INTERMEDIATE ACCOUNTING 1

Inventories

Inventories  are assets held for sale in the ordinary course of business, in
the process of production for such sale or in the form of materials or supplies
to be consumed in the production process or in rendering of services.
A. Trading  Merchandise Inventory
B. Manufacturing:
a. Finished Goods
b. Goods in process
c. Raw Materials
d. Factory or Manufacturing Supplies
C. Service  labor and other costs of personnel directly engaged in
providing the service.

Goods includible in the 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 hand of salesmen or agents
F. Goods held by customers on approval or on trial

Measurement:
o Initial  Cost
o Subsequent  LCNRV (Lower of Cost and Net Realizable Value)

Cost of Inventories (Initial Measurement):

A. Cost of Purchase
 Purchase Price (+)
 Import Duties (+)
 Irrecoverable Taxes (+)
 Freight Cost (+)
 Handling Cost (+)
 Other Directly Attributable Costs (+) – Directly related to purchase
 Trade Discounts (-)
 Rebates (-) – the same as discounts but it has necessary criteria to
avail
 Ignored or if included, deducted:
1. Foreign Exchange Differences
2. Interest Expense over the financing period

B. Cost of Conversion
 Direct Labor (+)
 Overhead (+)
o Factory Expenses
o Indirect Materials
o Indirect Labor
a. Fixed Overhead  constant overtime irrespective of the
production
b. Variable Overhead  move along the level of production

C. Other cost incurred in bringing the inventories to their present location

and condition.
 Sample: Cost incurred due to customer’s specification
 Excluded:
 a. Abnormal Wastages – wastes not necessarily normal in the
production
b. Storage Cost  Finished Goods
o Storage Costs for DM and WIP are INCLUDED
o Storage Costs for Finished Goods are EXCLUDED
c. Administrative Expenses
d. Distribution/ Selling Expenses

Notes:

 Invoice doesn’t matter. What matters is if the goods are in the

company or not.
 Who owns the goods will pay the freight. Therefore, terms are
important in determining the goods that must be included in the
inventory.
 It is presumed that the company owns the goods in the shipping
department if the problem is silent.
 Cash discounts are deducted whether taken or not.

LCNRV (Subsequent Measurement)

o Subsequent Measurement of Inventories  LCNRV on item-by-item
basis.
o LCNRV  Lower of COST and NET REALIZABLE VALUE
o Net Realizable Value  is the estimated selling price in the ordinary
course of business less estimated cost of completion and the estimated
cost of disposal.
NRV = SP – Cost to complete – Cost to Sell
o Reasons as to why NRV < Cost:
1. Inventories are damaged
2. Inventories have become wholly or partially obsolete
3. The selling price have declined
4. Estimated Cost of completion/ cost of disposal has increased

o Rule:
Cost > NRV  WITH inventory write-down
Cost < NRV  NO inventory write-down

o Accounting Method:
1. Direct Method (COGS Method)
Inventory, end xxx
Income Summary xxx
Presentation:
Inventory, beg xxx
Net Purchases xxx
TGAS xxx
Inventory, end (xxx)
COGS xxx

2. Allowance Method
Loss on Inventory Write-down xxx
Allow. On Inv Write-down xxx

Presentation:
Inventory, beg xxx
Net Purchases xxx
TGAS xxx
Inventory, end (xxx)
COGS, before inv. write-down xxx
 Loss on Inventory write-down xxx (Deducted if GAIN)
COGS, after xxx

If Reversal happens,
Allowance on Inv. Write-down xxx
Gain on Reversal xx

Trade and Cash Discounts

o Trade Discounts  are deductions from the list/catalog price in order
to arrive at the invoice price which is the price actually charged to the
buyer. Its purpose is to encourage trading or increase sales.
o Cash Discounts  are deductions from the invoice price when the
payment is made within the discount period. Its purpose is to
encourage prompt payment.

Returns and Allowances

o Buyers may be dissatisfied with the merchandise received either
because the goods are damaged or defective, of inferior quality or not
in accordance with their specification.
o Returns  decrease the amount AND physical volume of the goods
sold
o Allowances  decrease the amount but NOT the physical volume of
the goods sold
o Credit Memorandum  formal acknowledgement that the seller has
reduced the amount owed by the customer.

