty for the delay-an amount in excess of the
cash price. This penalty represented by the "purchase discount lost" should not be treated
as part of the cost of inventory or of cost of goods sold but rather as "other expenses" or
"finance cost" (interest expense).

Accounts payable initially recorded at net amount may need to be adjusted for purchase
discounts that have expired as of inventory cut-off date. However, no adjustment should be
made on the cost of inventory for purchase discounts not taken.

Theoretically, the net method should be used because it supports the concepts of
conservatism, historical cost, and matching. However, the gross method is more commonly
used because of cost-benefit considerations and convenience.

Illustration:

An entity purchases inventory with a list price of P10,000 on account under credit terms of
20%, 10%, 2/10, n/30.

Gross method Net Method

1. Purchase of inventory
Purchases 7,200 Purchases 7,056
Accounts payable 7,200 Accounts payable 7,056

(10,000 x 80% x 90%) (10,000 x 80% x 90% x 98%)

2. Assume payment is made within discount period

Accounts payable 7,200 Accounts payable 7,056
Purchase discounts (7,200 x 2%) 144 Cash 7,056
Cash 7,056

3. Assume payment is made beyond discount period.

Accounts payable 7,200 Accounts payable 7,056
Cash 7,200 Purchase discount lost 144
Cash 7,200

Conversion costs
As mentioned earlier, conversion costs refer to direct labor and manufacturing overhead costs,
which are necessary in converting raw materials into finished goods. On the other hand, prime
costs refer to the sum of direct materials and direct labor costs.

Manufacturing overhead are costs of production that are not directly traceable to the finished
goods but are necessary costs in producing the goods (e.g ., depreciation on factory
equipment, cost of electricity to run a factory equipment, and the like). Manufacturing or
production overhead are sub-classified into (a) variable production overhead and (b) fixed
production overhead.

Variable production overheads are indirect costs of production that vary directly with the
volume of production, such as indirect materials and indirect labor.

Fixed production overheads are indirect costs of production that remain relatively constant
regardless of the volume of production, such as depreciation and maintenance of factory
buildings and equipment, and cost of factory management and administration.

Allocation of production overheads

 Fixed production overheads are allocated to the costs of conversion 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 actual level of production may be used if it approximates normal capacity. The amount
of fixed overhead allocated to each unit of production is not increased as a consequence of
low production or idle plant.

Unallocated overheads are recognized as expenses in the period in which they are incurred.

 Variable production overheads are allocated to each unit of production based on the actual
use of the production facilities.

Absorption costing and Variable costing

Absorption (full) costing is a costing method in which both fixed and variable production
overheads are included in cost of inventories.

Variable costing is a costing method in which only variable production overhead is included in
cost of inventories. Fixed production overhead is expensed immediately.

PAS 2 requires the use of absorption costing. Variable costing is used only for internal
reporting purposes

Joint and By-products

A production process may result in more than one product being produced simultaneously.
This is the case, for example, when joint products are produced (i.e ., main product and a by-
product).

When the conversion costs of each product are not separately identifiable, they are allocated
between the products on a rational and consistent basis. The allocation may be based, for
example, on the relative sales value of each product either at the stage in the production
process when the products become separately identifiable, or at the completion of production.

Most by-products, by their nature, are immaterial. When this is the case, they are often
measured at net realizable value and this value is deducted from the cost of the main product.
As a result, the carrying amount of the main product is not materially different from its cost.

Standard cost system

Standard costs are budgeted inventory unit costs established to motivate optimal productivity
and efficiency. Standard costs take into account normal levels of materials and supplies, labor,
efficiency and capacity utilization. They are regularly reviewed and, if necessary, revised in the
light of current conditions.

A standard cost system is designed to alert management when the actual costs of production
differ significantly from target or standard costs. The use of a standard cost system is allowed
under PAS 2 for convenience provided the results approximate cost.

Borrowing costs

Borrowing cost (interest expense) forms part of the cost of inventory only if it is incurred on
borrowings taken to finance the acquisition or production of inventory that meets the
definition of a qualifying asset. A qualifying asset is an asset that necessarily takes a substantial
period of time to get ready for its intended use or sale. All other interests are charged as
expenses.

