Inventories (PAS 2)

Definition
Inventories are assets which are held for sale in the ordinary course of business, in the process of production for such sale
or in the form of materials or supplies to be consumed in the production process or in the rendering of services.

Inventories encompass goods purchased and held for resale, for example:
a. Merchandise purchased by a retailer and held for resale
b. Land and other property held for resale by a subdivision entity and real estate developer

Inventories also encompass finished goods produced, goods in process and materials and supplies awaiting use in the
production process.

Classes of Inventories
- Inventories are broadly classified into two, namely inventories of a trading concern and inventories of manufacturing
concern.
- A trading concern is one that buys and sells goods in the same form purchased.
- The term “merchandising inventory” is generally applied to goods held by a trading concern.
- A manufacturing concern is one that buys goods which are altered or converted into another form before they are made
available for sale.
- The inventories of a manufacturing concern are:
a. Finished goods
b. Goods in process
c. Raw materials
d. Factory or manufacturing supplies

Definitions
1. Finished goods are completed products which are ready for sale. Finished goods have been assigned their full share of
manufacturing costs.

2. Goods in process or work in process are partially completed products which require further process or work before
they can be sold.

3. Raw materials are goods that are to be used in the production process. No work or process has been done on them as
yet by the entity inventorying them.

Broadly, raw materials cover all materials used in the manufacturing operations. However, frequently raw materials are
restricted to materials that will be physically incorporated in the production of other goods and which can be traced
directly to the end product of the production process.

4. Factory or manufacturing supplies are similar to raw materials but their relationship to the end product is indirect.
Factory or manufacturing supplies may be referred to as indirect materials. It is indirect because they are not physically
incorporated in the products being manufactured.

There are other manufacturing supplies like paint and nails which become part of the finished product. However, since the
amounts involved are insignificant, it is impractical to attempt to allocate their costs directly to the product. These
supplies find their way into the product cost as part of the manufacturing overhead.

Goods Includible in the Inventory

- As a rule, all goods to which the entity has title shall be included in the inventory, regardless of location.
- The phrase “passing of title” is a legal language which means “the point of time at which ownership changes”

Legal Test
- Is the entity the owner of the goods to be inventoried?
- If the answer is in the affirmative, the goods shall be included in the inventory.
- If the answer is in the negative, the goods shall be excluded in the inventory.
- Applying the legal test, the following items are included in inventory:
a. Goods owned and on hand
b. Goods in transit and sold FOB destination
c. Goods in transit and purchased FOB shipping point
d. Goods out on consignment
e. Goods in the hands of salesman or agents
f. Goods held by customers on approval or on trial

Exception to the Legal Test

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

Who is the owner of goods in transit?

- This will depend on the terms, whether FOB destination or FOB shipping point. FOB means free on board.
- Under FOB destination, ownership of goods purchased is transferred only upon receipt of the goods by the buyer at
the point of destination. Thus, under FOB destination, the goods in transit are still the property of the seller.
Accordingly, the seller shall legally be responsible for freight charges and other expenses up to the point of destination.
- On the other hand, if the term is FOB shipping point, ownership is transferred upon shipment of the goods and
therefore, the goods in transit is the property of the buyer. Accordingly, the buyer shall legally be responsible for
freight charges and other expenses from the point of shipment to the point of destination.
- In practice, during an accounting period, the accountant normally records purchases when goods are received and sales
when goods are shipped, regardless of the precise moment at which title passed.
- This procedure is expedient and no material misstatements occur in the financial statements because title usually passes
in the same accounting period.
- However, the accountant should carefully analyze the invoice terms of goods that are in transit at the end of the
accounting period to determine who has legal title.
- Accordingly, adjustments are in order if errors are committed in recording purchases and sales.

FOB Destination
FOB Shipping Point
Who owns the goods in transit? Who must pay the freight charge?
Seller Seller
Treated as Freight Out / Expense
Buyer Buyer
Treated as Freight In / Inventory

Who actually paid the freight charge?

Freight Collect Buyer
Freight Prepaid Seller

Freight Terms

Freight Collect – This means that the freight charge on the goods shipped is not yet paid. The common carrier shall
collect the same from the buyer. Thus, under this, the freight charge is actually paid by the buyer.

