378 Chapter7 Chapter 7 Inventories Related standard: PAS 2 Inventories Learning Objectives 1. Define inventory and identify the timing of its recognition, 2. Differentiate between the periodic and the perpetual inventory systems. 3. Measure inventories and apply the cost formulas. 4. Account for inventory write-down and the 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. Ordinary course of business refers to the necessary, normal or usual business activities of an entity. Scanned with CamScanner379 Inventories 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: Goods in transit Consigned goods Inventory financing agreements Sale with unusual right of return Sale on trial or sale on approval Installment sale Bill and hold sale Lay away sale PNAYUswne Soods in transit ane ds in transit pertain to goods already shipped by the seller but may ve yet received by the buyer. The lack of physical possession Pose a question on who owns the goods in transit. Scanned with CamScanner380 Chapter oo 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 1. FOB shipping point or 2. FOB destination. FOB stands for “free on board.” > Under 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. > Under 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. Goods in transit If the sale term is FOB SHIPPING POINT, ‘ownership over the goods is transferred here, ie., the point of shipment. If the sale termis FOB DESTINATION, ownership over the goods is transferred here, ie., the destination =F Seller delivers goods to carrier for shipment to the buyer. Scanned with CamScannerEe. pyventories 381 dpe sale contracts may also contain terms for shipping costs indicated by any of the following: — 3, 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. £. 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 “sage. 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 traction, Freight prepaid” because the owner of the goods in "sit is also the one who pays for the freight charges. Scanned with CamScanner382 Chapter 7 Special accounting arises when the term of the sale contract is either “FOB shipping point, Freight prepaid” or “FOR destination, Freight collect.” a. Under FOB shipping point, freight prepaid, the buyer owns the goods being shipped but the seller already paid the shipping costs. b. Under FOB destination, freight collect, the seller owns the goods being shipped but the carrier will be collecting the shipping costs from the buyer. Illustration: Goods in transit ABC Co. purchased goods with invoice price of P1,000 on account on December 27, 20x1. The related shipping costs amounted to P10. The seller shipped the goods on December 31, 20x1. ABC Co. received the goods on January 2, 20x2 and settled the account on January 5, 20x2. The pertinent entries in the books of ABC Co. under the different terms of purchase are as follows: a. FOB shipping point, freight collect Dec. 31, | Purchases. 1,000 20x1 Accounts payable 1,000 to record purchases on account Jan. 2, | Freight-in 10 20x2 Cash 10 to record the payment of freight to the carrier Jan. 5, | Accounts payable 1,000 20x2 Cash 1,000 to record the settlement of accounts payable The buyer records the P10 freight cost (as “Freight-it”) because the buyer is the one who is supposed to pay for the freight. Under FOB shipping point, the buyer owns the goods in transit. Therefore, the buyer bears the cost of transportation. “Freight-in” i8 included as cost of the inventories purchased. Scanned with CamScannerB 3 centories 383 p. FOB destination, freight prepaid rc. 31, 7 ra No entry 7 Jan. 2, Purchases 1,000 20x2 Accounts payable 1,000 to record purchases on account Jan. 5, Accounts payable 1,000 20x2 Cash 1,000 to record the settlement of accounts payable The buyer does not record the P10 freight cost because the seller is the one who is supposed to pay for the freight. Under FOB destination, the seller owns the goods in transit. Therefore, the seller bears the cost of transportation. c.FOB shipping point, freight prepaid 8 Dec. 31, | Purchases 1,000 20x1 | Freight-in 10 ‘Accounts payable 1,010 to record purchases on account and freight- in reimbursable to the seller Jan, 2, 2 20x2 No entry . Jan. 5, | Accounts payable 1,010 20x2 Cash 1,010 to record the settlement of account payable inclusive of reimbursement for freight The buyer records the: P10 freight cost as “Freight-in” ie the buyer is the one who is supposed to pay for the pet However, since the seller already paid the freight (ie., L8H prepaid), the freight-in is recorded as an increase in cee payable.” This is because the buyer shall reimburse the ®t for the freight. A “reimbursement payable” account may be in lieu of “accounts payable” most especially when the Bht cost is material. ’ Scanned with CamScanner384 Chapter d, FOB destination, freight collect me No entry Jan.2, | Purchases 1,000 20x2 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, | Accounts payable 990 20x2 Cash 990 to record settlement of account payable net of freight paid on behalf of the seller The buyer does not recognize freight-in for the freight he had paid (i.e., Freight collect) because the seller is the one who is supposed to pay for the shipping cost (i.e, FOB destination). Accordingly, the buyer treats the freight cost as a reduction to the amount that will be remitted to the seller. The freight does not affect the cost of inventory. Notice that the accounting for goods in transit by the buyer is exactly the same as that of the seller. See discussions in Chapter 4. 