Deferred settlement terms

When payment for purchases is deferred and the arrangement effectively contains a financing
element, the difference between the purchase price for normal credit terms and the amount
paid is recognized as interest expense over the period of the financing.

Illustration: Deferred payment

On January 1, 2020 ABC Co. acquired goods for sale in the ordinary course of business for
P100,000, including P5,000 refundable purchase taxes. The supplier usually sells goods on 30
days' interest-free credit. However, as a special promotion, the purchase agreement for these
goods provided for payment to be made in full on December 31, 2020. In acquiring the goods,
transport charges of P2,000 were paid on January 1, 2020. An appropriate discount rate is 10%
per year.

Requirement: Compute for the initial cost of the inventories.

Solution:

Total purchase price 100,000

Refundable purchase taxes (5,000)
Purchase price excluding refundable purchase taxes 95,000
Multiply by: PV of 1 @ 10% for 1 period 0.90909
Cash price equivalent of inventory purchased 86,364
Transportation cost 2,000
Initial cost of inventories 88,364
Cost of agricultural produce harvested from biological assets

Inventories comprising agricultural produce harvested from biological assets are initially
measured at fair value less cost to sell at the point of harvest in accordance with PAS 41
Agriculture. This will be the deemed cost for subsequent measurement at the lower of cost and
net realizable value using PAS 2.

Cost of inventories purchased in lump sum

The cost of different inventories having different values purchased on a lump sum basis is
allocated to the inventories based on their relative sales prices.

Illustration: Purchase in lump sum

ABC Co. acquired a tract of land for P1,000,000. The land was developed and subdivided into
residential lots at an additional cost of P200,000. Although the subdivided lots are relatively
equal in sizes, they were offered at different sales prices due to differences in terrain and
locations. Information on the subdivided lots is shown below:

Lot group No. of lots Price per lot

A 4 400,000
B 10 200,000
C 15 160,000

Requirement: Compute for the allocated costs of the groups of lots

Solution:

Lot No. of Price per lot Total price per Allocation Allocated
group lots lot group costs
a b c=axb
A 4 400,000 1,600,000 1.2M x (1.6/6) 320,000
B 10 200,000 2,000,000 1.2M x (2/6) 400,000
C 15 160,000 2,400,000 1.2M x (2.4/6) 480,000
6,000,000 1,200,000

Cost formulas

One of the major objectives of inventory accounting is the determination of costs of

inventories recognized as expense when the related revenues are recognized. This is important
for the proper determination of periodic income. Proper determination of such costs may be
obtained by selecting an appropriate cost formula from the following:

1. Specific identification - this shall be used for inventories that are not ordinarily
interchangeable (i.e ., those that are individually unique) and those that are segregated for
specific projects.

Under this formula, specific costs are attributed to identified items of inventory.
Accordingly, cost of sales represents the actual costs of the specific items sold while ending
inventory represents the actual costs of the specific items on hand.
 For example, if an inventory with a serial number of "ABC-123" costing P10,948.67 is sold,
the amount charged to cost of sales is also P10,948.67. If that inventory remains unsold, the
amount included in ending inventory is also P10,948.67.

In this regard, records should be maintained that enables the entity to identify the cost and
the movement of each specific inventory.

Specific identification, however, is not appropriate when inventories consist of large

number of items that are ordinarily interchangeable. In such cases, the entity shall choose
between formulas 2 and 3 below.

2. First-In, First-Out (FIFO) - Under this formula, it is assumed that inventories that were
purchased or produced first are sold first, and therefore unsold inventories at the end of
the period are those most recently purchased or produced.

Accordingly, cost of sales represents costs from earlier purchases while the cost of ending
inventory represents costs from the most recent purchases.

3. Weighted Average - Under this formula, cost of sales and ending inventory are determined
based on the weighted average cost of beginning inventory and all inventories purchased
or produced during the period. The average may be calculated on a periodic basis or as
each additional purchase is made, depending upon the circumstances of the entity.