Freight Prepaid – This means that the freight charge on the goods shipped is already paid by the seller.

The terms “FOB destination” and “FOB shipping point” determine ownership of the goods in transit and the party who
is supposed to pay the freight charge and other expenses from the point of shipment to the point of destination.

The terms “freight collect” and “freight prepaid” determine the party who actually paid the freight charge but not the
party who is supposed to legally pay the freight charge.

Maritime Shipping Terms

1. FAS or free alongside – A seller bears all the expenses and risk involved in delivering the goods until the dock next
to or alongside of the vessel on which the goods are to be shipped. The buyer bears the cost of loading and shipment;
title passes to the buyer when the carrier takes possession of the goods.

2. CIF or Cost, Insurance and Freight – Under this shipping contract, the buyer agrees to pay in a lump sum the cost
of the goods, insurance cost and freight charge. The shipping contract may be modified as CF which means that the buyer
agrees to pay in a lump sum the cost of the goods and freight charge only. In either case, the seller must pay for the cost
of loading. Thus, title and risk of loss shall pass to the buyer upon delivery of the goods to the carrier.
3. Ex-Ship – A seller who delivers the goods ex-ship bears all expenses and risk of loss until the goods are unloaded
at which time title and risk of loss shall pass to the buyer.

FOB Seller - free on board up to the place of seller; also classified as FOB shipping point

FOB Origin - free on board to the place of origin (or place of seller); also classified as FOB shipping point

FOB Buyer - free on board to the place of buyer; also classified as FOB Destination

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

Bill and Hold Arrangement

- A bill and hold arrangement is a contract of sale under which an entity bills a customer for a product but the entity
retains physical possession of the product until it is transferred to the customer at a point in time in the future.
- The goods sold under a bill and hold sale is excluded from the seller’s inventory and included in the buyer’s
inventory at the time of sale when title passes to the buyer and he accepts billing provided:
a. The reason for the bill and hold arrangement must be substantive (for example, the customer has requested the
arrangement)
b. The product must be identified separately as belonging to the customer
c. The product currently must be ready for physical transfer to the customer
d. The entity cannot have the ability to use the product or to direct it 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 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.

Goods shipped subject to Installation and Inspection

- Revenue is normally recognized when the buyer accepts delivery, and installation and inspection are complete.
However, revenue is recognized immediately upon the buyer’s acceptance of delivery when:
a. The installation process is simple in nature
b. The inspection is performed only for purposes of final determination of contract price

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

Accounting for Inventories

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

Journal Entries

Transaction Periodic System Perpetual System

1. Purchase of merchandise Purchases xx Merchandise Inventory xx
on account Accounts Payable xx Accounts Payable xx

2. Payment of freight Freight In xx Merchandise Inventory xx

on the purchase Cash xx Cash xx

3. Return of merchandise Accounts Payable xx Accounts Payable xx

purchased to supplier Purchase Return xx Merchandise Inventory xx

4. Sales of merchandise Accounts Receivable xx Accounts Receivable xx

on account Sales xx Sales xx
Cost of Goods Sold xx
Merchandise Inventory xx

5. Return of merchandise Sales Return xx Sales Return xx

sold from customer Accounts Receivable xx Accounts Receivable xx
Merchandise Inventory xx
Cost of Goods Sold xx

6. Adjustment of Merchandise Inventory - end xx

ending inventory Income Summary xx No entry

Inventory Shortage or Overage

- If at the end of the accounting period, a physical count indicates a different amount, an adjustment is necessary to
recognize any inventory shortage or overage.
- The inventory shortage is usually closed to cost of goods sold because this is often the result of normal shrinkage
and breakage in inventory.
- However, abnormal and material shortage shall be separately classified and presented as other expense.

Trade Discounts and Cash Discounts

1. Trade discounts are deductions from the list or catalog price in order to arrive at the invoice price which is the amount
actually charged to the buyer. Thus, trade discounts are not recorded.

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

2. Cash discounts are deductions from the invoice price when payment is made within the discount period. The purpose
of cash discounts is to encourage prompt payment. Cash discounts are recorded as purchase discount by the buyer and
sales discount by the seller.

Purchase discount is deducted from purchases to arrive at net purchases and sales discount is deducted from sales to arrive
at net sales revenue.