Goods in Transit
o FOB  Free on Board
o FOB Shipping Point  ownership is transferred upon shipment of the
goods
o FOB Destination  ownership is transferred only upon the receipts of
goods by the buyer
o Freight Prepaid  freight is actually paid before shipment
o Freight Collect  freight charge on the goods shipped is not yet paid
o FAS/Free Alongside  transfers ownership when the goods are
alongside the carrier
o CIF/ Cost, Insurance, Freight  buyer assumes CIF
o Ex-Ship  seller transfers the title after the goods are unloaded

Consignment
o Consignment is a method of marketing goods in which the owner
called the consignor transfers physical possession of the goods to an
agent called the consignee who sells them in the owner’s behalf.
o Freight and Handling from supplier to consignor  INCLUDED
o Freight and Handling from consignor to consignee  INCLUDED
o Freight and Handling from consignee to customer  EXPENSED

Periodic and Perpetual Inventory System

o Periodic Inventory System  calls for the physical counting of goods
on hand at the end of accounting period to determine quantities.
 Low value
 High volume
 Updated only when FS are prepared
o Perpetual Inventory System  requires the maintenance of records
called stock cards that usually offer a running summary of the
inventory inflow and outflow.
 High value  Always Updated
  Low volume
 With stock cards

Periodic Perpetual
1. Purchase of Merchandise
Purchases xx Inventory xx
A/P xx A/P xx
2. Payment of Freight
Freight In xx Inventory xx
Cash xx Cash xx
3. Discount, Return and Allow
A/P xx A/P xx
Purch Disc/Ret. & Allow xx Inventory xx
4. Sale of Merchandise
A/R xx A/R xx
Sales xx Sales xx
COGS xx
Inventory xx
5. Return of Merch Sold
Sales Return xx Inventory xx
A/R xx A/R xx
6. Inventory at Year end
Inventory, end NO ENTRY unless there is
Income Summary shortage or overage

Inventory Cost Flow

 Subsequent COST of Inventories has two methods:
1. FIFO
2. AVERAGE

A. FIFO (First In, First Out)

 This method assumes that “the goods first purchased are first sold”
and consequently the goods remaining in the inventory at the end of
the period are those most recently purchased.
 Subsequent COST of Inventories has two methods:
3. FIFO
4. AVERAGE
 FIFO-Perpetual

Purchase Sales Balance

Date Units UC Total Units UC Total Units UC Total
28 100 5 500 100 5 500
29 350 10 3500 100 5 500
350 10 3500
30 100 5 500
150 10 1500 200 10 2000
31 100 15 1500 200 10 2000
100 15 1500
Ending Inventory 300 3500

 FIFO-Periodic

Units Unit Cost Total Cost

From Jan. 29 200 10 2000
purchase
From Jan. 31 100 15 1500
purchase
Ending Inventory 3500

NOTE:
o During INFLATION, the company has lower COGS
therefore higher NET INCOME if FIFO method is used.
 o During DEFLATION, the company has higher COGS
therefore lower NET INCOME.

B. Weighted Average Method

 This method allows the company to mingle the cost of similar items
purchased and use weighted averages to measure inventories held,
either on a periodic basis or as each the shipment is received.

 Weighted Average  Periodic

Units Unit Cost Total Cost

Jan. 28 100 5 500
Jan. 29 350 10 3500
Jan. 31 100 15 1500
TGAS 550 5500

Weighted Average Unit Cost = 5500 / 550

= 10
Inventory, end = 300 * 10
Inventory, end = 3000

 Moving Average  Perpetual

Purchase Sales Balance

Date Units UC Total Units UC Total Units UC Total
28 100 5 500 100 5 500
29 350 10 3500 450 8.89 4000
30 250 8.89 2223 200 8.89 1,777
31 100 15 1500 300 10.92 3277

Relative Sales Type Method

 This method is used to apportion the cost of commodities purchased at a
lump sum using their respective sales price.

 Illustration:
Products Browny, Blackie and Muning are purchased at a basket price
of 3,000,000. Assume that the said beauty products have the following
sales price.
Browny  500,000
Blackie  1,500,000
Muning  3,000,000
Compute for the inventory cost of each product.

Sales Price Fraction Allocated Cost

Browny 500,000 5/50 300,000
Blackie 1,500,000 15/50 900,000
Muning 3,000,000 30/50 1,800,000
Total 5,000,000 3,000,000

Purchase Commitments
 Purchase Commitments  are obligations of the entity to acquire certain
goods sometime in the future at a fixed price and fixed quantity.
 Cancelable commitments are NOT part of purchase commitments.
 RULE: You can only recognize GAIN up to the amount of the previously
recognized LOSS.
 LCNRV is used in recording the PURCHASES.
 Illustration 1:
 ABC Company entered into a commitment to purchased 100,000
barrels of aviation fuel from XYZ Company.
Price
November 15: Contract Date 500,000
December 31: End of the period 500,000
January 15: Purchase Date 500,000