The cost formulas refer to "cost flow assumptions," meaning they pertain to the flow of costs
(i.e ., from inventory to cost of sales) and not necessarily to the actual physical flow of
inventories. Thus, the FIFO or Weighted Average can be used regardless of which item of
inventory is physically sold first.

Same cost formula shall be used for all inventories with similar nature and use. Different cost
formulas may be used for inventories with different nature or use. However, a difference in
geographical location of inventories, by itself, is not sufficient to justify the use of different cost
formulas. (PAS 2.26)

PAS 2 does not permit the use of a last-in, first out (LIFO) cost formula. Illustration 1: Cost
formulas ABC Co. is a wholesaler of guitar picks. The activity for product "Pick X" during August
is shown below:
.
Date Transaction Units Unit cost Total Cost
Aug. 1 Beg. Inventory 2,000 P 36.00 P 72,000
7 Purchase 3,000 37.20 111,600
12 Sales 4,200
13 Sales return 600
21 Purchase 4,800 38.00 182,400
22 Sales 3,800
29 Purchase 1,900 38.60 73,340
30 Purchase return 300 38.60 (11,580)
Total goods available for sale P427,760

Requirements:
Compute for (a) ending inventory and (b) cost of goods sold under the following cost
formulas:
1. FIFO – periodic
2. FIFO – perpetual
3. Weighted average - periodic
4. Weighted average - perpetual

Solutions:

1. FIFO – Periodic

Beginning inventory in units 2,000

Net purchases in units (3,000 + 4,800 + 1,900 – 300) 9,400
Total goods available for sale in units 11,400
Quantity of goods sold (4,200 – 600 + 3,800) (7,400)
Ending inventory in units 4,000

Using the concept that the cost of ending inventory under FIFO is from the cost of the most
recent purchase, the ending inventory in units is allocated as follows:

Units Unit cost Total cost

Ending inventory to be allocated 4,000
Allocated as follows:
From August 29 net purchases (1,900 -300) (1,600) P38.60 P61,760.00
Balance to be allocated to the next most recent 2,400
purchase date
From August 21 purchase (2,400) 38.00 91,200.00
P152,960.00

Cost of goods sold is then computed as follows:

Total goods available for sale in pesos (given) 427,760
Ending inventory at cost (152,960)
Cost of goods sold 274,800

2. FIFO – Perpetual

Units Unit Total cost

Date Transactions
cost
Aug 1 Ending inventory to be allocated 2,000 P36.00 P72,000
7 Purchase 3,000 37.20 111,600
Moving average unit cost 5,000 36.72 183,600
12 Net sales (4,200) 36.72 (154,224)
Sales return 600 36.72 22,032
21 Purchase 4,800 38.00 182,400
Moving average unit cost 6,200 37.71 233,808
22 Sales (3,800) 37.71 (143,298)
29 Purchase 1,900 38.60 73,340
30 Purchase returns (300) 38.60 11,580
Ending inventory 4,000 P 152,270

The cost of goods sold is derived from the table above as follows:
(72,000 + 59,520 + 52,080 + 91,200) = P274,800
3. Weighted average – periodic

The weighted average unit cost is computed as follows:

Weighted Total goods available for sale (TGAS) in pesos

=
Average Cost Total goods available for sale (TGAS) in units

Weighted Average Unit Cost = (P427,760 ÷ 11,400) = P37.52

Ending inventory at cost is computed as follows::

Ending inventory in units 4,000
Multiply by: Weighted average unit cost 37.52
Ending inventory at cost 150,080

Cost of goods sold is then computed as follows:

Total goods available for sale in pesos (given) 427,760
Ending inventory at cost (150,080)
Cost of goods sold 277,680