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. Scanned with CamScanner385 Freight and other incidental costs of transferring consigned ods to the consignee form part of the cost of the consigned ods. Repair costs for damages during shipment and storage and 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. \ other 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, 20x1: 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-tiansit purchased FOB Shipping Point 2,100,000 Freight incurred under “freight prepaid” for the é 800ds purchased under FOB Shipping Point 60,000 ods held on consignment from XYZ, Inc. 1,800,000 Reoy a rement How much is the total inventory on December 31, Solution: Scanned with CamScanner386 Chapter 7 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 incurred under "freight prepaid” for the goods purchased under FOB Shipping Point ___ 60,000 Total inventory on December 31, 20x1 19,560,000 & Notes: ?- ABC Co. will include the goods in-transit purchased under FOB Destination in its inventory only when it receives them. * The goods held on consignment belong to XYZ (ie, the consignor). Therefore, they are excluded from ABC Co.'s inventory. Illustration 2: Consigned goods ABC Co. consigned goods costing P10,000 to XYZ, Inc. Transportation costs of delivering the goods to XYZ totaled 2,000. 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 + 2,000 freight) Illustration 3: Correct inventory and accounts payable On December 31, 20x1, 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 10,000, shipped FOB shipping point from a vendor on December 30, 20x1, was received an recorded on January 5, 20x2. 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 Scanned with CamScannergnventories 387 _tyventors 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, 20x2. Goods in the shipping area were included in inventory because shipment was not made until January 4, 20x2. The goods, billed to the customer FOB shipping point on December 30, 20x1, had a cost of 20,000. d. Goods shipped F.O.B. destination on December 27, 20x1, from a vendor to ABC Co. were received on January 6, 20x2. The invoice cost of 30,000 was recorded.on December 31, 20x1 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, 20x1. Solutions: Accounts Inventory payable Unadjusted balances 160,000 100,000 a. Purchase on FOB shipping pt. 10,000 10,000 b. Unshipped goods not counted 50,000 - c. Unshipped goods counted fe - d. FOB destination improperly included 0,000) (30,000) Adjusted balances 190,000 80,000 * Notes: 3 ABC Co. owns the goods in transit purchased under FOB shipping point. Thus, the cost of the goods is included in both Inventory and accounts payable. The goods marked “Hold for shipping instructions” are not yet shipped to the buyer as of December 31, 20x1, i.e., they Were shipped only on January 3, 20x2. Therefore, ABC Co. still Owns the inventory. No adjustment is made to accounts Scanned with CamScanner388 Chapter? payable because the transaction relates to a sale transaction and not a purchase transaction. c. The goods are properly included in inventory because shipment is not yet made as of December 31, 20x1. The Boods were shipped only on January 4, 20x2. d. ABC Co. does not own the goods in transit purchased under FOB destination. Thus, they must be excluded from both inventory and accounts payable. 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. ™ arrangement results to transfer of control over the eae Accordingly, the borrower includes the loaned goods in * inventory. Scanned with CamScannerInventories: 389 - gale 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: 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. a. 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 “ntil itis transferred to the customer at a future date. Scanned with CamScanner390 Chapter 7 The goods are excluded from the seller's inventory and included in the buyer's inventory upon billing, provided: 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, a. 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. (2 Remember the following: ___Type ofarrangement in the inventory of 1. FOB shipping point > ~ 2. FOB destination > 3. Consigned goods > Consignor 4. Inventory financing > Borrower 5. Sale with unusual right of return > Buyer, except when unsalable 6. Sale on trial (or approval) > Seller 7. Billand 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 retained by ABC Co. until full Scanned with CamScanner391 ayment is made. XYZ, Inc. took possession of the goods. 750,000 Goods sold to Alpha Co., for which ABC Co. has signed an agreement to repurchase the goods sold 680,000 at a set price that covers all costs related to the inventory. Goods sold where large returns are predictable. 270,000 d. Goods received from Beta Co. for which an agreement was signed requiring ABC Co. to replace such goods in the near future. 