Journal Entries:
2020
November 15 NO ENTRY
December 31 NO ENTRY
2021
January 15 Purchases 500,000
A/P 500,000
 Illustration 2:
ABC Company entered into a commitment to purchased 100,000
barrels of aviation fuel from XYZ Company.
Price
November 15: Contract Date 500,000
December 31: End of the period 450,000
January 15: Purchase Date 420,000

Journal Entries:
2020
November 15 NO ENTRY
December 31 Loss on purch commit 50,000
2021 Est. Liab 50,000
January 15 Purchases 420,000
Estimated Liab 50,000
Loss on Purch commit 30,000
A/P 500,000

 Illustration 3:
ABC Company entered into a commitment to purchased 100,000
barrels of aviation fuel from XYZ Company.
Price
November 15: Contract Date 500,000
December 31: End of the period 450,000
January 15: Purchase Date 480,000

Journal Entries:
2020
November 15 NO ENTRY
December 31 Loss on purch commit 50,000
2021 Est. Liab 50,000
January 15 Purchases 480,000
Estimated Liab 50,000
Gain on purch commit 30,000
A/P 500,000
 Illustration 4:
ABC Company entered into a commitment to purchased 100,000
barrels of aviation fuel from XYZ Company.
Price
November 15: Contract Date 500,000
December 31: End of the period 450,000
January 15: Purchase Date 510,000

Journal Entries:
2020
November 15 NO ENTRY
 December 31 Loss on purch commit 50,000
2021 Est. Liab 50,000
January 15 Purchases 500,000
Estimated Liab 50,000
Gain on purch commit 50,000
A/P 500,000
Inventory Estimation
 Reasons as to why it is allowed to estimate inventory
1. The inventory is destroyed by fire and other catastrophe, or theft of
the merchandise has occurred and the amount of inventory is required
for insurance purposes.
Total Goods Available for Sale xxx
Less: COGS (xxx)
Ending Inventory, estimated xxx
Less: Salvage (xxx)
Consignment out (xxx)
Goods in Transit (xxx)
Other inventory not destroyed (xxx)
Fire/Theft Loss xxx

2. A physical count of goods on hand is made and it is necessary to prove

the correctness or reasonableness of such count by making an
estimate.
Total Goods Available for Sale xxx
Less: COGS (xxx)
Ending Inventory, estimated xxx
Ending Inventory, actual (xxx)
Variance xxx

3. Interim financial statements are prepared and a physical count of the

goods on hand is not necessary either because it may take time to do
the same or because only an estimate thereof is required to fairly
present the financial position and performance of the entity.
Total Goods Available for Sale xxx
Less: COGS (xxx)
Ending Inventory, estimated xxx

 Two Approaches:
A. Gross Profit Method  based on the assumption that the rate of
gross profit remains approximately the same from period to period
therefore the ratio of cost of goods sold to net sales is relatively
constant from period to period.

Formula:

Based on Sales Based on Cost

Net Sales* 100% 140%
Cost of Goods Sold 60% 100%
Gross Profit 40% 40%
*Net Sales = Sales – Sales Returns

Total Goods Available for Sale xxx

COGS (xxx)
Ending Inventory xxx

B. Retail Inventory Method

TGAS xxx
Net Sales (xxx)
Inventory, end @ retail xxx
 Cost Ratio xx%
Inventory, end @ cost xxx

Treatment of Items:

Cost Retail
Beginning Inventory xxx xxx
Purchases xxx xxx
Purchase Return (xxx) (xxx)
Purchase Allowance (xxx)
Purchase Discount (xxx)
Freight In xxx
Departmental Transfer In/Debit xxx xxx
Departmental Transit Out/Credit (xxx) (xxx)
Abnormal Wastes (xxx) (xxx)
Mark-up (Additional) xxx
Mark-up Cancellation (xxx)
Markdown (xxx)
Markdown Cancellation xxx
TGAS xxx xxx

Net Sales
Sales xxx
Sales Return (xxx)
Employee Discount xxx
Normal Losses xxx
Net Sales xxx

Cost Ratio = TGAS @ cost/ TGAS @ retail

Methods in Computing Cost Ratio

Beg. Inv Mark-ups Markdown

1. FIFO   
2. Average   
3. Conservative   

Note:
o Any items that affect inventory should be deducted or
added to the cost and retail.
o If it doesn’t affect inventory but is necessary in
computing the cost, therefore it should be ONLY included
in the computation of cost.
o If the problem is silent about purchase return and
allowances, it is presumed to be all purchase return.