4. Weighted average – perpetual (Moving average)

Date Transactions Units Unit Total cost

cost
Aug 1 Ending inventory to be allocated 2,000 P36.00 P72,000
7 Purchase 3,000 37.20 111,600
12 Net sales (4,200 – 600) 3,600
Allocation:
From Beg. Inventory (2,000) 36.00 P72,000
From Aug. 7 Purchases (1,600) 37.20 (59,520)
21 Purchases 4,800 38.00 182,400
22 Sales 3,800
Allocation:
From Aug 7 purchase balance (1,400) 37.20 (52,080)
From Aug 21 purchase (2,400) 38.00 (91,200)
29 Net purchases (1,900 – 300) 1,600 38.60 61.760
Ending inventory P 152,960

Cost of goods sold is then computed as follows:

Total goods available for sale in pesos (given) 427,760
Ending inventory at cost (152,270)
Cost of goods sold 275,490

Net realizable value (NRV)

Inventories are measured at the lower of cost and net realizable value.

Net realizable value is "the estimated selling price in the ordinary course of business less the
estimated costs of completion and the estimated costs necessary to make the sale." (PAS 2.6)

NRV is different from fair value. "Net realizable value refers to the net amount that an entity
expects to realize from the sale of inventory in the ordinary course of business. Fair value
reflects the price at which an orderly transaction to sell the same inventory in the principal (or
most advantageous) market for that inventory would take place between market participants
at the measurement date. The former is an entity-specific value; the latter is not. Net realizable
value for inventories may not equal fair value less costs to sell." (PAS 2.7)

Measuring inventories at the lower of cost and NRV is in line with the basic accounting
concept that an asset shall not be carried at an amount that exceeds its recoverable amount.

The cost of an inventory may exceed its recoverable amount if, for example, the inventory is
damaged, becomes obsolete, prices have declined, or the estimated costs to complete or to
sell the inventory have increased. In these circumstances, the cost of the inventory is written-
down to NRV. The amount of write-down is recognized as expense.

Write-down of inventory

Write-downs of inventories are usually carried out on an item by item basis, although in some
circumstances, it may be appropriate to group similar items. It is not appropriate to write down
inventories on the basis of their classification (e.g ., finished goods or all inventories of an
operating segment).

If the cost of an inventory exceeds its NRV, the inventory is written down to NRV, the lower
amount. The excess of cost over NRV represents the amount of write-down. If the cost of an
inventory is lower than its NRV, no write-down is necessary

Write-downs of inventories are normally charged to cost of goods sold. However, material
write-downs and those that arise from abnormal losses, such as theft, obsolescence, and
casualties, are charged to loss.

Illustration:

ABC Co. buys and sells products A & B. The following unit costs are available for the inventory
as of December 31, 2020: (All costs are borne by ABC Co.)

Product A Product B
Number of units 2,000 3,000
Purchase cost per unit P100 P200
Delivery cost from supplier 20 30
Estimated selling price 150 250
Selling costs 22 40
General and administrative 15 18

Requirements:

a. Determine the amount of write-down. Provide the adjusting entry.

b. Compute for the valuation of the inventories in ABC’s December 31, 2020 statement of
financial position.

Solutions:

Requirement a

Product A Product B
Cost 120 230
NRV 128 210
Lower 120 210
Cost of goods sold (210 – 230) x 3,000 units 60,000
Inventory or Allowance for inventory write-down 60,000

Requirement b:

Product A Product B
Lower of Cost and NRV 120 210
Multiply by number of units 2,000 3,000
Inventory, December 31, 2020 240,000 630,000

Write-down of raw materials

Raw materials inventory is not written down below cost if the finished goods in which they will
be incorporated are expected to be sold at or above cost. If, however, this is not the case, the
raw materials are written down to their NRV. The best evidence of NRV for raw materials is
replacement cost.

Illustration:

Information on Entity A's inventories is as follows:

Raw materials Finished goods

Cost 60,000 100,000
Replacement cost/NRV 50,000 120,000

Requirement: Compute for the valuation of the inventories in Entity A's statement of financial
position.

Answer: P160,000 total cost (60,000 + 100,000). The raw materials need not be written-down to
replacement cost because the NRV of the finished goods exceeds the cost.