580,000 Requirement: How much is included as part of ABC Co.’s inventory? Answer: 1,260,000 (680,000 + 580,000) * Notes: a. The installment sale is considered a regular sale. Thus, the inventory is excluded from ABC Co.’s (seller) inventory. b. There is no sale because significant risks of ownership are not transferred, i.e, ABC Co. retains obligation to repurchase the g00ds. Thus, the inventory is included in ABC Co,’s inventory, © There is sale because future returns can be estimated reliably, Thus, the goods are excluded for ABC Co's (seller) inventory. 4. The goods borrowed are included in ABC Co’s (borrower) inventory, See previous discussion on “loan of inventory.” Mlustration 2: Bill and hold and Lay away a following are among the transactions of ABC Co. during the ar: ‘ Putchased 800ds costing P10,000 from XYZ, Inc. Billing was ceived although delivery was delayed per request of ABC Co, fe © 800ds purchased were segregated and ready for delivery ‘ te demand aeased Sods costing P25,000 from Alpha Corp. on a lay ¥ sale agreement. The goods were not yet delivered until Scanned with CamScanner392 Chapter after ABC makes the final payment on the purchase price. ABC Co. made total payments of P10 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 Tevenue. 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 © performing a physical count of inventories. Physical count is Scanned with CamScannerInventories 393 erformed only as an internal control to determine the accuracy of Jance per records. All increases and decreases in inventory, such as urchases, 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 yalued, such as cars, machineries, furniture and heavy equipment. the bal 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 . Pxx Add: Net purchases “ bie MK Total Goods Available for Sale (xx) Less: Ending inventory (physical count) (xx) Cost of Goods Sold Pxx Scanned with CamScanner| Chapter 7 ete ©) “Net purchases” is computed as follows: Purchases Pxx Add: Freight-in Xx Less: Purchase returns (xx) Less: Purchase discounts —) Net purchases Pxx 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 Scanned with CamScannernventories 395 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 1 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 § Notes: * 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. v Under the perpetual inventory system, the balances of 'nventory on hand and cost of goods sold are readily determinable from the ledger. See T-accounts below: Scanned with CamScanner396 Chapter 7 beg. bal. (1) Purchases 10,000 2,000 (3) Purchase return (2) Freight-in 1,000 5,000 (4) Cost of goods sold (5) Sales return 200 4,200 end. bal. (4) Cost of goods sold (5) Sales return 4,800 __ end. Bal. > 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 Pos Purchases (1) 10,000 Freight-in (2) 1,000 Purchase returns (3) : (2,000) Purchase discounts : Net purchases 9,000 Total goods available for sale 9,000 Ending inventory (105 units x P40 per unit) (4,200) 4,800 Cost of goods sold —— | Scanned with CamScanner: - pg variation Shortages/Overages en an entity uses a perpetual inventory system and a difference xists between the perpetual inventory balance and the physical invertOrY count, there is inventory shortage or overage. ‘Assume in the illustration above that the physical count revealed a balance of 4,000. The inventory shortage is determined as follows: Balance per count 4,000 Balance per records 4,200 Difference - shortage (200) The adjusting entry under perpetual system is as follows: Date | Loss on inventory shortage 200 (or Inventory shortage or overage) Inventory 200 Inventory shortage is charged to cost of goods sold if it is considered normal spoilage, (c.g., shrinkage and breakages within a tolerable limit set by management). If considered abnormal spoilage, the shortage is charged as loss, e.g., theft, pilferage, and loss on casualty. Note that an entity using the periodic inventory system does not report the account Inventory shortage/overage. The reason is that the periodic method does not have accounting records against which to compare the physical count. As a result, the entity subsumes inventory overages and shortages in cost of 800ds sold. { Summary: > Perpetual system Periodic system All increases and decreases | 7 Increases and decreases in Minventory are recorded in inventory during the period are recorded in the “purchases,” “freight-in,” “purchase returns,” and “purchase discounts” the “Inventory” account. Scanned with CamScanner Ls398 _ Chapter er re | accounts, as aj * “Cost of goods sold” is debited | * “Cost of goods sold” is not when inventory is sold and recorded. credited for sales returns. Physical count is performed | * Physical count is necessary to only to check the accuracy of determine the balances of the ledger balances. inventory on hand and cost of goods sold. ‘ Does not require the use of | * Requires the use of the any formula to determine following formula when cost of goods sold because this determining cost of goods sold: information is readily available from the ledger. BI ’ Net purchases Xx TGAS xx EI (physical count) (xx) cocs xx Inventory errors under the periodic system Under the periodic system, cost of goods sold