CODE: AC438 [FINANCIAL ACCOUNTING AND REPORTING] FAR-005LN (22-23)

INVENTORIES
Nature of Inventories
 Held for sale in the ordinary course of business
 In the process of production for such sale, or
 In the form of materials and supplies to be consumed in the production process or in the
rendering of services

Initial Measurement:
Cost inclusions
 Purchase price (net of trade discounts and rebates)
 Import duties
 Non-refundable purchase taxes
 Transport and handling costs
 Conversion costa
 Other directly attributable cost

Cost exclusions
 Abnormal amount of wasted materials, labor or other production costs
 Selling cost
 Administrative overheads
 Storage costs

Goods in transit - goods already shipped by the seller but have not yet arrived but have not yet arrived
at the point of destination

 FOB Shipping point – ownership of goods is transferred to the buyer upon shipment of goods
 FOB Destination – ownership of the goods in transit , the freight charges shall be shouldered by
the seller

Payment terms
 Freight Collect – buyer paid the freight
 Freight Prepaid – seller paid for the freight

Maritime Shipping Terms:

 Free Along Side (FAS) – buyer shoulders the freight charges, and the ownership of the goods is
transferred to the buyer upon possession of the shipping carrier.
 Cost, Insurance and Freight – same as FOB shipping point; buyer shoulders all the freight
charges.
 Ex-ship – seller is responsible for the freight costs and risks of loss until the goods are unloaded
at the point of destination; same as FOB destination point.

Consigned Goods
 Included in the consignor’s inventory as goods out on consignment
 Goods held on consignment shall be excluded from the inventory of the consignee

Consignment – method in which the consignor transfers the physical possession of goods to the
consignee who sells them on the consignor’s behalf (does not involve transfer of ownership).

Goods in the hand of an agent – similar to consigned goods, the goods in the hand of an agent shall be
included in the inventory of the principal (seller).

Goods held by the customer for approval or trial – ownership of these goods remains with the seller
even if the physical possession of the goods is with the customer

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Bill and hold arrangement – a contract 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.

 Excluded from seller’s inventory and included in the buyer’s inventory upon billing
provided:
 The reason for the arrangement is substantive
 Goods are identified separately as belonging to the customer and are available
for immediate transfer
 Seller cannot use the goods or sell them to another customer

Segregated goods - these goods reserved for a specific customer

 Special order goods – manufactured according to customer specifications shall be considered
sold when completed, even if it is still in the possession of the seller
 Customarily manufactured goods – goods customarily manufactured and constitute stock items of
the entity even if physically segregated, are still included in the inventory of the seller until
delivered to the customer

Installment sales – goods sold on instalment basis are included in the inventory of the buyer despite the
retention of the title by the seller until fully paid

Goods sold with buyback arrangement – owner of the goods sells the inventory to another party and
agrees to repurchase the goods at specific price (product financing agreement; inventory is used as
collateral). Goods sold under this case is include in the inventory of the transferor

Goods sold with refund offers – buyers are given trhe right to rescind the purchase of goods for a
reason specified in the sales contract. goods sold with refund orders shall be excluded from the inventory
of the seller.

Goods under layaway sale – ownership of the goods will not be transferred to the buyer unless the price
is fully paid.

Consideration Inclusion Exclusion

Goods in transit
Consigned goods
Goods in the hand of an agent
Goods held by the customer
for approval or trial
Bill and hold arrangement
Segregated goods
Installment sales
Goods sold with buyback
arrangement
Goods sold with refund offers
Goods under layaway sale
Goods in transit and purchased
FOB shipping point
Goods in transit and sold FOB
destination
Goods out on consignment
Goods owned and on hand
(excluding goods held on
consignment)
Goods in the hand of an agent
Goods held by the customer for
approval or trial
Goods purchased under bill and
hold arrangement
Segregated customarily
manufactured goods
Goods purchased under
installment basis
Goods sold with buyback
arrangement
Goods purchased with refund
offers
Goods sold under layaway
arrangement
Goods in transit and sold FOB
shipping point
Goods in transit and purchased
FOB destination
Goods held on consignment
Goods sold under bill and hold
arrangement
Special order goods produced
Goods sold under instalment
basis
Goods purchased with buyback
arrangement
Goods sold with refund offers
Goods purchased under layaway
arrangement

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Inventory systems
 Periodic Inventory system – entity does not maintain records that show the running balances of
the inventory on hand and cost of goods sold at any given point in time. It is used for products
with low prices but in large quantities. Hence, a physical count is required to determine the year-
end inventory balance.
 Perpetual Inventory system – records called “stock cards” are maintained from which the
quantities and balances of goods on hand and goods sold can be determined at any given point
in time without the need of performing physical count.