Reversal of write-downs

If the NRV subsequently increases, the previous write-down is reversed. However, the amount
of reversal shall not exceed the original write-down. This is so that so that the new carrying
amount is the lower of the cost and the revised NRV.

Illustration:

ABC Co. has the following comparative information regarding its inventories:

2021 2020
Inventory, December 31 at Cost 300,000 240,000
Inventory, December 31 at NRV 330,000 220,000
Cost of goods sold before adjustment 1,800,000 2,000,000

Requirements:

a. Provide journal entries in 2020 and 2021

b. Compute for the (a) adjusted ending inventories and (b) cost of goods sold as of December
31, 2020 and 2021. Assume that all write downs are considered normal.
Solutions:

Requirement a

The entry to record the write-down on December 31, 2020 is as follows:

Cost of goods sold (240k – 220k) 20,000

Inventory or Allowance for inventory write-down 20,000

The entry to record the write-down on December 31, 2021 is as follows:

Inventory 20,000
Cost of goods sold 20,000

Notice that although the NRV in 2021 exceeds the cost by P30,000 (330,000 - 300,000), the
amount of reversal recognized is P20,000. This is because the amount of reversal should not
exceed the amount of write-down previously recognized.

Requirement b:

The adjusted inventories on December 31, 2020 and 2021 are computed as follows:

2020 2021
Cost 240,000 300,000
(Write-down)/ Reversal (20,000) 20,000
Adjusted ending inventories 220,000 320,000

The adjusted costs of goods sold on December 31, 2020 and 2021 are computed as follows:

2020 2021
Unadjusted cost of goods sold 2,000,000 1,800,000
(Write-down)/ Reversal 20,000 (20,000)
Adjusted cost of goods sold 2,020,000 1,780,000

Variation: Material/Abnormal write-down

If the write-down is considered material or have resulted from abnormal loss, the amount
written-off would be charged as loss. Consequently, the reversal is recognized as gain. The
journal entries would be as follows:

Dec 31 2020 Impairment loss (240K-220K) 20,000

Inventory 20,000

Dec 31 2021 Inventory 20,000

Gain 20,000

Purchase commitments

A firm purchase commitment is "an agreement with an unrelated party, binding on both
parties and usually legally enforceable, that

a. specifies all significant terms, including the price and timing of the transactions, and
b. includes a disincentive for non-performance that is sufficiently large to make
performance highly probable." (PFRS 5.Appdx.)
A contracting party under a firm purchase commitment cannot cancel the contract without
suffering penalty. Thus, the buyer has to accept future delivery even if the goods promised to
be purchased become impaired (price decrease). In such case, the buyer recognizes loss on
purchase commitment.

When prices subsequently increase, the buyer recognizes gain on purchase commitment.
However, the gain should not exceed the loss on purchase commitment previously recognized.

Illustration: Purchase commitment

On January 1, 2020, ABC Co. signed a three year, non-cancelable purchase contract, which
allows ABC Co. to purchase up to 60,000 units of a microchip annually from XYZ Co. at P25 per
unit and guarantees a minimum annual purchase of 15,000 units. At year-end, it was found out
that the goods are obsolete. ABC Co. had 10,000 units of this inventory at December 31, 2020,
and believes these parts can be sold as scrap for P5 per unit.

Requirement: Compute for the loss on purchase commitment to be recognized on December

31, 2020.

Solution: The loss on purchase commitment is computed as follows:

Guaranteed minimum annual purchases 15,000

Multiply by: Remaining years in the contract (2021 and 2022) 2
Total goods to be accepted in the future 30,000
Multiply by: Purchase price per unit less salvage value 20
Loss on purchase commitment 600,000

Dec 31 2020 Loss on purchase commitment 600,000

Estimated liability on purchase commitment 600,000

Loss on purchase commitment is recognized only on guaranteed future purchases.

Consequently, “Impairment loss” and no “Loss on purchase commitment” is recognized on the
10,000 units on hand on December 31 2020. The entry is provided below:

Dec 31 2021 Impairment loss (10,000 x (25 -5) 200,000

Inventory 200,000