is a residual amount. Thus, it is affected by errors in ending inventory as well as beginning inventory and net purchases. When cost of goods sold is misstated, so is the profit for the period. The following relationship between accounts can provide guidance in determining the effects of inventory errors on profit or loss under a periodic system. Ending inventory: Profit - Direct relationship Ending inventory and Profit or loss have a direct relationship. Direct relationship means that if ending inventory is understated, profit is also understated. Other relationships between inventory accounts may be derived from the relationship shown above as follows: * Beginning inventory & Purchases : Profit - Inverse relationship Scanned with CamScannerending inventory : Cost of goods sold - Inverse relationship peginning inventory & Purchases : Cost of goods sold - Direct relationship + Inverse relationship means that if an account (e.g., ending inventory) is understated, the related account (e.g,, cost of goods sold) is overstated. Illustration: ‘Assume that ending inventory is understated by P5,000. Using the above relationships, the effects of the understatement on profit and cost of goods sold are shown below. Should be Erroneous Inventory, beg. 10,000 10,000 Net purchases 100,000 100,000, Total goods avail. for sale 110,000 110,000 Understated by Inventory, end. (20,000) 15,000) “P5,000 overstated by Cost of goods sold 90,000 95,000 (P5,000) ec Net sales 220,000 220,000 Cost of goods sold (90,000) (95,000) tated by Gross profit 130,000 125,000 ue o If a contra-purchases account (i.e, purchase returns and discounts) is misstated, its effect would be the reverse of the effect of the related purchases account. For example, if purchase returns 'Sunderstated, the effect on profit is also understatement, a direct telationship - the reverse of the effect of purchases on profit, which 'Sinverse relationship. its If an adjunct-purchases account (i.e., freight-in) is misstated, x &ffect would be the same as the effect of the related purchases “ount. For example, if freight-in is understated, the effect on Profit is overstatement, - the same as the effect of purchases on ke. Which is inverse relationship. Scanned with CamScannerErrors in purchases account (and contra and aadjun accounts) affect only cost of goods sold and profit. They do wot affect ending inventory. This is because ending inventory is determined independently through physical count. The above-mentioned relationships are not applicable under a perpetual inventory system because cost of goods sold under perpetual inventory is determined independently of the physical count of ending inventory. 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 i" converting raw materials into finished goods. Conversion costs include direct labor and production overhead costs. c. Other costs necessary in bringing the inventories t their present location and condition. The following are excluded from the cost of inventor and are expensed in the Period in which they are incurred: Scanned with CamScannerens Abnormal amounts of wasted materials, labor or other production costs; Gelling costs, &8, advertising and promotion costs and delivery expense or freight out; 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 payer, 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 2130,000 Requirement: How much is the cost of i :H chase of ao pur the imported Answer: "swer: £117,000 excluding VAT (100K + 10K + 5K + 2K). 1 Th < entry to record the purchase is as follows: Dat me | Inventory 117,000 Input VAT 13,000 Cash 130,000 | ae Scanned with CamScanner402 Chapter? If the purchaser is not a VAT payer, the VAT paid forms part of the cost of inventory. For a non-VAT business, any VAT paid is non-refundable/non-recoverable. Trade discounts and Cash discounts > 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. > 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 The two accounting methods for cash discounts are (a) Gross method and (b) Net method. - a. 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. b. 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 a" established price to encourage prompt payment. That is, the seller offers sales on account at a slightly higher price than * selling for cash. The cash discount offered offsets the int. Thus, customers who Pay within the discount period actu® y Scanned with CamScannerurchase 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. + Notes: © The “20%” and “10%” pertain to trade discounts which are deducted from the list price when determining the invoice price. * The “2/10” means that the buyer is entitled to a 2% discount off the invoice price if he pays within the discount period of 10 days. After 10 days, the cash discount expires. * The “n/30” means that the buyer is given a credit period of up to 30 days to settle his account. Failure to pay within 30 days tenders the account as past due. Penalty may be charged on Past due accounts or credit may not be extended to the buyer in the future. Scanned with CamScanner404 Chapter Net method Purchases 7,056" A counts payable 7,200 Accounts payable 7,056 *(P10,000 x 80% x 90%) (10,000 x 80% x 90% x 98%) Trade discounts are deducted from ‘Trade discounts and cash the list price to determine the invoice | discount are deducted from the price gross of cash discounts, list price to determine the invoice price net of cash discounts. 