Format of Computation:
List Price xx
Less: Trade Discount (xx) (This may have 2 trade discount rates)
Invoice Price xx
Less: Cash Discount (xx)
Receivable or Payable xx
Methods of Recording Purchases
1. Gross Method – Purchases and accounts payable are recorded at gross amount.
2. Net Method – Purchases and accounts payable are recorded at net amount.

Journal Entries

Transaction Gross Method Net Method

1. Purchases on account Purchases - Gross xx Purchases - Net xx
Accounts Payable xx Accounts Payable xx

2. Payment is within Accounts Payable xx Accounts Payable xx

the discount period Cash xx Cash xx
Purchase Discount xx

3. Payment is beyond Accounts Payable xx Accounts Payable xx

the discount period Cash xx Purchase discount lost xx
Cash xx

4. If at the end of the No Entry Purchase discount lost xx

accounting period and no Accounts Payable xx
payment is made and
discount period expired

Gross Method vs. Net Method

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

Cost of Inventories
The cost of inventories shall comprise:
a. Cost of Purchase
b. Cost of Conversion
c. Other cost incurred in bringing the inventories to their present location and condition

Cost of Purchase
- The cost of purchase comprises the purchase price, import duties and irrecoverable taxes, freight, handling and other
costs directly attributable to the acquisition of finished goods, materials and services.
- Trade discounts, rebates and other similar items are deducted in determining the cost of purchase.
- The cost of purchase shall not include foreign exchange differences which arise directly from the recent acquisition of
inventories involving a foreign currency.
- Moreover, when inventories are purchased with deferred settlement terms, the difference between the purchase price
for normal credit terms and the amount paid is recognized as interest expense over the period of financing.

Cost of Conversion (DL + FOH)

- The cost of conversion of inventories includes cost directly related to the units of production such as direct labor.
- It also includes a systematic allocation of fixed and variable production overhead that is incurred in converting
materials into finished goods.
- Fixed production overhead is the indirect cost of production that remains relatively constant regardless of the volume of
production.
- Examples are depreciation and maintenance of factory building and equipment, and the cost of factory management and
administration.
- Variable production overhead is the indirect cost of production that varies directly with the volume of production.
- Examples are indirect labor and indirect materials.
Allocation of Fixed Production Overhead
- The allocation of fixed production overhead to the cost of conversion is based on the normal capacity of the
production facilities.
- Normal capacity is the production expected to be achieved on average over a number of periods or seasons under normal
circumstances taking into account the loss of capacity resulting from planned maintenance.
- The amount of fixed overhead allocated to each unit of production is not increased as consequence of low production or
idle plant.
- Unallocated fixed overhead is recognized as expense in the period in which it is incurred.

Allocation of Variable Production Overhead

- Variable production overhead is allocated to each unit of production on the basis of the actual use of the production
facilities.
- A production process may result in more than one product being produced simultaneously.
- This is the case, for example, when joint products are produced or where there is a main product and a by-product.
- When the costs of conversion are not separately identifiable, they are allocated between the products on a rational and
consistent basis, for example, on the basis of the relative sales value of each product.
- Most by-products by their nature are not material.
- By-products are measured at net realizable value and this value is deducted from the cost of the main product.

Other Cost
- Other cost is included in the cost of inventories only to the extent that it is incurred in bringing the inventories to their
present location and condition.
- For example, it may be appropriate to include the cost of designing product for specific customers in the cost of
inventories.
- However, the following costs are excluded from the cost of inventories and recognized as expenses in the period when
incurred:
a. Abnormal amounts of wasted materials, labor and other production costs.
b. Storage costs, unless these costs are necessary in the production process prior to a further production stage. Thus,
storage costs on goods in process are capitalized but storage costs on finished goods are expensed.
c. Administrative overheads that do not contribute to bringing inventories to their present location and condition
d. Distribution or selling costs

Cost of Inventories of a Service Provider (Work in Progress)

- The cost of inventories of a service provider consists primarily of the labor and other costs of personnel directly engaged
in providing the service, including supervisory personnel and attributable overhead.
- Labor and other costs relating to sales and general administrative personnel are not included but are recognized as
expenses in the period in which they incurred.