Inventory Cost Formulas

Items are not Specific

interchangeable Identification

Cost
Formulas First in, First out
Periodic System Weighted Average
Method

Items are
interchangeable

Average Method Perpetual System Moving Average

 Specific Identification Method – specific cost are assigned to identified items in the inventory. It
is used for inventories that are not ordinarily interchangeable.
 First-in, First-out (FIFO Method) – assumes 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
 Average Method – cost of each item is determined from the weighted average of the cost of
similar items at the beginning of a period and the cost of similar items purchased or produced
during the period.
o Average Method (Periodic) – weighted average method
COGAS / No of units available for sale = Weighted average unit cost
o Average Method (Perpetual) – moving average method. A new average unit cost is
computed every after purchase

Subsequent measurement of Inventories – inventories shall be measured at lower of cost and net
realizable value (LCNRV)

Computation:
Estimated selling price xx
Less: Estimated cost of disposal (xx)
Less: Estimated cost to complete (xx)
Net Realizable Value of Inventory xx

**Inventories are usually written down to net realizable value on an item-by-item basis.

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Accounting for inventory write-down:

 Direct Method – inventory account will be debited equal to the LCNRV, therefore the loss on
inventory write-down will already be included as part of the cost of goods sold
 Allowance Method – inventory write-down shall be recorded separately in a “loss” account.

Reversal of inventory write-down

 Occurs when the value of inventory subsequently increases after a write-down
 Allowed to be recognized but only to extent of the allowance for inventory write-down balance.
 Treated as deduction from the cost of goods sold

Net Realizable Value of Raw Materials – shall not be written down below cost if finished goods in which
they will be incorporated are expected to be sold at or above cost. However, when a decline in the price
of materials indicates that the cost of the finished goods exceeds the net realizable value, the materials
are written down to net realizable value.

Purchase Commitments - entity’s commitment to purchase goods or services at some future date at a
fixed price.
 Cancellable purchase commitment - entity can simply cancel the contract (or agreement) when
the circumstances become unfavorable on its part.
 No provision is required when the price of product falls below the contract (or agreed
price).
 Disclose only when the amount is material; future loss is possible; and amount of the
commitment can be reasonably estimated
 Non-cancellable purchase commitment – entity is obligated to perform under the contract even
if the circumstances are unfavourable on its part.
 When the price of the product falls below the contract (or agreed) price, a loss on
purchase commitment can be recognized.
 If the market price recovers after the fall in price below the contract price, gain or reversal
of loss on purchase commitment will be recognized only to the extent of the loss
previously recognized.

Inventory Method Estimation – when physical count is impossible to perform due to some
circumstances and inventory information is needed. Estimation of inventory is made for the following:
 Interim financial statements are prepared
 Physical inventory count is made and necessary to prove the correctness or reasonableness of
such count
 Inventory is destroyed by fire or other catastrophes, or theft has occurred, and the amount is
required for insurance purposes.

 Gross Profit Method – assumes that the gross profit remains approximately the same from
period to period
o Gross Profit based on Sales
Estimated amount of cost of goods sold = Net sales x Cost Ratio
o Gross Profit based on Cost
Estimated amount of cost of goods sold = Net sales / 100% + Gross profit rate on cost

Estimated Cost of Inventory > Actual inventory = Inventory Shortage

Estimated Cost of Inventory < Actual inventory = Inventory Overage

 Retail Inventory Method – used in the retail industry for measuring large quantities of
inventories rapidly changing items and similar margins and for which it is impracticable to use
other costing methods
o Initial markup – original markup on the cost of goods
o Original retail – sales price at which the goods are first offered for sale
o Additional markup – increase in sales price above the original retail price

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o Markup cancellation - decrease in sales price that does not decrease the sales price
below the original retail price
o Net markup – markup less markup cancellation
o Markdown – decrease in sales price below the original retail price
o Markdown cancellation – increase in sales price that does not increase the sales price
above the original retail price
o Net markdown – markdown less markdown cancellation

Computation of COGAS:
Cost Retail
Inventory, beginning xx xx
Purchases xx xx
Purchase returns (xx) (xx)
Purchase discounts (xx)
Purchase allowance (xx)
Freight-in xx
Markups xx
Markup cancellation (xx)
Departmental transfer-in xx xx
Departmental transfer-out (xx) (xx)
Abnormal loss (xx) (xx)
Markdown (xx)
Markdown cancellations _ xx__
Goods Available for Sale xx xx__

Computation of COGS at retail:

Sales xx
Sales Return (xx)
Sales allowances -
Sales discounts -
Employee discounts xx
Normal loss xx_
Cost of Goods Sold (retail) xx (Net sales)

Computation of estimated ending inventory at retail

Goods available for sale at retail xx
Less: Cost of goods sold at retai l (xx)
Estimated Ending Inventory (retail) xx

Computation of estimated cost of ending inventory

Estimated ending inventory at retail xx
Multiplied (X): Cost-to-Retail Ratio %
Estimated Cost of Ending Inventory xx

Methods in Computing Cost-to-Retail Ratio

 Average Method – considers both price markups and price markdowns

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 FIFO Method – excludes the beginning inventory

 Conservative Method – Considers markups but not markdowns

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