80% = 100% minus 20% trade discount 90% = 100% minus 10% trade discount 98% = 100% minus 2% cash discount 2. Assume payment is made within discount period Accounts payable 7,200 Accounts payable 7,056 Purchase discounts 144 Cash 7,056 (7,200 x 2%) 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 equipmen t 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. Scanned with CamScannerInventories 405 =) Variable production overheads are indirect costs of roduction 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 duction, 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 Mventories, __ Variable costing is a costing method in which only mie production overhead is included in cost of inventories. ‘xed production overhead is expensed immediately. _ PAS 2 requires the use of absorption costing. Variable Sosting is used only for internal reporting purposes. Scanned with CamScannereve Chapter 7 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 jot 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. Asa 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 co inventory only if it is incurred on borrowings taken to finance the acquisition or production of inventory that meets the definition a qualifying asset. A qualifying asset is an asset that necessarily takes a substantial period of time to get ready for its intended 4° or sale. All other interests are charged as expenses. st of Scanned with CamScannerInventories 407 peferred 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, 20x1 ABC Co. acquired goods for sale in the ordinary course of business for P100,000, including 5,000 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, 20x1. In acquiring the goods, transport charges of P2,000 were paid on January 1, 20x1. 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 (e.g., Value added tax) (__5,000) Purchase price excluding refundable purchase taxes 95,000 Multiply by: PV of P1 @10%, n=l (or simply divide by 110%) _0.90909 Cash price equivalent of inventory purchased Transport costs (Freight-in) Initial cost of inventories Cost of agricultural produce harvested from biological assets nventories 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. is Will be the deemed cost for subsequent measurement at the wer of cost and net realizable value using PAS 2. Scanned with CamScanner408 Chapter 7 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 Priceper Total price Allocated _group __ lots lot __perlot group Allocation _costs a b c=axb A 4 400,000 1,600,000 1.2M x (1.6/6) 320,000 z 10 200,000 +~——2,000,000 1.2Mx (2/6) 400,000 15 160,000 __2,400,000_1.2Mx (2.4/6) __ 480,000. 6,000,000 1,200,000. The fractions used in the allocation of costs are derived from the sales prices per lot group. The unit cost per lot in a group may also be computed a6 follows: Scanned with CamScannerInventories 409 Lot group Allocated costs No. of lots Cost per lot a b c=azb A 320,000 4 80,000 B 400,000 10 40,000 c 480,000 15 32,000 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 tepresents 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. Scanned with CamScanner410 Chapter 7 4A iter 2. First-In, First-Out (FIFO) — Under this formula, it is assumeg that inventories that were purchased or produced first are sold first, and therefore unsold inventories at the end of the Periog are those most recently purchased or produced. Accordingly, cost of sales represents costs from earlier purchases while the cost of ending inventory represents cost, 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 1-Aug 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 Scanned with CamScannerInventories 411 21 Purchase 4,800 38.00 182,400 2 Sales 3,800 29 Purchase 1,900 38.60 73,340 30 Purchase return 300 38.60 (11,580) Total goods available for sale £427,760 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 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 ‘ventory in units is allocated as follows: Scanned with CamScanner412 Chapter7 units Unit Total cost cost Ending inventory to be allocated 4,000 Allocated as follows: From Aug. 29 net purchases (1,900 - 300) (1,600) P38.60 P 61,760 Bal. to be allocated to the next most 2,400 recent purchase date From Aug. 21 purchase (2,400) 38.00 91,200 Ending inventory at cost S P152,960 Cost of goods sold is then computed as follows: Total goods available for sale in pesos (given) 427,760 Ending inventory at cost (152,960) Cost of goods sold 274,800 2. FIFO - perpetual Date Transaction Units Unit cost Total cost 1-Aug _ Inventory 2,000 736.00 —~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 (72,000) from Aug. 7 purchase (1,600) 37.20 (59,520) 21 Purchase 4800 _38.00__—:182,400 22 Sales 3,800 Allocation: from Aug. 7 purchase (1,400) 37.20 (52,080) from Aug. 21 purchase (2,400) 38.00 _(91,200) 29 Net purchases (1900-300) 1,600 __38.60___ 61,760 Ending inventory at cost Cost of goods sold is derived from the table above as follows (72,000 + 59,520 + 52,080 + 91,200) = 274,800 Scanned with CamScanner